What Is a Trading Book?
Let me explain what a trading book is: it's the portfolio of financial instruments that a brokerage or bank holds. You see, these instruments are bought or sold for various reasons, such as facilitating trades for customers, profiting from the spreads between bid and ask prices, or hedging against different risks.
These trading books can vary greatly in size, from hundreds of thousands of dollars up to tens of billions, depending on how large the institution is.
Key Takeaways
You should know that trading books act as accounting ledgers containing records of all a bank's tradeable financial assets. They are directly affected by gains and losses, which impact the financial institution. Moreover, losses in these books can cascade and affect the global economy, much like what happened in the 2008 financial crisis.
Understanding a Trading Book
Most institutions use advanced risk metrics to manage and reduce risks in their trading books. Think of the trading book as an accounting ledger that tracks the securities the institution holds, which are regularly bought and sold. It also keeps a record of trading history, making it easy to review past activities with those securities.
This is different from a banking book, where securities are held until maturity. In the trading book, they're not meant for long-term holding. Remember, securities in a trading book must be eligible for active trading.
Gains and losses occur as the prices of these securities fluctuate. Since the institution holds them, not individual investors, these changes directly affect the institution's financial health.
Impact and Examples of Trading Book Losses
The trading book can lead to massive losses for a financial institution. These losses often come from the high leverage used to build the book or from concentrated bets on specific securities or sectors by rogue traders.
Such losses can have a global, cascading effect when they hit multiple institutions simultaneously. Examples include the Long-Term Capital Management collapse, the 1998 Russian debt crisis, and the 2008 Lehman Brothers bankruptcy. The 2008 global credit crunch was largely due to hundreds of billions in losses from mortgage-backed securities in trading books.
During that crisis, banks used Value at Risk models to quantify risks and shifted risks from banking books to trading books because VaR values were lower. Attempts to hide these losses led to criminal charges, like against a former Credit Suisse vice president. In 2014, Citigroup bought Credit Suisse's commodity trading books amid regulatory pressure to reduce commodities involvement.
What Is Included in the Trading Book?
All of a financial institution's tradeable assets are listed in the trading book.
What Is the Difference Between a Bank Book and a Trading Book?
The trading book holds assets for short-term trading, while the bank book contains assets meant to earn interest over the long term.
What Are the Benefits of a Trading Book?
A trading book serves as a legal document that can be used as evidence in court and as a tool for planning future trades.
The Bottom Line
In summary, a trading book is an accounting ledger that a brokerage or financial institution uses to track its portfolio of all tradeable assets. Depending on the institution's size, these can involve billions in investments.
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