What Is a Trading Book?
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. For example, they might be bought or sold to facilitate trading actions for customers or to profit from trading spreads between the bid and ask prices, or to hedge against different forms of risk. Trading books can range in size from hundreds of thousands of dollars to tens of billions depending on the size of the institution.
Basics of a Trading Book
Most institutions employ sophisticated risk metrics to manage and mitigate risk in their trading books. Trading books function as a form of accounting ledger by tracking the securities held by the institution that are regularly bought and sold. Additionally, trading history information is tracked within the trading book by creating a simple way to review the institution's previous activities of associated securities. This differs from a banking book as securities in a trading book are not intended to be held until maturity while the securities in the banking book are going to be held long-term.
Securities held in a trading book must be eligible for active trading.
Trading books are subject to gains and losses as prices of the included securities change. Since these securities are held by the financial institution, and not by individual investors, these gains and losses impact the financial health of the institution directly.
- Trading books are a form of accounting ledger that contains records of all tradeable financial assets of a bank.
- Trading books are subject to gains and losses that affect the financial institution directly.
- Losses in a bank's trading book can have a cascading effect on the global economy, such as those that occurred during the 2008 financial crisis.
Impact of Trading Book Losses
The trading book can be a source of massive losses within a financial institution. Losses arise due to the extremely high degrees of leverage employed by an institution to build the trading book. Another source of trading book losses is disproportionate and highly concentrated wagers on specific securities or market sectors by errant or rogue traders.
Trading book losses can have a cascading, global effect when they hit numerous financial institutions at the same time, such as during the Long-Term Capital Management, LTCM, Russian debt crisis of 1998, and the Lehman Brothers bankruptcy in 2008. The global credit crunch and financial crisis of 2008 was significantly attributable to the hundreds of billions of losses sustained by global investment banks in the mortgage-backed securities portfolios held within their trading books. During that crisis, Value at Risk (VaR) models were used to quantify trading risks in trading books. Banks transferred their risk from the banking book to trading books because VaR values are low.
Attempts to disguise mortgage-backed security trading book losses during the financial crisis ultimately resulted in criminal charges being brought against a former vice president of Credit Suisse Group. In 2014, Citigroup Inc. purchased the commodity trading books held by Credit Suisse. Credit Suisse participated in the sale in response to regulatory pressure and their intent to lower their involvement in commodities investing.