Wednesday, November 17, 2010

Wall Street Exposed

From where we sit, Wall Street is hard to understand, so can seem suspicious. I have interviewed several thousand Wall Street executives and employees, so have a hint of how it works. It is both simpler and more complicated than most people think.

First, investment bank offices are divided into three parts: front office, middle office, and back office. Front office is composed of sales and trading, and origination. Back office is the support functions (settlements, operations, HR). Middle office people are supposed to monitor and keep in check the front office (risk management, compliance, legal). The relationship between front and middle is adversarial.

The bank is also divided into primary markets and secondary markets. Primary markets are the people who create securities, and are often referred to as "the investment bankers." They do the IPOs, the M&A advisory, bond issuance, and those sorts of activities. In secondary markets, they trade the securities. They either make money by trading (prop traders): buy low, sell high. Or they trade for customers, and earn a fee. Those two types of traders are not supposed to talk to each other.

The relationship between investment bankers and the traders is sometimes competitive. They compete for resources. Which business will the bank focus on? That depends on the bank's culture, but it affects the budget and prestige enjoyed by each group.

That is how the industry is organized. It is not one giant, perpetual conspiracy. And it is only part of the finance industry.

In general, Wall Street bankers are a lot smarter than we think they are. And not nearly as smart and they individually think they are.

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