Proprietary Trading - What is Prop Trading & How Does It Work?
What is Proprietary Trading?
Proprietary Trading (Prop Trading) occurs when a bank or firm trades stocks, derivatives, bonds, commodities, or other financial instruments in its own account, using its own money instead of using clients’ money. This enables the firm to earn full profits from a trade rather than just the commission it receives from processing trades for clients.
Banks and other financial institutions engage in this type of trade with the aim of making excess profits. Such firms often have an edge over the average investor in terms of the market information they have. Another advantage comes from having sophisticated modeling and trading software.
Prop traders use various strategies such as merger arbitrage, index arbitrage, global macro-trading, and volatility arbitrage to maximize returns. Proprietary traders have access to sophisticated software and pools of information to help them make critical decisions.
Although commonly viewed as risky, proprietary trading is often one of the most profitable operations of a commercial or investment bank. During the financial crisis of 2008, prop traders and hedge funds were among the firms that were scrutinized for causing the crisis. The Volcker rule, which severely limited proprietary trading, was introduced to regulate how proprietary traders can operate. A major concern was avoiding possible conflicts of interest between the firm and its clients. Individual investors do not benefit from prop trading because the activity does not involve trades executed on behalf of clients.
Benefits of Proprietary Trading
One of the benefits of proprietary trading is increased profits. Unlike when acting as a broker and earning commissions, the firm enjoys 100% of the profits from prop trading. As a proprietary trader, the bank enjoys maximum benefits from the trade.
Another benefit of proprietary trading is that a firm can stock an inventory of securities for future use. If the firm buys some securities for speculative purposes, it can later sell them to its clients who want to buy those securities. The securities can also be loaned out to clients who wish to sell short.
Firms can quickly become key market markers through prop trading. For a firm that deals with specific types of securities, it can provide liquidity for investors in those securities. A firm can buy the securities with its own resources and then sell to interested investors at a future date. However, if a firm buys securities in bulk and they become worthless, it will be forced to absorb the losses internally. The firm only benefits if the price of their security inventory rises or others buy it at a higher price.
Proprietary traders can access sophisticated proprietary trading technology and other automated software. Sophisticated electronic trading platforms give them access to a wide range of markets and the ability to automate processes and engage in high-frequency trading. Traders can develop a trading idea, test its viability, and run demos on their computers.
In most proprietary companies, the trading platforms used are exclusively in-house and can only be used by the firm’s traders. The firms reap substantial benefits from owning the trading software, something that retail traders lack.
Hedge Fund vs. Prop Trading
Hedge funds invest in the financial markets using their clients’ money. They are paid to generate gains on these investments. Proprietary traders use their firm’s own money to invest in the financial markets, and they retain 100% of the returns generated. Unlike proprietary traders, hedge funds are answerable to their clients. Nonetheless, they are also targets of the Volcker Rule that aims to limit the amount of risk that financial institutions can take.
Proprietary trading aims at strengthening the firm’s balance sheet by investing in the financial markets. Traders can take more risks since they are not dealing with client funds. Firms go into proprietary trading with the belief that they have a competitive advantage and access to valuable information that can help them reap big profits. The traders are only answerable to their firms. The firm’s clients do not benefit from the returns earned through prop trading.
The Volcker Rule on Proprietary Trading
The Volcker rule is part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. It was suggested by the former chairman of the Federal Reserve, Paul Volcker. The rule aims to restrict banks from making certain speculative investments that do not directly benefit their depositors. The law was proposed after the global financial crisis when government regulators determined that large banks took too many speculative risks.
Volker argued that commercial banks engaged in high-speculation investments affected the stability of the overall financial system. Commercial banks that practiced proprietary trading increased the use of derivatives as a way of mitigating risk. However, this often led to increased risk in other areas.
The Volcker Rule prohibits banks and institutions that own a bank from engaging in proprietary trading or even investing in or owning a hedge fund or private equity fund. From a market-making point of view, banks focus on keeping customers happy, and compensation is based on commissions. However, from a proprietary trading point of view, the customer is irrelevant, and the banks enjoy the full profits.
Separating both functions will help banks to remain objective in undertaking activities that benefit the customer and that limit conflicts of interest. In response to the Volcker rule, major banks have separated the proprietary trading function from its core activities or have shut them down completely. Proprietary trading is now offered as a standalone service by specialized prop trading firms.
The Volcker Rule, like the Dodd-Frank Act, is generally viewed unfavorably by the financial industry. It is seen as unnecessary and counterproductive government interference. For example, as noted above, banks’ proprietary trading provided important liquidity for investors. That source of liquidity is now gone.