Deck 13: Investment Banks, Securities Firms, Dark Pools, and High Frequency Trading

Question 1

Discuss the major roles of investment banks and securities firms and different types.

Answer 1

Investment Banks and Securities firms are often part of the same financial holding company, whereby investment banks finance major capital financing for corporations, launching initial public offerings (IPOs), secondary offerings, negotiating private placements, and assisting in mergers and acquisitions, and other more wholesale level services. Security firms perform services related to investment management, portfolio management, risk management, brokerage and dealer services, and trading of derivatives. Today securities firms, commercial banks, investment banks, and private banks often operate under one umbrella.
A number of different types of securities firms include:
(1) National full-line firms offer both investment banking and corporate advisory services and trading activities for customers and for the firm itself as principal transactions, along with retail brokerage services and advice including Bank of America Merrill Lynch, UBS, among many others. National full line firms often receive the largest percentage of their revenues from brokerage commissions on securities firms as well as from the net interest spread (interest revenues from loans to customers less interest cost to borrow). Customers are loaned securities that are in the firm's name for short selling and provided with margin credit. National full-line firms also have a large number of employees with a national branch network, and financial advisers often receive fee income from customers for financial planning advice.
(2) Large often global wholesale investment banks usually focus on wholesale (corporate) underwriting and advisory services, underwriting and distributing common stock and corporate and municipal debt, arranging private placements, acting as advisors in mergers and acquisitions, and providing other corporate services including for instance Goldman Sachs in New York and Credit Suisse First Boston in Boston.
(3) Regional securities firms are based in a particular region, such as A.G. Edwards, Inc. and Morgan Keegan, Inc., and primarily provide brokerage service to clients in their region. These firms are often also involved in some regional investment banking activity, such as underwriting the stock or debt of select firms in their region and providing institutional investor and other services depending on the particular nature of the firm.
(4) Global regional securities firms focus on particular regions of the world. Examples include Piper Jaffray, Raymond James, SunTrust Robinson Humphrey, Wells Fargo & Co. in the U.S., and RBC Capital Markets, Scotiabank, and TD Securities in Canada, HSBC Holdings PLC, RBS, Credit Agricole, BNP Paribas, ABN AMRO, among many others.
(5) Discount securities and online trading are firms that trade for customers at low cost, without offering investment advice, such as E-Trade or subsidiaries of large firms such as TD-Ameritrade, or lower cost trading and advice, and Charles Schwab, which is also a full service brokerage firm.
(6) Online platform investment banking firms such as WRHAMBRECHT+CO discussed earlier use a Dutch Auction platform, and other FinTech firms
have rapidly evolved in recent years for investments and securities trading.
(7) Boutique Investment Banks focus on particular industries or types of
underwriting. Examples include Miller, Buckfire & Co that focuses on restructuring, Montgomery & Co. that is Media and Internet and Technology focused, Berkery, Noyes & Co that is financial services focused.
With the growth of mega financial and bank holding companies many of these categories have become blurred, with many investment banks and securities operating under the umbrella of larger bank and financial holding companies.

Question 2

Provide an overview of key areas of activities for securities firms.

Answer 2

Key areas of activity for securities firms include the following:
(1) Investment banking underwriting fees and gross spread (difference between the price paid for securities from a corporation and the offering price securities are sold for to the public) for debt and equity securities, private placements, management fees, M&A, restructuring, advisory services, among others.
(2) Principal transactions involving trading and investments; for trading this involves making securities, foreign exchange, or commodity trades that are profitable for the firm. For investing it means managing an investment portfolio to reap returns for the firm itself. Principal transactions also include revenues from mortgage-backed securities, swaps, derivatives, hedging strategies, among others.
(3) Selling and dealing activities and trading for customers as an agent involve marketing and distributing securities and receiving commission income, making trades for customers in foreign exchange, commodities, bonds, or other instruments, and margin lending to customers.
(4) Investing activities as an agent involves managing mutual funds and pension funds or portfolios for wealthy investors, receiving fee income for this activity.
(5) Back office activities include clearing and escrow services, research services, and advisory services, and M&A advice.
(6) Other types of activities, such as merchant banking in which the securities firm takes an equity financing position in a merger or leveraged buyout, venture capital and private equity subsidiary activities, and real estate subsidiary activities, among others. Investment banks have entered many other new areas as well including banking services, as part of a bank holding company or financial holding company or having a bank subsidiary.

Question 3

Discuss dark pools and high speed trading, and regulatory actions against dark pool trading.

Answer 3

Dramatic changes in market structure and trading technologies include new trading venues that include dark pools, electronic trading platforms, and high speed trading, and the development in the U.S. of a national market system.
Dark pools opened up in Europe about 2008, resulting in many European investors trading in dark pools, estimated to be about 8 percent of total books trades by ITG Europe, an operator of a dark pool, with Bats Chi-X-Europe, a pan European exchange increasing its market share to 24 percent in early 2016 from 21 percent in 2014, with gains made in Spain and Germany. Advantages for asset managers and pension funds are that venues, such as. Liquidnet, match trades in private, whereby prices aren't displayed until after deal completion, permitting asset managers to make large block trades off exchange to avoid the risk of prices going against the seller to the buyer, but frustrating regulators with much publicity making asset managers aware that through dark pools trading games often are played at their expense.
Dark pools are used to facilitate block trading by institutional investors who wish to hide their trades to avoid large impacts in financial markets of large orders that could adversely affect their trades. Michael Lewis's Flash Boys: A Wall Street Revolt discusses these along with high frequency trading used to both hide and speed up trades. The net result of this non-transparent trading can be disruption of markets and lower costs for the traders involved at the expense of other traders and small investors.
Regulators have taken actions against institutional investors for engaging in dark
pools that limit market transparency, and in legal actions won $150 million from Credit Suisse and Barclays for oversight failures and/or misleading consumers with respect to their dark pools operations including Crossfinder, one of two dark pools for Credit Suisse, and Barclay's LX dark pool, and fine for ITG and UBS as well for oversight failures. Despite this, dark pools continue to operate and grow, such as Credit Suisse's Crossfinder, a popular pool, and Liquidnet Europe, a block-trading venue, experiencing a record year in 2015. Dark pool trading in Europe rose by 45 percent for value traded and by 25 percent for volume traded in December of 2015 versus 2014. Data from the U.S. Financial Regulatory Authority reveals a similar 22 percent rise in the number of stocks traded in dark pools for 2015:Q3 versus 2014:Q3. European regulators plan the introduction of caps on the amount of trading that can be done in dark pools in an attempt to return trading to the exchanges. London Stock Exchange's Turquoise, Bats Chi-X Europe, and Deutsche Borse also provide discreet block trading services, with benefits of both exchanges and dark pools.

Question 4

Discuss electronic trading platforms and algorithmic trading.

Question 5

Why have regulators been concerned about automated trading?

Question 6

Discuss recent regulations affecting bank holding companies regarding proprietary trading, and investment advisers regarding their fiduciary role.

Question 7

Discuss different risks that must be managed for securities firms.

Question 8

Morgan Stanley and Goldman Sachs, previously operating as independent investment banks, converted to bank holding companies (BHC) in late September 2009 during the U.S. Subprime Loan Crisis. A primary reason for their conversion to a BHC includes which of the following:

A) As a bank holding company, the companies would have access to borrowing from the Fed's discount window as a source of liquidity.
B) As BHCs, they would be more closely regulated by the Federal Reserve.
C) As BHCs, they would have higher capital requirements.
D) All of the above.

Question 9

Which is the best definition of a dark pool?

A) A lagoon used for offshoring sensitive accounts.
B) A type of securitization that is backed by a deep pool of mortgage loans.
C) New trading venues that allow nontransparent trading where large investors are able to hide their trades.
D) None of the above.

Question 10

Which of the following is false about investment banking?

A) Reputation is very important in attracting and keeping clients.
B) Investment banks generally have higher financial leverage than commercial banks.
C) Investment banks deal with investing or facilitating investment and financing in different ways including taking firms public and assisting in seasoned offerings and providing research, advice, and expertise.
D) Investment banks in the U.S. are not allowed to operate in the same holding company as an insurance firm or commercial bank.

Question 11

Which of the following is often referred to as the category for securities firms that offer both investment banking and corporate advisory services and trading activities and retail brokerage services and advice?

A) Wholesale investment banks
B) National full-line firms
C) Discount securities and online trading firms
D) Online platform investment banking firms
E) Boutique investment banks

Question 12

Key activities for securities firms include which of the following:

A) Investment banking underwriting fees and gross spread
B) Principal transactions
C) Selling and dealing activities and trading for customers and wealth management services
D) Back office activities and other types of activities
E) All of the above

Question 13

In a summary of sources of expenses for investment bank and securities firms by FINRA of 4,679 member firms for 2010, which expense item was the largest typical % of expenses?

A) Interest Expense
B) Occupancy and Equipment Costs
C) Data Processing Costs
D) Total Compensation Expense
E) Other Expenses

Question 14

In a summary of sources of revenue for investment banks and securities firms by FINRA of 4,679 member firms for 2010, which revenue item was the largest typical % of revenues of the items listed below?

A) Trading gains
B) Commissions
C) Underwriting revenue
D) Asset management fees
E) Margin interest

Question 15

Securities firms typically on average have low ROA's and very high equity multipliers.

Question 16

Which of the following is true about the primary holders of total equities in the U.S.?

A) Institutional investors hold over 65% of total equities in the U.S.
B) Small retail investors holder over 65% of total equities in the U.S.
C) Banks hold over 65% of total equities in the U.S.
D) None of the above

Question 17

Institutional investors do not include which of the following:

A) Mutual funds
B) Hedge funds and private equity managed accounts
C) Micro finance companies
D) Insurance companies
E) Pension funds

Question 18

Regulators are concerned about dark pools for which of the following reasons:

A) Non-transparent trading
B) Disruption of markets
C) Lower costs for dark pool traders at the expense of other traders and small investors
D) All of the above

Question 19

Advantages of dark pool trading for asset managers and pension funds do not include which of the following:

A) Trades are made in private, with prices not displayed until after deal
Completion, permitting asset managers to make large block trades off exchange to avoid the risk of prices going against the seller to the buyer.
B) Trades are made quickly often with high frequency trading used to both hide and speed up trades.
C) Legal actions taken by regulators for large fines for large investment banks involved in dark pool trading.
D) None of the above.

Question 20

Which of the following is false about electronic trading platforms?

A) Millennial investors have increased their use of apps from investment
Companies that provide access to robo-computers to allocate funds to ETFs based on an individual's goals and target retirement date, with computers changing allocations as customers age or goals change.
B) Electronic trading platforms offer a massive disruption potential for
Wealth management advising.
C) Fees tend to be higher since computers are more expensive than hiring
Expert employees as advisers for managing portfolios.
D) All of the above are true.

Question 21

Which of the following is false about algorithmic trading?

A) Algorithmic trading is random trading to avoid investor biases.
B) Algorithmic trading on automated trading systems allows traders to set up specific rules for trades including simple rules or complex strategies that will be automatically executed by a computer.
C) Once rules are established, the computer monitors markets for buy or sell opportunities based on the specifications of the trading strategy, allowing for instantaneous order entry in fast moving markets.
D) Disadvantages include the potential for mechanical failures and over optimization with some trading systems doing fine on historical data but doing terribly in real markets.

Question 22

Today electronic trading represents greater than half of the overall trading volume for U.S. Treasuries.

Question 23

Which of the following is false about the Volcker Rule?

A) The Volcker Rule's purpose is to prevent banks from conducting certain investment activities with their own accounts, and limits their ownership of and relationship with hedge funds and private equity funds.
B) The Volcker Rule has the purpose of preventing banks from taking on certain types of speculative investments.
C) The Volcker Rule disallows short-term proprietary trading of securities, derivatives, commodity futures, and options for a bank's own accounts to be phased in based on the premise that these activities are risky and do not benefit a bank's customers.
D) Banks can no longer to continue to offer hedge funds and private equity funds, do market making, underwriting, hedging, trading of government securities, insurance company activities, or act as agents, brokers or custodian.
E) All of the above are true.

Question 24

Which of the following is false about the U.S. Department of Labor
Fiduciary Rule for Investment Advisors?

A) Under this rule, anyone providing investment advice on retirement accounts given in exchange for compensation must act in the interest of the client.
B) Under this rule, brokers are allowed to steer investors into in-house funds with higher fees than non-house funds.
C) The standard also applies to advisers acting as fiduciaries, going beyond just the disclosure of conflicts of interest.
D) All of the above are true.

Question 25

Risks that must be managed in security firms include which of the following:

A) Trading risk
B) Underwriting risk
C) Liquidity risk
D) Reputational risk
E) All of the above

Question 26

Security firms have significant liquidity risk to manage, since they purchase securities to be sold in the short-term for underwritings and in their capacity security dealers.

Question 27

To reduce risk for negotiated offerings, syndicates of securities are
formed to take on a portion of the selling of an offering and reduce selling risk for the lead underwriter.