Treasury and Financial Markets

Money Market, Fixed Income and Bonds, Foreign Exchange, Equities, Commodities

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The Balance Sheets of commercial banks are usually not completely homogeneous - based on the character of their business, banks always have a certain imbalance in the maturities of their assets and liabilities, their products have different interest rate profiles, banks use different currencies, etc. For the bank to be able to cope with these problems, it has to have access to financial markets. Trades with instruments of the financial market in the bank's name are usually conducted by the Treasury department.

Roles of the Treasury

The main role of the Treasury in the bank is to realize trades on financial markets. Even though this seems simple at first glance, it is necessary to take into account several facts for a complete and correct understanding of the function of the Treasury:

• Financial markets are composed of multiple parts, which are more or less related. On the financial market, trading is done with a huge multitude of various products - from basic simple instruments (so-called “plain vanilla” instruments) to complex derivatives. When trading on the financial market, a bank can have multiple intentions, for example:
  • An effort to lower market risk (hedging)
  • An effort to immediately eliminate new risk positions (so-called “back-to-back” operations)
  • The opening of new risk positions (trading or proprietary trading)
  • Fulfilling regulative measures (for example required minimum reserves)
• The bank can have various counterparties on the financial market, for example other commercial banks, other financial institutions (for example insurance companies, funds, etc.), central banks, as well as firms or physical individuals.

Due to this, Treasury departments of banks can have multiple subordinated sections, depending on the size and type of the bank. These are known as “desks”. Based on the Treasury department, we usually distinguish the following parts:

• Trading Desk - conducts operations on the bank’s own account, usually with other banks
• Customer Desk - realizes financial market trades with the bank’s clients

Depending on the size of the bank and its intentions, Trading Desk and Customer Desk (also known as Treasury Sales Desk or Corporate Desk) can be divided into additional components, based on the part of the financial market in which they operate (for example FX Desk, Money Market Desk, Derivative Desk etc.).

The larger the banks and its effect on the financial market, the larger the Treasury Department and therefore also the more accurate the division into individual “desks”. On relevant parts of the financial markets, the largest banks usually ensure continuous provision of product prices (so-called quotations) for the other, smaller, participants. They are therefore the market makers. Other smaller participants are market users.

The main roles of the Trading Desk in a Standard Commercial Bank are the following:

• Performing financial market trades in the name of the bank, mainly in order to manage risk positions. In a common bank, these are mainly meant to be interest, liquidity and FX positions.
• Managing the required minimum reserves prescribed by the regulator. The required minimum reserves are a regulator prescribed average cash remainder in the balancing account of the bank in the central bank.
• Upholding prescribed limits (on positions, dealers, etc. - details about these limits can be found in the “Risk Management” chapter)
• With the consent of the bank management, performing trades on the financial market with the goal of creating profit and thus ensuring a certain revenue from trading. This type of trading is often labeled “speculation” on the financial market. Speculation deals are strictly limited through regulation (and by type of bank) and are more suitable for investment banks than common commercial banks.

The main roles of the Customer Desk in a standard commercial bank are the following:

• Realizing products on the financial market with the bank’s clients in the name of the banks, mainly with larger corporate clients and financial institutions.
• Providing consulting service to select bank clients, usually in partnership with retail, private and corporate banking. This consulting service is usually geared towards identification of the market risk of a bank’s client and an offer for the competent securing (hedging) of clients. 
• Realizing internal trades of the bank with other bank departments, mainly with retail, private and corporate banking. The bank also sets the minimum and maximum level of financial transactions, which these departments are required to realize through internal trades with the Customer desk. The price of this kind of agreed upon internal trade is the set as individual internal FTP.

Financial Markets

From ancient history, it is known that the first trading with agro-products supposedly occurred, according to some historians, as far back as 4000 years before the Common Era.  Written references to trading with commodities are found in the 10th century. The history of the creation of more modern financial markets reaches from the 12th - 13th century – information about trading with state obligations comes from the region that is now Italy and Benelux. Later, in the 18th century, stock exchange transactions began to develop in London and America, the most important exchange NYSE (New York Stock Exchange) also developed in the late 18th century. Trading with commodities and precious metals, shares, money and FX rates and various derivatives developed further and meant several other significant milestones. However, the largest boom of financial markets and derivatives occurred at the turn of the millennium and grew until the financial crisis after the bankruptcy of the investment bank Lehman Brothers in the year 2008.

On current financial markets, a huge amount of transactions and products are traded daily. It is expedient to divide them for better orientation. The following can be considered basic parts of the financial market.

• Foreign Exchange, FX - market with foreign currency rates
• Money market - market with short-term interest rates
• Capital Market - market with securities. However, here it is important to distinguish between securities without maturity and long-term instruments with a defined maturity (for example bonds). With bonds, it is important to consider the related instruments and long-term interest rates (for example interest rate swaps or options), as well as independent with relevant credit spreads. For these reasons the original capital market is usually divided into:
  • Fixed-income Market - trading with long-term interest rates
  • Credit spread Market - trading with credit risk of the issuer
  • Shares (or Equity or Stock Market) - trading with shares
• Commodity Market - trading with various commodities for example precious metals, energy resources (oil, gas ...), industrial metals (copper, aluminum ...), agricultural commodities (wheat and corn) and livestock, etc.

Another method of dividing instruments of the financial market is based on the level of their complexity and method of settlement.  Simply, it is possible to say that we know the basic “plain vanilla” instruments and the derived i.e. derivatives. However, a better division of the instruments of the financial market would be the following:

• Basic “plain vanilla” - their value date (beginning of application) is usually on the deal date, or within 2 business days. The settlement of transactions usually takes place in the nominal value. Examples of these trades are deposits, bonds, conversions on the FX market etc. 
• Basic derivatives (plain-vanilla derivatives) - their value date (beginning of application) is usually on the deal date, or within 2 business days. However, they don't have a real nominal value, just a notional value which serves for calculation purposes. Settlement of these transactions then only refers to the calculated interests, or their differences, respectively the differences between FX rates. Examples of these trades are simple derivatives, for example, swaps.
• Future (forward) - their value date is usually in the future, or more than 2 business days after the deal date. Forward transactions are divided similarly to basic transactions into:
  • Cash, with a real nominal value, for example, deposits with future value date, FX forwards (also called “outrights”), forward buying of shares or bonds, etc.
  • Non-cash, which have only a notional amount, for example an agreement about a future interest rate, (FRA = Forward Rate Agreement), futures, forward swaps, etc.
• Conditional basic (plain vanilla options) - their realization is conditional, usually to exchange rates or interest rates on the market in the time of the realization. Examples of these trades are foreign exchanges, shares, or interest options.
• Exotic options - usually contain another internal requirement. They are basically options on options. Examples of these trades are barrier options, digital options, various hybrid instruments of the financial market, etc.

Foreign Exchange (FX) Market

The average daily turnover on the world foreign exchange markets is around 5 trillion USD.  According to the statistics of the Bank for International Settlements (BIS), the currency pair EUR/USD has the largest share of the market (approx. 23%). Other significant currencies on the FX market are JPY, GBP, AUD, CAD, CHF, CNY etc.