Investment banks and broker-dealers · RiskAtoms Academy

By the end you will be able to

1Describe the four core businesses of an investment bank: underwriting, trading, market making and advisory.
2Explain how a market maker earns the bid-ask spread, and why the inventory it holds is risky.
3Work out what underwriters earn from a new issue, and what they risk.
4Tell a broker (agent) from a dealer (principal).

Why it matters

When you tap “buy” in a trading app, someone sells to you within a second. When a company lists on a stock exchange, it raises billions in a day. In both cases, an investment bank or broker-dealer is usually standing in the middle.

Core explanation

The firms that make markets work

A commercial bank (L1.2.01) earns most of its money by lending. An investment bank earns most of its money in the securities markets: helping companies and governments raise money, advising them, and trading shares, bonds and derivatives. Some are standalone firms; many sit inside large universal banks that also take deposits.

Broker or dealer? A broker acts for a client, like an estate agent: it finds the other side of the trade and charges a commission, but never owns what is sold. A dealer trades for itself, like a second-hand car dealer: it buys, holds and resells. In the US a firm registered to do both is called a broker-dealer. The difference matters because a dealer puts its own money at risk.

Four businesses.

Advisory

Fees for advice

Advising a company on buying another firm, selling a division, defending a takeover or restructuring its debts. Paid largely on success. Needs skilled people, not much capital.

Underwriting

Fees for raising money

Bringing new shares (equity capital markets) or bonds (debt capital markets) to investors. The banks keep a cut of the money raised, the gross spread.

Market making

The bid-ask spread

Quoting a price to buy and a price to sell, all day, so clients can trade at once. The bank earns the gap but must hold whatever it has not yet sold.

Brokerage and trading services

Commissions and financing

Executing clients' orders, plus prime brokerage for hedge funds: lending them cash and securities and settling their trades.

Market making in plain words. A market maker is like a currency booth at an airport. It buys euros from you at one price and sells them to the next traveller at a slightly higher price. The gap is the bid-ask spread. On a busy day the small gaps add up. The danger comes when buyers and sellers do not balance: the booth ends the day holding a pile of one currency (its inventory), and if that currency falls overnight, the loss can be larger than all the spread it earned.

Underwriting in plain words. In a firm-commitment deal, the banks agree to buy the whole issue from the company at a set price and resell it to investors. The company gets certainty; the banks take the risk that investors pay less. In a best-efforts deal the banks only promise to try, so the company keeps the risk. The banks gauge demand first through bookbuilding.

ExploreThe life of a share listing (IPO)

Click a box to see what happens there.

Mandate

The company picks a group of banks, the syndicate, led by one or more bookrunners. They agree the fee and whether the deal is firm commitment or best efforts.

Sort itWhich business line is it?

A bank is paid a success fee when its client completes a takeover.
A bank buys a government's new 10-year bond issue and sells it on to pension funds.
A dealer quotes 99.50 bid, 99.55 offered on a corporate bond all day.
A firm executes an investor's order on an exchange for a commission, never owning the shares.
A bank lends cash and shares to a hedge fund and settles its trades.

Where the risks sit. Market making and underwriting create market risk: the value of inventory can fall. Trading with clients creates counterparty risk: the client may not pay. Investment banks also fund much of their inventory with short-term secured borrowing (repo, L1.6.04), so they face liquidity risk if lenders stop rolling it over. That is what brought down Bear Stearns and Lehman Brothers in 2008.

The formal version

Both money-makers fit on a line or two. These build on the arithmetic of L1.2.01, so here they are derived step by step without animation.

Market maker's day. Start from the two sources of profit, then fill each in:

\text{Profit} = \text{spread income} + \text{inventory gain or loss}

\text{spread income} = (\text{ask} - \text{bid}) \times \text{shares bought and resold}

\text{inventory gain or loss} = \text{shares held} \times \text{change in price}

Shares held is negative if the dealer is short, so a short position gains when the price falls.

Underwriting. With $N$ shares sold at offer price $P$ and a gross spread $s$ :

\text{Banks pay the issuer } N \times P \times (1 - s), \qquad \text{banks earn } N \times P \times s

Try it

You make a market in a $50 share. At the start you earn a 2-cent spread on 400 matched trades of 1,000 shares: $8,000. But you end the day holding 20,000 shares, and the price falls $0.50 overnight: −$10,000. A fall of just $0.40 would have wiped out the day's spread. Try closing the inventory to zero, or going short.

Try itA day on the market-making desk

Bid-ask spread2¢

Matched trades of 1,000 shares400

Shares left at the close20,000 long

Overnight price move−$0.50

Bid $49.990 · Ask $50.010

Spread income$8,000

Inventory−$10,000

Day's profit−$2,000

Where the day's profit came fromBars to the right are gains, to the left losses.

Worked example

Underwriting a US$1 billion listing

A made-up company lists 40 million shares at $25 each on a US exchange. The banks underwrite on a firm-commitment basis with a gross spread of 6%. Amounts are in US dollars.

Following the money

Step 1 of 5

1
Money raised from investors
40m × $25 = $1,000m

Conventions

Gross spreads differ by deal: they tend to be higher for smaller listings and much lower for bond issues. The figures here are round numbers for illustration.

Regulatory lens

United States. Broker-dealers register with the Securities and Exchange Commission (SEC) and join FINRA, the industry's self-regulatory body. The SEC's net capital rule makes them hold liquid capital, and its customer protection rule keeps clients' assets separate from the firm's own. The Volcker rule limits banks that take insured deposits from trading purely for their own profit.
European Union. MiFID II sets conduct rules for investment firms and trading venues. The Investment Firms Regulation and Directive (IFR/IFD) set their capital; the very largest are treated as banks and, in the euro area, supervised by the European Central Bank.
United Kingdom. The FCA supervises conduct; the PRA supervises the largest firms for safety. Large UK banks must ring-fence retail deposit-taking from investment banking.
Asia-Pacific. Japan's Financial Services Agency, Hong Kong's Securities and Futures Commission and the Monetary Authority of Singapore license and supervise securities firms.

Looking ahead: the capital banks hold against trading positions (the Basel market risk framework, known as FRTB) and against client counterparties return in later levels.

Sparks

SparkTwo investment banks that became banks overnight

In September 2008, a week after Lehman Brothers failed, Goldman Sachs and Morgan Stanley became bank holding companies. That gave them access to the Federal Reserve's lending, in exchange for Fed supervision. The era of large standalone US investment banks ended that weekend.

SparkWhy it is called a greenshoe

The over-allotment option is nicknamed after the Green Shoe Manufacturing Company, the first issuer to grant one to its underwriters. Bankers on every continent now say “greenshoe” for a stabilisation tool named after a shoe maker.

Key takeaways

Investment banks earn money in securities markets: advisory, underwriting, market making and brokerage.
A broker acts as agent for a fee; a dealer trades as principal and carries the risk.
Market makers earn the bid-ask spread but carry inventory risk that can outweigh it.
In a firm-commitment deal the banks buy the issue and keep the gross spread, taking the risk that investors pay less.
Broker-dealers face market, counterparty and funding liquidity risk, and are regulated for capital and conduct.

Reaction

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Glossary

Broker: A firm that buys and sells for a client, as the client's agent, and earns a commission.
Dealer: A firm that buys and sells for its own account, as principal, holding the securities itself.
Market maker: A dealer that stands ready to quote both a price to buy (bid) and a price to sell (ask) in a security, all day.
Bid-ask spread: The gap between the ask price and the bid price. It is the market maker's reward for providing liquidity.
Inventory: The securities a dealer holds on its own books at any moment. Their price can move against it.
Underwriting: Helping an issuer sell new shares or bonds, often by agreeing to buy the whole issue and resell it to investors.
Gross spread: The share of an issue's offer price that the underwriting banks keep as their fee.
Bookbuilding: Collecting investors' orders before pricing a new issue, to find the price that will sell it.
Greenshoe: An option that lets underwriters sell up to 15% more shares than planned, used to steady the price after listing.
Advisory: Fee-earning advice on mergers, acquisitions, sales and restructurings.
Prime brokerage: A bundle of services for hedge funds: lending cash and securities, holding assets and settling trades.

Deep Dives & Origins

Deep Dives

Saunders and Cornett, Financial Institutions Management: A Risk Management Approach (McGraw-Hill), the chapter on investment banks and securities firms. Beginner.
Harris, Trading and Exchanges: Market Microstructure for Practitioners, Oxford University Press, 2003, the chapters on dealers and bid-ask spreads. Intermediate.

Origins

Ellis, Michaely and O'Hara, “When the Underwriter Is the Market Maker: An Examination of Trading in the IPO Aftermarket”, Journal of Finance 55(3), 2000.
Chen and Ritter, “The Seven Percent Solution”, Journal of Finance 55(3), 2000.
US Securities and Exchange Commission, Rule 15c3-1 (net capital) and Rule 15c3-3 (customer protection).
Regulation (EU) 2019/2033 (IFR) and Directive (EU) 2019/2034 (IFD); Directive 2014/65/EU (MiFID II).
Board of Governors of the Federal Reserve System, press releases of 21 September 2008.

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