If you are new to capital markets — whether you are a graduate joining a bank, a professional moving from another industry, or someone who simply wants to understand how investment banking works — one of the first questions is: how does this business actually make money? Unlike a retail bank, which earns by lending at higher rates than it borrows, a markets business generates revenue in several distinct and less obvious ways. This article sets out those revenue streams in plain English.
The Spread: The Simplest Form of Revenue
The most fundamental way a bank's markets business earns money is through the spread between its buying price and selling price. Imagine a dealer making a market in government bonds. The dealer quotes a price of 99.95 to buy and 100.05 to sell. If a client buys at 100.05 and another client sells at 99.95, the dealer has earned 10 cents on 100 of face value — a 10 basis point spread — for facilitating the transaction. This is called the bid-offer spread.
The same principle applies across every product the bank trades: interest rate swaps, FX forwards, corporate bonds, equity derivatives. The spread compensates the bank for the risk it takes on in the period between buying from one client and selling to another — during that time, the market may move against the bank's inventory position. In competitive, liquid markets (such as EUR/USD FX spot or on-the-run US Treasuries), spreads are tiny — sometimes less than one basis point. In less liquid or more complex products, spreads can be many times larger.
Structured Product Margins
A structured product is a customised financial instrument designed to meet a specific client need — for example, a note that provides investors with capital protection alongside participation in equity market upside, or a corporate bond issuance combined with a currency swap. Because these products are complex and tailored, they carry much wider margins than vanilla flow products. The client cannot easily compare the bank's price to a market price for an identical product, because no identical product exists elsewhere. The structuring team's intellectual effort in designing the solution, and the bank's risk-taking in providing it, justifies the higher margin.
Commission and Fees
In some parts of the markets business, revenue takes the form of explicit fees rather than implicit spread. Equity execution for institutional clients has historically generated commission income — the client pays a fixed commission per share traded in exchange for the bank's execution service and access to research. Post-MiFID II in Europe, research commissions have been separated from execution fees, but the commission model persists in listed equity markets. DCM (Debt Capital Markets) fees are earned when the bank arranges and underwrites a bond issuance: the issuer pays an underwriting fee (typically expressed as a percentage of the face value) to the banks that bring the deal to market.
Financing Revenue: Repo and Securities Lending
Banks earn significant income from financing: lending money to clients against collateral (through repo), or lending securities to clients who want to sell them short (through securities lending). In a repo transaction, the bank's client pledges bonds as collateral and receives cash — the bank earns the difference between the rate at which it funds itself and the rate it charges the client. In securities lending, the bank's client lends stock from their long portfolio to short sellers; the bank intermediates and earns a fee.
These financing activities are sometimes called "balance sheet businesses" because they require the bank to commit capital — funding assets on its balance sheet. The revenue per dollar of balance sheet is lower than in derivatives market-making, but the risks are lower and the revenues are more predictable. Repo and securities lending income has become increasingly important as post-crisis regulation has made purely risk-taking revenue harder to generate at acceptable returns on capital.
Prime Brokerage
Prime brokerage is the business of providing financial services to hedge funds: holding their assets in custody, providing leverage, facilitating securities lending, and offering execution services. The bank earns revenue through the financing spread on leverage provided, income from lending out the hedge fund's securities, and commissions on execution. Prime brokerage is capital-intensive but generates valuable, recurring revenue from the most active trading clients.
Why Markets Earnings Are Volatile
Unlike retail banking — where deposit margins and loan interest provide relatively stable, predictable income — markets revenues can swing dramatically. Several factors drive this volatility:
- Market conditions: When volatility is high, clients trade more, bid-offer spreads widen, and structured product demand increases. When volatility is very low or markets are range-bound, client activity falls and spreads compress.
- Risk-taking: Even with predominantly client-driven business, trading desks accumulate inventory risk. Large adverse market moves can generate significant losses that offset spread income.
- One-off events: A single large structured transaction or a particularly active primary market can generate fees in one quarter that are not repeated the next.
- Regulatory change: Post-2008 capital requirements dramatically changed the economics of certain activities, reducing the available return on equity and forcing banks to exit product areas that were previously profitable.
This volatility is why investors discount markets businesses at lower multiples than more stable banking businesses — and why banks invest heavily in building more diversified, fee-based revenue streams that are less dependent on market conditions.
Capital Allocation: The Hidden Cost
Every activity in a markets business consumes regulatory capital — the buffer of equity that must be held against the risk of losses. Under Basel III, market risk positions attract capital charges based on their risk profile, leverage positions consume capital under the leverage ratio, and counterparty credit exposure requires capital under the counterparty credit risk framework. The capital allocated to each activity is priced into the cost of running that business: a trading desk's return on equity is calculated by dividing its revenues by the capital allocated to support it. Activities with poor risk-adjusted returns are pruned; activities with strong risk-adjusted returns attract additional investment. Understanding capital allocation is essential for understanding why markets businesses have changed so dramatically since 2010.