Proprietary trading (also known as "prop trading") occurs when a trader trades stocks, bonds, currencies, commodities, their derivatives, or other financial instruments with the firm's own money, aka the nostro account, contrary to depositors' money, in order to make a profit for itself. Proprietary trading can create potential conflicts of interest such as insider trading and front running.
Proprietary traders may use a variety of strategies such as index arbitrage, statistical arbitrage, merger arbitrage, fundamental analysis, volatility arbitrage, or global macro trading, much like a hedge fund. Many reporters and analysts believe that large banks purposely leave ambiguous the proportion of proprietary versus non-proprietary trading, because it is felt that proprietary trading is riskier and results in more volatile profits.
Relationship to banking
Banks are companies that assist other companies in raising financial capital, transacting foreign currency exchange, and managing financial risks. Trading has historically been associated with large banks, because they are often required to make a market to facilitate the services they provide (e.g., trading stocks, bonds, and loans in capital raising; trading currencies to help with international business transactions; and trading interest rates, commodities, and their derivatives to help companies manage risks).
For example, if General Store Co. sold stock with a bank, whoever first bought shares would possibly have a hard time selling them to other individuals if people are not familiar with the company. The investment bank agrees to buy the shares sold and look for a buyer. This provides liquidity to the markets. The bank normally does not care about the fundamental, intrinsic value of the shares, but only that it can sell them at a slightly higher price than it could buy them. To do this, an investment bank employs traders. Over time these traders began to devise different strategies within this system to earn even more profit independent of providing client liquidity, and this is how proprietary trading was born.
The evolution of proprietary trading at banks reached the point where many banks employed multiple traders devoted solely to proprietary trading, with the hopes of earning added profits above that of market-making. These proprietary trading desks were often considered internal hedge funds within the bank, performing in isolation away from client-flow traders. Proprietary desks routinely had the highest value at risk among other trading desks at the bank. At times, investment banks such as Goldman Sachs, Deutsche Bank, and the former Merrill Lynch earned a significant portion of their quarterly and annual profits (and losses) through proprietary trading efforts.
Regulatory bodies worldwide require that the proprietary trading desk is kept separate from its client-related activity and trading. This is achieved by the use of information barriers (also known as "Chinese walls"), which prevent conflict of interest which might, for example, allow a bank to front run its own customers.
There often exists confusion between proprietary positions held by market-making desks (sometimes referred to as warehoused risk) and desks specifically assigned the task of proprietary trading.
Because of recent financial regulations like the Volcker Rule in particular, most major banks have spun off their prop trading desks or shut them down altogether. However, prop trading is not gone. It is carried out at specialized prop trading firms and hedge funds. The prop trading done at many firms is usually highly technology-driven, utilizing complex quantitative models and algorithms.
One of the main strategies of trading, traditionally associated with banks, is arbitrage. In the most basic sense, arbitrage is defined as taking advantage of a price discrepancy through the purchase or sale of certain combinations of securities to lock in a market-neutral profit. The trade will remain subject to various non-market risks, such as settlement risk and other operational risks. Investment banks, which are often active in many markets around the world, constantly watch for arbitrage opportunities.
One of the more-notable areas of arbitrage, called risk arbitrage or merger arbitrage, evolved in the 1980s. When a company plans to buy another company, often the share price of the buyer falls (because the buyer will have to pay money to buy the other company) and the share price of the purchased company rises (because the buyer usually buys those shares at a price higher than the current price). When an investment bank believes a buyout is imminent, it often sells short the shares of the buyer (betting that the price will go down) and buys the shares of the company being acquired (betting the price will go up).