Investment Banking For Dummies - Matthew Krantz

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to individual investors. Buy-side analysts, though, also use sell-side research to bolster their own insights about potential investments.

      How an analyst’s research can make money for investors

      Investment bankers, looking to sell shares of a security they’re pitching for a client raising money, will often seek out buy-side analysts to stoke demand. The buy-side analysts are the ones who decide whether the risk of a particular investment is worthwhile given the potential returns. There are massive potential conflicts of interest here, because there’s the danger that the buy-side analysts at an investment bank may issue positive reports on IPOs sold by that investment bank. For that reason, sell-side analysts at investment banks that did an IPO must wait 40 days before issuing a research report on that company.

      What do the analysts do?

      Sell-side analysts are billed as industry experts who follow companies closely and provide insights. These professionals typically build financial models that tell them how much a stock is worth and what investors should be willing to pay. These financial models aren’t made with plastic parts and model glue; instead, they’re made from spreadsheets and quantitative analysis.

      What recommendations are and why they are important

      Typically, sell-side analysts provide a recommendation on a stock, on whether investors should buy, sell, or hold the shares. Most sell-side analysts also put a price target on the shares, putting their best guess on what the shares may be worth a year from now. Some sell-side analysts also do channel checks from time to time. In channel checks, the analysts find out how much demand for products there is by examining orders from end-users and customers.

      How the sell side interacts with the buy side

      Sell-side analysts are also often given the role of providing buy-side analysts access to the management teams of a company. Most large investment banks put on conferences or presentations that allow potential investors to hear CEOs of companies talk about the prospects of their firms.

      How sell-side analysts make money for the investment bank

      Research continues to be one area in which making money can be somewhat problematic. With the money-raising functions of investment baking, the ways investment banks generate fees is pretty straightforward. A company pays the investment bank a charge for handling an IPO, for instance.

      Getting paid for research is a bit more elusive, though. There are some instances where buy-side investors pay an investment bank to access the research from its sell-side research team. But more often than not, research is paid for in less direct methods.

      One of the most common ways that investment banking operations are paid for research is through trading commissions. Sell-side analysts try to pitch investment ideas to buy-side analysts. Instead of paying for the research reports, the buy-side analysts may instead place trades for the investment through the investment bank’s trading desk. By trading through the investment bank’s trading desk, the buy-side analyst’s firm pays a trading commission, which acts as payment for the research services.

      Most major investment banks maintain trading desks. These trading desks are responsible for buying and selling securities. The trading operations of investment banks are typically involved in buying and selling everything from stock to bonds, futures contracts (contracts that allow buyers to take delivery of an asset at a certain time in the future at a preset price), commodities (claims on real assets ranging from energy to agricultural products), and foreign exchange contracts.

      

The trading desk of an investment bank often sits at the epicenter of its operations. On one hand, the investment bank is tasked with selling securities to help raise money for clients; on the other hand, it’s in charge of helping to find buyers. The buyers and sellers often intersect at the trading operations.

      Why investment banks are into trading

      Investment banks’ trading operations are designed to serve several purposes. At the source, the trading operations are made to handle the demands of customers of the firm who need to purchase or unload large amounts of stock or other investments.

      The trading desks of investment banks can assist customers, including pension plans and mutual funds, to build large positions in a financial asset or unload it.

      Many investment banks get involved in trading to generate money from a variety of sources, including the following:

       Trading financing: Many investment banking operations lend lines of credit to other financial institutions, usually on a short-term basis. These loans can be used by the investment bank’s clients who want to place trades.

       Trade facilitation: Companies that use big investment banks usually aren’t buying or selling 100 shares of a stock. Hundreds of thousands of shares may be bought or sold by these mega players. There are so many moving parts that having an investment bank can help in the transactions, including offering insurance services where a client can be protected if there’s an unforeseen drop in portfolio values. Investment banking operations often serve the role of market maker (a position where they buy and sell securities). As a market maker, investment banks stand ready to buy or sell lots of stock just to make sure there’s adequate trading in a security.

       Creating securities to be traded: Investment banks are routinely cooking up new securities, typically those that have value based on other investment like stocks, for investors to trade. These invented securities are called derivatives, because they derive their value based on another asset.

      How investment banks turn pennies into billions

      Next time you log onto your online brokerage account to buy a stock, don’t think there’s a human on the other end selling to you. More likely than not, you’re buying the stock from a computer that trades in and out of stocks millions of times a day.

      Wall Street has been taken over by an army of computers that buy and sell stocks as easily as you may shoot down aliens in a video game. Some sources estimate that 70 percent or more of the trading on the major stock market exchanges is being done by computer programs. These programs, often referred to as algorithmic trading, program trading, or automated trading, are a big area of interest for many investment banking operations.

      Computerized trading can be used for a number of reasons, including the following:

       Serving needs of clients: Sometimes computers are employed to serve the customers of investment banks, helping them sell large positions of stock. Selling for big customers takes a bit of finesse — if all the stock is dumped at one time, the stock price can be pushed lower and cause the seller to reduce his or her own proceeds. Investment bankers have systems in place to help them sell more gradually to avoid these problems.

       Part of market-making responsibilities: Computerized trading may also be part of investment banks’ role as market makers. Investment banks certainly trade to try to make a profit, looking for chances to buy and sell stocks for a gain. But in some cases investment banks can also serve a secondary role. When making a market,

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