How Dealers Make Money

How Dealers Make Money

Three ways to profit

If you don't work as a dealer you probably see transactions or their results after they have been completed. Your role may be in operations, finance, risk, audit or compliance. You expect dealers to be profitable, after all isn't this what they are paid for?

You definitely know that they can lose money too! So how do dealers make profits and what are the implications for the business? There are three ways a dealer can make money:

Trading, taking advantage of bid-offer spreads;
Arbitrage, exploiting risk free opportunities;
Risk taking, sometimes called proprietary trading.

1. Trading

Trading is about taking advantage of bid and offer prices. It’s just like having a stall in the fruit market, a strange comparison maybe. But when a stall holder buys apples at 60p a kilo and sells them at 90p a kilo it’s trading. Financial markets are identical only the products differ. A bond dealer has a buying price and a selling price. Let’s suppose a quote was 95% - 96% for a particular bond. The dealer buys at 95% - and sells at 96%".The golden rule is buy low and sell high!

Let's see how much he makes when he deals in $10,000,000.

Two things affect how much money the dealer makes. First the volume or size of deals-the larger the trade the more profit:

The second is the difference between buying and selling prices, the wider this is the more the dealer makes.

The dealer has control over the buying and selling prices. If the dealer narrows the bid-offer spread he will encourage customers to deal with him because his prices will become more competitive. But every time he deals the profit from each individual transaction will be lower. The difference between the buying and the selling is critical. Too wide and nobody deals with him. Too narrow and he won't make money. What influences the bid-offer spread?

Competitive conditions. The more that dealers chase business the narrower the dealing spreads will become. Anything else? Yes, risk or at least the perception of risk.

If you were a dealer and you thought that the market could go violently up or down in price what would this do to your bid-offer spreads? You would widen your spreads. This would reduce the amount of money you could lose if markets went against you after you traded.

This is why when markets are volatile dealers widen spreads or even refuse to make prices.

It’s also surprisingly easy to lose money too. Suppose a dealer buys $10m of a bond at 95.00% and there are more sellers. Does he want to buy more at 95.00%? Probably not. So the bid price is adjusted downwards say to 94.50%. If customers keep selling the bid will go lower, say to 94.00%. At a bid price of 94.00% the offer price is 94.50%.The original bonds bought at 95.00% now show a loss. Dealers say “I've been long and wrong!".

2. Arbitrage

Arbitrage means buying something in one market and selling it in another market for a risk free profit. When a dealer does a trade with a customer and subsequently matches the deal with a further transaction this is not arbitrage. The two transactions are not simultaneous and prices could change leading to the risk of loss. So do risk free money making opportunities really exist?

In efficient markets where everyone has perfect information arbitrage opportunities should not exist. What would happen if they did? Dealers would exploit them and in so doing they would influence market prices and restore the equilibrium price. Does this mean arbitrage never occurs? No, mis-pricing can and does occur and arbitrage opportunities arise. In fact as a result of the credit crises arbitrage opportunities are more rather than less likely to arise because markets have become less efficient.

A simple example of arbitrage is the “cash and carry” trade. This involves buying a bond and simultaneously selling a bond futures contract.

On the expiry date of the futures contract the dealer delivers the bond into the futures contract.

At the start of the trade the dealer will know the purchase and sale price of the bond and also the interest income and expense. By making a few calculations on a spreadsheet a dealer can identify such arbitrage opportunities and take advantage of them.

Another example is futures-swap arbitrage. A swap has fixed and floating interest payments:

How is this linked to futures? The dealer receives Libor and pays a known fixed rate:

The dealer can now buy short term interest rate futures to hedge the forward Libor resets.

Sometimes the futures prices are not in line with the swap rate. In such cases the dealer can calculate the interest received and paid and lock in a profit. Is making money this easy? The trades can be quite complicated. Furthermore arbitrage opportunities are generally only available to professional dealers. This is because the profit margins are tiny and the trades need to be done in sufficient size to make them worthwhile.

Arbitrage is a legitimate way that dealers can make money. But the term can be abused. It is perhaps no coincidence that rogue traders including Leeson and Ruznak described their business as one of arbitrage. Perhaps it was an attempt to disguise the truth. Maybe that's something to remember?

3. Risk taking

This is also known as proprietary trading or speculation. When a dealer expects prices to rise he buys in anticipation of a capital gain.

When prices are expected to fall the dealer goes short. That means selling something you don’t own and then buying it back at a lower price to pocket a profit. This sounds complicated but it isn’t. Futures or forwards allow you to sell now and deliver later and therefore facilitate “shorting”.

Of course if dealers are allowed to speculate there needs to be proper control over what they do. That’s why there are limits on the amount and type of risk that can be taken.

The Board determine the risk appetite for the firm. This is then translated into rules or limits for the dealer. It is then approved for use by the Board or delegated committee.

Appropriate limits should significantly reduce the probability of a loss exceeding the risk appetite of the firm. If the firm decides it does not wish to put capital at risk dealers should not be taking proprietary risk.

Do you know how your firm makes money?

This may sound like a trivial question. But it is at the heart of good management. Working out where the money is made is not the easiest thing to do. That’s because dealers often do a mixture of things. Sometimes they trade, sometimes they arbitrage and sometimes they speculate. And of course every dealer would like to think that it’s the skill used in speculation that makes all the money and we know in many cases this is only part of the story.

The serious point is that if you don’t know how the money is made how do you know the risks that you face?

Working out how you make money can be difficult because dealers do a mixture of things.

First Published by Barbican Consulting Limited 2009