A trading book is the portfolio of financial instruments held by a brokerage or bank. Financial instruments in a trading book are purchased or sold for several reasons, such as facilitating trading actions for customers, profiting from trading spreads between the bid and ask prices, and hedging against various forms of risk. Trading books can vary greatly in size, from hundreds of thousands of dollars to tens of billions, depending on the size of the institution.
Mastering the Fundamentals of a Trading Book
Most institutions employ sophisticated risk metrics to manage and mitigate risk within their trading books. Serving as a form of accounting ledger, trading books track the securities held by the institution that are regularly bought and sold. The trading book also records trading history, providing an easy way to review previous activities involving associated securities. This method contrasts with a banking book, where securities are intended to be held until maturity, while those in a trading book are meant for active trading.
Securities in a trading book must be eligible for active trading. Consequently, trading books are subject to gains and losses as the prices of the included securities fluctuate, directly impacting the financial health of the institution.
Key Insights
- Trading books are a type of accounting ledger that records all tradeable financial assets of a bank.
- Gains and losses in trading books affect the financial institution directly.
- Losses in a bank’s trading book can cascade, impacting the global economy, as seen during the 2008 financial crisis.
Understanding the Impact of Trading Book Losses
The trading book can be a source of massive losses within a financial institution. High degrees of leverage used to build the trading book and disproportionate, highly concentrated bets on specific securities or market sectors by rogue traders are two primary sources of such losses.
Trading book losses can trigger a global ripple effect, impacting numerous financial institutions simultaneously, as witnessed during crises like the Long-Term Capital Management (LTCM) Russian debt crisis of 1998 and Lehman Brothers’ bankruptcy in 2008. The global credit crunch and financial crisis of 2008 were significantly attributed to the hundreds of billions in losses sustained by global investment banks from mortgage-backed securities portfolios within their trading books.
During the 2008 financial crisis, Value at Risk (VaR) models quantified trading risks in trading books. Risk was shifted from banking books to trading books due to perceived low VaR values.
Attempts to obscure mortgage-backed security trading book losses during the crisis led to criminal charges, including those against a former vice president of Credit Suisse Group. The regulatory pressure eventually led Credit Suisse to sell its commodity trading books to Citigroup Inc. in 2014, demonstrating a strategic retreat from commodities investing.
Related Terms: banking book, leverage, value at risk, rogue traders, credit crunch.
References
- United States Department of Justice. “Former Credit Suisse Vice President Sentenced In Manhattan Federal Court In Connection With Scheme To Hide Losses In Mortgage-Backed Securities Trading Book”.
- Reuters. “Citi buys Credit Suisse commodities trading book”.
