Set the main business lines of dealer banks side by side, noting the risk factors each line carries.
The idea
A dealer bank earns its living by standing between clients and markets, and each business line carries a different dominant risk. Market making earns the bid-ask spread and carries inventory risk, the chance that prices fall or buyers vanish while the dealer holds bonds. OTC derivatives dealing adds counterparty credit exposure, margin and collateral demands, and rating triggers. Matched-book repo and securities financing runs on thin spreads and exposes the dealer to rollover and haircut risk when client loans are funded with shorter-term repo. Prime brokerage bundles financing, custody and clearing for hedge funds, so it carries client credit risk and run risk, because clients can pull cash balances and the dealer may have rehypothecated their collateral. Underwriting leaves the dealer holding unsold securities. Proprietary trading is pure market risk. Exam point: dealers fail through funding and counterparty channels faster than through trading losses alone.
A practice question
A dealer bank borrows cash from a money market fund against Treasury collateral and, at the same time, lends cash to a hedge fund against the same Treasuries. Which risk is most characteristic of this matched-book financing business?
- Underwriting pipeline risk from holding unsold new issues between commitment and distribution to investorsWhy not: Confuses matched-book repo with underwriting; no new securities are being distributed.
- Rollover and haircut risk, since short-term borrowing funds longer-dated loans to clients - correct
- Large directional market risk on the Treasuries themselvesWhy not: The collateral passes through the dealer and the cash legs offset, so there is little outright price exposure.
- Model risk from valuing exotic derivativesWhy not: Repo on Treasuries involves no exotic valuation; this mixes up financing with structured derivatives dealing.
In a matched book the dealer earns a thin spread and its main vulnerability is funding: short-term lenders can stop rolling or demand larger haircuts while the loans to clients stay in place.
A harder one
How does the risk profile of OTC derivatives dealing differ from that of market making in cash bonds?
- Derivatives dealing adds counterparty credit exposure and margin needs lasting the life of each contract; cash bond market making is mainly inventory risk - correct
- Cash bond market making carries counterparty exposure for years, whereas derivatives are settled immediately and leave only market riskWhy not: Reverses the two businesses: it is derivatives that stay open and create long-lived exposure.
- The two carry the same risks because both lines are hedged by the dealer, so the business models are interchangeableWhy not: Hedging does not make the risk profiles identical; the derivative book keeps credit and collateral risk.
- Derivatives dealing has no market risk at all because every trade with a client is offset by an identical trade elsewhereWhy not: Offsets are never perfect and the residual basis and gap risk is still market risk.
A derivative stays on the books until maturity, so the dealer faces credit exposure to the counterparty and ongoing variation and initial margin flows. A cash bond trade settles within days, leaving inventory risk.
The hardest tier
A dealer finances a hedge fund position. It lends cash to the fund against a bond with market value USD 4,000 million at a 2% haircut and, to fund itself, repos the same bond to a money market fund at a 5% haircut. The money market fund then raises its haircut to 10%. Ignoring any change in bond price, the dealer's unsecured funding requirement for this position becomes:
- USD 200 millionWhy not: Gives only the increase in the requirement (from 120 to 320), not the new total requirement.
- USD 400 millionWhy not: Applies the full 10% haircut and forgets that the dealer already gave its client a 2% haircut; (10% - 2%) x 4,000 is the gap.
- USD 120 millionWhy not: Uses the gap before the haircut shock: (5% - 2%) x 4,000.
- USD 320 million - correct
The dealer lends 98% x 4,000 = 3,920 and borrows 90% x 4,000 = 3,600 after the shock, so it must fund 320 itself. Before the shock the gap was 3,920 - 3,800 = 120, so the haircut increase added 200.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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