A financial firm is said to practice proprietary trading if it invests its own money to make profits for itself, instead of earning commissions by trading on a client’s behalf. While the firm’s clients don’t benefit from proprietary trading, it can be very profitable for a financial firm. Read on to learn the ins and outs of proprietary trading, as well as government limits placed on the practice in the wake of the Great Recession.
Proprietary Trading, Explained
Proprietary trading, or “prop trading,” occurs when a financial firm or commercial bank uses its own money — and not that of its clients — to trade stocks, bonds, mutual funds or other securities. In other words, the firm puts up their own funds to earn a profit instead of relying on client fees and commissions. This allows the firm to capitalize on all profits earned from the transaction.
Firms that engage in proprietary trading believe they have more market knowledge than the average investor. That, combined with increased access to advanced technology and trading software gives these financial institutions a competitive advantage over individual investors.Benefits of Proprietary Trading
Proprietary trading is generally considered high risk, but if done successfully it can greatly increase a firm’s profits. Since the company is not trading on its clients’ behalf, it can reap 100% of the trading profits from every transaction instead of only receiving a small fee or commission.
Another benefit to prop trading is that the firm can build up an inventory of securities to use in the future, which can help it in a few ways. For starters, a speculative inventory can give clients a leg up — the securities can be loaned to clients looking to take a short position, for example. A stockpile of securities also means that a firm is better equipped in the event of a down or illiquid market when it becomes tougher to buy and sell on the open market.
Another pro of prop trading: It gives financial firms the opportunity to act as important market makers. Using its own money, a firm can buy a security and then sell it to clients, providing liquidity in that security for investors. The firm benefits if the security becomes more valuable or if investors are willing to purchase it at a higher price. There is a downside to this approach, though: If the firm buys too much of a security and it loses value, the firm will be forced to absorb any losses.Proprietary Trading Regulations
In the wake of the Great Recession, many firms and hedge funds came under scrutiny for their role in causing the 2008 financial crisis. As a response, the federal government enacted rules and reforms to prevent something similar from happening again.
The Volcker Rule, established as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, limits federally insured depository banks from making risky investments using their own money. Proposed by Paul Volcker, a former Federal Reserve chairman, the legislation also prevents these banking institutions from owning any part of a hedge or private-equity fund, subject to a few exceptions. The rule was designed, in essence, to better separate commercial banking from investment banking.
Volcker argued that propriety trading affected the entire economy, as banks looking to maximize their profits created too much risk in the consumer market. Many banks that had engaged in prop trading used derivatives to minimize their risk exposure, which often resulted in increased risk in other areas.
As a result, the Volcker Rule bans FDIC-insured banks from prop trading. This has led some banks to wall off their prop trading activities from their other functions, while other institutions have ceased prop trading altogether.The Bottom Line
Tips for Investors
While propriety trading is extremely profitable for financial firms, it doesn’t directly benefit individual investors. Since the 2008 financial crisis, prop trading has become more highly regulated to ensure that banks and other financial firms are focusing on their client’s best interests.
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