Proprietary trading refers to a financial firm or commercial bank that invests for direct market gain rather than earning commission dollars by trading on behalf of clients. Also known as “prop trading,” this type of trading activity occurs when a financial firm chooses to profit from market activities. Proprietary trading may involve the trading of stocks, bonds, commodities, currencies, or other instruments.
Financial firms or commercial banks that engage in proprietary trading believe they have a competitive advantage that will enable them to earn an annual return that exceeds index investing, bond yield appreciation, or other investment styles.
Key Takeaways
- Proprietary trading refers to a financial institution using its own capital, rather than client funds, to conduct financial transactions.
- Proprietary traders may execute an assortment of market strategies that include index arbitrage, statistical arbitrage, merger arbitrage, fundamental analysis, volatility arbitrage, technical analysis, and/or global macro trading.
- Market analysts understand that large financial institutions purposely obfuscate details on proprietary vs. non-proprietary trading operations to obscure activities promoting corporate self-interest.
Diving Deep: How Proprietary Trading Works
Proprietary trading, which is also known as “prop trading,” occurs when a trading desk at a financial institution, brokerage firm, investment bank, hedge fund, or other liquidity source uses the firm’s capital and balance sheet to conduct self-promoting financial transactions. These trades are usually speculative in nature, executed through a variety of derivatives or other complex investment vehicles.
Reaping the Rewards: Benefits of Proprietary Trading
Proprietary trading provides many benefits to a financial institution or commercial bank, most notably higher quarterly and annual profits. When a brokerage firm or investment bank trades on behalf of clients, it earns revenues from commissions and fees, which might represent a small percentage of the invested amount or the generated gains. Instead, proprietary trading allows an institution to realize 100% of the gains earned from an investment.
Another benefit is that the institution can stockpile an inventory of securities. This helps in two ways. First, it offers a potential advantage to clients by enabling them to execute speculative inventory. Second, it helps these institutions prepare for down or illiquid markets when buying or selling securities becomes more challenging.
Additionally, proprietary trading enables a financial institution to become an influential market maker by providing liquidity on a specific security or group of securities.
A Closer Look: An Example of a Proprietary Trading Desk
To ensure the efficacy of proprietary trading while also considering clients, a proprietary trading desk is typically “roped off” from other trading desks. This desk is responsible for generating part of the institution’s revenues unrelated to client work while acting autonomously.
However, proprietary trading desks can also operate as market makers. This occurs when a client wants to trade a large amount of a single security or a highly illiquid security. Given the scarcity of buyers or sellers for such trades, a proprietary trading desk acts as the buyer or seller, fulfilling the other side of the client trade.
The Strategic Reasons Behind Engaging in Proprietary Trading
Financial institutions dive into proprietary trading to harness perceived competitive advantages and maximize profits. Since proprietary trading utilizes the firm’s own money, not the clients’, prop traders can take higher risks without having to answer to client concerns.
Navigating Regulations: Can Banks Engage in Proprietary Trading?
The Volcker Rule, enacted after the 2007-2008 financial crisis, restricts large banks from using their own accounts for short-term proprietary trading of securities, derivatives, and commodity futures. This rule aims to protect customers by preventing banks from engaging in the kind of speculative investments that fueled the Great Recession.
Bottom Line: Risk and Reward in Proprietary Trading
Proprietary trading occurs when financial institutions carry out transactions using their own capital rather than trading on behalf of clients. This practice allows financial firms to maximize their profits, keeping 100% of the investment earnings from proprietary trades. Brokerage firms, investment banks, and hedge funds frequently maintain proprietary trading desks. However, regulations like the Volcker Rule limit the ability of large banks to engage in prop trading to minimize risky speculative investments.
Related Terms: derivatives, market maker, Volcker Rule, hedge funds, financial institutions.
