6.1.1 Large Corporate Credit

The large corporate credit segment serves large corporations, often multinationals that have a presence in multiple jurisdictions. Large corporates are offered the same products as mid‐market companies, but in a bigger size. Large corporates in particular tend to engage in more derivative activities, therefore derivatives lines become more important.

Also, the loan documentation becomes more complex: a large corporation consists of a group of companies, and ultimately it is loan companies entering into agreements, not the corporations who themselves do not have a legal identity. It is therefore important to consider which group company is the actual borrower, which group companies guarantee it, whether there are specific assets that can be pledged, what kind of covenants—like limits on additional borrowing—should be attached to the loan, and which companies should those covenants relate to.

Because of size reasons, single banks are often reluctant or not able to deal with all the financing needs of large corporations who therefore have multiple banking relationships. In principle, corporations could enter into independent loan agreements with each of their banks, but this is impractical, and it can easily violate loan covenants. Instead, banks enter into syndicated loan agreements, where a syndicate of banks lends to the company on the basis of a single loan documentation. Syndicated loans are fungible, ie they are all treated equally in all respects, and they are tradeable, meaning banks can buy and sell them on the secondary market.

Also, large corporates often engage in derivatives business, and in order to do so they need derivatives lines. In the section on derivatives I discuss that in many cases derivatives transactions need to be subject to a margining agreement, meaning that whenever, because of market moves, the replacement value of a contract changes, the person whose side gained in value gets cash or other collateral from the side that lost, so that at any given point in time the replacement value of the derivative net of collateral held is zero for both sides. For corporates, there is often no margining agreement in place as their treasuries are not operationally set up to service them. So if a derivatives contract goes against a corporate, one could see that as the corporate ‘owing’ the margin payment to the counterparty, but being allowed to defer the payment until the maturity date of the derivative contract. In a nutshell, the right to defer margin payment until the maturity is a derivative credit line, and it is being ‘drawn’ whenever the value of the derivative moves against the corporate. Those lines have no explicit fees associated with them—they are priced into the cost of the derivative itself.

Large corporates can also issue bonds, ie loans in security format that are sold directly to the market; I will discuss bonds in the primary issuance section below.

6.1.2 Real Estate, Project and Other Asset Finance

Real estate and infrastructure projects like power stations, toll roads etc. offer very predictable returns and are therefore financed with debt. Lending in this space is known as real estate lending or infrastructure lending if it relates to the finished object, and as construction finance or project finance if it relates to the object being under construction.

The loans relating to the finished objects tend to be regular loans, except that they are non‐recourse, ie if a sponsor has borrowed against multiple objects, those are all financed independently, and financial distress in one of them does not lead to a claim on the other objects of the sponsor. This is an important feature because it allows the objects to be sold independently without having to rearrange the financing due to a change in risk structure. Real estate loans are also often balloon or even bullet loans because the maturity of the financing is shorter than the end of the economic life of the object, so refinancing is envisaged, but there is a refinancing risk.

When objects are not finished, loan agreements are more complex as the funds are being released subject to milestones being reached. In the event of major breaches the lender can step in, take over the object and arrange for it to either be finished or to be sold to another sponsor.

As in the retails space discussed previously, there are a number of different lending models here: loans can be extended by banks and they can hold those loans on balance sheet; or they can be originated by banks or by non‐bank originators and sold to financial investors, typically either a fund or fund‐like investment vehicle, or into a securitisation structure.

6.3.1 ECM, DCM, and Syndicated Loans

Equity capital markets are about selling equity securities, ie company shares. This includes initial public offerings (IPOs), when a company is listed on a stock exchange for the first time, and secondary offerings, where large blocks of additional shares are being sold in the market. Note that secondary offerings should not be confused with the secondary market which covers the transactions in already‐issued securities held by market participants. Another product in that space is the rights issue, where existing shareholders are given for free the right, but not the obligation, to purchase additional shares at a discount to where they are currently trading. The greater the discount, the more likely that those rights are taken up. Usually those rights are tradeable, which allows shareholders who don't want to or can't put up additional money not to lose the value associated with those rights, and which increases the uptake.

Debt capital markets are about selling debt securities. They are similar to ECM, but the services provided are more technical. For example, only a group holding company issues equity, but debt can be issued from any company in a group. Then there is the question of what the maturity of the debt should be, whether the coupon should be fixed or floating and at which level it should be set, what covenants should be included, if and where the debt security should be listed and so on. There is also the question of seniority: most debt is senior debt, ie high up in the pecking order of creditors in the event of default. There is also subordinated debt and mezzanine debt, which is lower in the pecking order, and therefore has a higher coupon.

Syndicated loan origination is, as far as the customers are concerned, very similar to DCM, even though it is usually in the corporate lending department as originators often retain some of the originated loans on their own balance sheet.

6.3.2 Securitisation

The key defining characteristics of securitisations is that they represent an asset pool, and the ownership of the asset pool is divided into horizontal tranches where losses are distributed in increasing order of seniority. The most senior tranche is akin to senior debt, the most junior one to equity, and the ones in‐between to various levels of subordinated or mezzanine debt.

I want to give a simple example of a three‐tranche securitisation: one equity tranche, one mezzanine tranche, and one senior tranche. Let's assume the overall pool is $100m, and the tranche sizes are $80m, $15m, and $5m respectively. When the assets in the pool repay, the first $80m goes to the senior tranche, the subsequent $15m to the mezzanine tranche, and everything else to the equity tranche. Or, to put it the other way around: the first $5m of losses are borne by the equity tranche, which also will benefit from all the gains made. The next $15m of losses are borne by the mezzanine tranche, and only if mezzanine and equity are fully wiped out, the senior tranche starts being eaten into. The expected return on those tranches will be commensurate to their risk, so the senior tranche will earn the risk‐free rate plus a small premium, the mezzanine tranche a few percentage points more, and the equity returns are typically in the 5–15% per annum range.

Depending on the underlying assets in the pool, securitisations are referred to by different names:

• the term ABS (asset‐backed security) is a generic term that is used for all type of securities mentioned below, and in particular for those that are based on asset classes not mentioned there (eg card ABS for credit card receivables)
• a CDO (collateralised debt obligation) is based on all kinds of debt, for example bonds or loans, usually investment grade; it is a generic term in this category
• a CLO (collateralised loan obligation) is based on loans, typically high‐risk leveraged loans that are related to private equity deals
• a CBO (collateralised bond obligation) is based on bonds, often high‐risk junk bonds, also related to private equity deals
• a REMIC (real estate mortgage investment conduit) is a term used in the US for securitisations based on real estate loans; in Europe the terms RMBS (retail mortgage‐backed security) for loans to individuals and CMBS (commercial mortgage‐backed security) for loans in relation to commercial real estate objects are more common.

The asset pools underlying securitisations can either be static, meaning asset proceeds are returned to investors as soon as the asset repays or is liquidated, or revolving, meaning asset repayments during the reinvestment period are reinvested into fresh assets. Even revolving deals turn static eventually after the reinvestment period is over.

Depending on the asset class, deals are either meant to finance the loan production of an originator—typically in the RMBS/CMBS/card space—in which case the originator usually retains the high‐risk/high‐return equity tranche, or they are meant to produce high returns for the investors in the equity tranche—typically for CLO/CBO—in which case the whole deal is managed by an asset manager who actively purchases the assets in the market.

6.4.1 Sales and Trading

The sales and trading segment covers the business of investment banks and broker dealers where they trade with customers, or among each other. At its base this is an intermediation business, and the dealers mostly take positions to facilitate client business. For example, if a client wants to sell an illiquid bond, chances are that no buyer can be found immediately, and a dealer taking it on its own books with a view to selling it later provides a service by offering liquidity to the market. In this case the dealer is often referred to as a market maker, ie a market participant who usually offers two‐way prices—bid and offer—at a reasonable spread (the difference between bid and offer) and in a reasonable volume.

At the other end of the spectrum there is the pure proprietary trading business where dealers go out into the market to actively purchase assets that they believe are undervalued. However, this latter is nowadays strongly discouraged by regulators, so dealing tends to happen more towards the client‐driven end of the spectrum. There are, however, non‐bank dealers that have somewhat stepped into that breach, notably high‐frequency trading (HFT) funds, who are willing to buy or sell depending on the flows they see on the various markets they cover.

One way to categorise the dealing activities is by legal format of the asset traded, notably:

• securities and syndicated loans
• foreign exchange
• derivatives and repo.

The first one deals with assets that are traded as standardised packages, and whilst in the era of electronic share certificates this is no longer really the case, it often helps to think of those assets as paper‐based share certificates that are physically traded. Foreign exchange, the second one, used to have the peculiarity that dealers would promise to exchange cash against cash. For example, a dealer selling GBP vs USD would make a GBP transfer into a UK bank account, and receive a USD transfer into a US bank account. More recently, however, a large majority of the forex trading is being cleared, and is therefore not much different from securities trading, other than that it is traded 24 hours a day out of the different financial centres around the world.

Derivatives are contracts to exchange cash flows based on the value of an underlying tradeable asset, like for example call options which correspond to the right, but not the obligation, of purchasing a specific asset at a specific price at a specific date in the future. Repurchase agreements (aka repos) are agreements to sell a security and purchase it back at a later date, or economically equivalent secured lending agreements. Both derivatives and repos are discussed in more detail below.

6.4.2 Brokerage

As opposed to dealers who can take positions for their own account, brokers only intermediate between counterparties. Brokers tend to be highly specialised both along customer and the product dimensions. Traditionally, the broking business used to be based on voice brokerages, where customers would phone in with their orders, or brokers would actively phone their customers with trading suggestions. For cost‐efficiency reasons, in the retail space this has now mostly moved to online brokerages, and in the wholesale space there are a number of dedicated electronic systems in place.

Retail brokerages mostly provide an interface for retail customers to deal on an exchange, or sometimes other trading venues. Whilst the most important type of securities covered here are equities, brokerages often allow the buying and selling of any type of security listed on the exchanges they cover, notably bonds and investment certificates. Most brokerages cover multiple exchanges, albeit often only exchanges in the country where they are based, meaning that only locally listed securities can be traded. Retail brokers usually offer a number of ancillary services, for example safekeeping and reporting, and sometimes financing.

In the wholesale markets, brokers not only serve to connect end‐customers with dealers, but there are also inter‐dealer brokers (IDBs) that connect dealers to each other. In some markets that are not covered by exchanges—for example the foreign exchange market—brokers run quasi‐exchanges for those asset classes, typically electronically. Also, more complex products, eg complex derivatives, are often intermediated through a broker rather than by dealing desks calling up each other directly. In the wholesale market, brokers provide few ancillary services—once the clients are introduced to each other those clients execute the deal directly between themselves.

I want to briefly mention prime brokerages here, which are not really brokerages, but rather a bundle of ancillary brokerage services—eg financing and reporting—offered by investment banks to hedge funds that transact with their dealing desks.

6.4.3 Exchanges

Exchanges are organised market places for securities or derivatives. Their role is to match buyers and sellers, up to the point where they agree on a transaction at a given price. There is no negotiation involved, and all derivatives contracts are standardised. Once a transaction is agreed, the involvement of the exchange is finished, and a clearing house takes over to ensure the trade is settled (see below).

Depending on the exchange and the security or derivative in question, there are a number of different ways how exchanges can organise the market‐place. The simplest way is continuous trading, where buyers and seller continuously submit their orders, and those orders are matched whenever a trade is possible. For example, a buyer might submit a limit order to buy at $101 or less, and a seller one to sell at $100 or more. Those orders can be matched, eg by splitting the difference and executing the transaction at $100.50. Both buyers and seller can leave market orders as well, which will be matched with the best available order on the other side. For illiquid securities, this can on occasion be very far away from where the person leaving the order expected it to be.

Continuous trading works best if the securities are highly liquid, so that there are at any given point in time sufficient sellers and buyers available. In particular, market orders are dangerous if there are not enough limit orders around to bracket the possible price range, as someone might just opportunistically jump in at a price very unfavourable for the person who had left the market order earlier. For less‐liquid securities, an alternative is periodic auctions, eg at the beginning and/or end of the business day. Those compress the daily liquidity into a much smaller time frame, leading to a more reliable price recovery, albeit at the expense of immediacy. Some exchanges also require market makers—privileged dealers on this exchange—to always quote two‐way prices in a reasonable volume, typically with an exception in times of market turbulence. This improves liquidity on the exchange, but dealers have to step in and take on the risk in the event of an imbalanced market. Given the tightening of capital requirements this business has become much less attractive to banks who used to be a major player in this area.

There is an interesting twist with derivatives exchanges. When trading bond futures—contracts to buy or sell bonds at a given point in the future—they are typically defined by the tenor of the bonds in question, eg ‘5 years’. However, for technical and legal reasons, the derivative contracts are defined by the bond maturity, eg ‘2022’. So after a year, a 5‐year contract becomes a 4‐year contract and so on. To constantly offer a 5‐year contract, periodically a new contract with the desired maturity date is offered on the exchange. In practice the front contract attracts by far the largest liquidity, and many investors roll their contracts, meaning that they at the same time take a position in the front future and cancel their previous one. Futures contracts are then often the basis for other derivatives contracts, for example calls that give the option to buy that future at a fixed strike, and puts that give the right to sell it.

The same dynamics happen on the commodity futures markets, where contracts are for forward delivery of, say, oil of a certain quality at a certain location. Those contracts almost always get closed out before the final maturity date, as few players want to deal with the actual physical delivery of the commodity.

Lastly, there are multilateral trading facilities (MTFs), which are similar to exchanges, but typically smaller in scope, and not universally accessible. Sometimes they have obtained certain waivers and are therefore not subject to the same reporting requirements, in which case they are usually referred to as dark pools. Specifically, on an exchange all trades are published with a very short delay. Dark pools can report with a more significant delay, allowing, for example, the wind‐down of large positions more easily. Broker/dealers, who run most of the dark pools, are subject to a best‐execution rule, implying that they can only route trades to the dark pool if it offers an execution better than the best price available for this volume on an exchange.

6.5.1 Clearing and Settlement

As discussed above, the purpose of exchanges and other trading facilities is to match buyers and sellers of securities or derivatives. An issue that arises is that the two sides of the deal don't know who their respective counterparty is before they commit to a deal, and they therefore cannot assess whether they trust their counterparty to deliver on their side of the bargain. To alleviate this issue, those trades are cleared in the associated clearing house, also referred to as central counterparty or CCP, that guarantees both parties' respective performance to each other.

6.5.2 Trade Repositories and Other Reporting Entities

Trade repositories are information service providers that collect trade information about all reportable derivatives trades—which includes all trades that are done on an exchange and/or cleared with a CCP—and make it publicly available in an aggregate format, and to the regulators with trade level granularity if requested. Fundamentally, this is not a complex task, but the data volume is tremendous, and the data is not always clean. In particular, currently every trade is reported twice, and data reconciliation is often a difficult and labour‐intensive task because of slight differences in the reported fields that need to be manually adjusted.

There are also a number of regulatorily‐required reporting services providers, notably approved publication arrangements (APAs), who publish trade reports on behalf of investment firms, approved reporting mechanisms (ARMs), who report details of transactions to regulators or ESMA on behalf of investment firms, and consolidated tape providers (CTPs), who collect trade reports from various venues and consolidate them into a continuous electronic live data stream.

6.5.3 Custodians and Registrars

Historically, securities were physical pieces of paper, and trading securities involved exchanging those pieces of paper against the agreed‐upon amount of cash. This, by the way, explains why settlement was, and for historical reasons often still is, a few days after the trade happened: the seller had to go back to his safe deposit box, retrieve the securities certificate and physically and safely transport it to the place of settlement.

This arrangement was rather cumbersome—and dangerous, because in transit papers could be stolen, destroyed, or lost—and markets developed a better solution: custody. Custodians can either offer individual safe deposit or collective safe deposit. In the former, the securities that belong to a given client are kept physically separated. In the latter, all securities belonging to the custodian's clients are kept in one big pile in the safe, and ownership is established using a ledger run by the custodian. The difference between the two deposit types becomes important if the custodian defaults and securities are missing, either because of operational issues at the custodian, or due to counterparty default when securities are lent to third parties.

When a security is traded and both counterparties are using the same custodian, changing ownership of the security is as easy as changing a ledger entry in the case of collective deposits, or moving a certificate from one package into another in the case of individual deposits. If the counterparties use different custodians it is up to the custodians to arrange for the handover of the certificates, which still is significantly more efficient and safer than having the counterparties arranging the exchange themselves, especially if the security is liquidly traded and only the net exchange of security certificates has to take place.

Most securities give the owner the right to recurrent payments, either dividends or coupons. Historically those were literally coupons that needed to be clipped off the corresponding certificate and that would allow whoever could present it to collect the payment. Again, custodians would usually take care of this, ie they would physically detach all the coupons and credit the owners' accounts with the cash they received. Finally, sometimes issuers need to get in touch with the owners of the securities they issued. They'd do that through the financial press, but, again, custodians would often also provide the service of notifying their customers of the events that concern them, for example annual shareholder meetings or rights issues.

Nowadays most shares are held electronically, meaning that there are no share certificates, but there is a central and authoritative ledger run by a registrar that contains the information regarding who owns how many of which securities. This ledger might either contain the name of the end customer who owns the security—that's the equivalent of an individual deposit—or it would contain the name of the custodian with whom the end customer has an account, which is the equivalent of a collective deposit. Issuers who want to contact their investors can in this case simply go through the registrar, who either notifies the investors directly, or notifies the custodian who in turn notifies the investors.

6.6.1 Investment Banking Advisory

Investment banking advisory is mostly about advising companies on mergers & acquisitions therefore this whole area is often referred to as M&A. However, this sells the business short, as the bankers in the advisory business tend to advise companies—and sometimes governments—on a wide range of finance‐related issues.

6.6.2 Broker Research and Ratings

Broker research, also referred to as sell‐side research, is research produced by investment banks or broker/dealers and provided to their clients. Traditionally research has been provided for free, with a general understanding that this would lead to increased deal flow. However, in some jurisdictions the possibility of doing this is being restricted, leading to a reduction in research resources within the banks and broker dealers, and an emergence of paid‐for research shops. The biggest research segment is equities research, where research analysts follow certain industry sectors, meet the companies, and in general opine on the fair valuation of the respective stocks. There is also credit research, that covers the bond issuance for the same companies. More generally, many trading operations will have some associated research staff. For example there are FX strategists for the fx markets, and structured finance analysts covering the structured finance markets. Also there are generally economists in the investment banks who provide a more high‐level economic research.

Rating agencies are similar to sell side analysts in that they opine on securities and issuers. The important difference is that ratings agencies only opine on fixed income products, ie bonds paying a coupon, not equities representing company ownership, and they express their opinion by assigning letter grades representing the credit quality of the respective security. The highest grade is triple‐A (AAA or Aaa, depending on the agency), and it goes down via AA/Aa, A/A, to BBB/Baa, which is the lowest so‐called investment grade rating. Below that are the sub‐investment grade ratings BB/Ba, B/B, CCC/Caa, CC/Ca, and C/C. There is also a D rating for securities that are in default. The three major rating segments are

• company debt ratings
• sovereign debt ratings
• structured finance (ABS) ratings.

Whilst they all use the same grading system, ratings in different segments are not easily comparable, ie ‘triple‐A rating’ has a very different meaning in the corporate, sovereign, and structured finance world.