Overview of Proprietary Trading

Proprietary trading is carried out by certain traders in the stock market. It is done through what is called the prop desk or the proprietary trading desk. This is a kind of trade wherein the firm decides to purchase financial instruments with its own money rather than the money of its customers. In other words, these are trades executed by the firm for obtaining direct gains rather than gaining from the commission from their customers' deals. It is done by firms in order to garner more profit because of the competitive advantage it offers.

Investment Banks

Financial institutions are involved in the acceptance of deposits from their customers and in issuing an interest for the amount deposited. Certain banks help their customers to invest in stock and other financial instruments. When such banks indulge in direct trading using their working capital, instead of using their clients’ money for trading, they are said to be engaged in proprietary trading. This is when they are making transactions to benefit themselves rather than their clients.

Proprietary Traders

Certain employees of some investment banks used to carry out the proprietary trading in the stock market. Yet, because of new rules that have been passed, financial companies cannot employ these types of traders anymore. The people who are directly involved in proprietary trading are called proprietary traders, but many of them are looking for new work now. Since investment banks are now restricted from proprietary trading, this revenue is lost, and many are looking at ways to make up for this shortfall outside of America.

Why Proprietary Trading Is Frequent

Proprietary trading provides some advantages to the traders, and these advantages form the basis for the indulgence in proprietary trading:

  • A fee for a transaction is much lower for a trader than for an investor.
  • A proprietary trader can start trading without anything in the margin account as opposed to the $25,000 needed in the margin account of the day traders.  

Consequences of Proprietary Trading

Investment traders will start actively purchasing various financial instruments like commodities, stocks, bonds, stock options and so on with their own money when they feel that the market is highly profitable. Such a profit is too volatile, and it can cause lots of credit crises in the market. It may also lead to the collapse of the banking system. Some of the problems are the following:

  • The front running of traders in the purchase of stocks can lead to increases in the prices of the stocks; bankers thereby earn more profits by resale.
  • Proprietary trading firm employees can advise their customers to purchase or invest in a poorly performing stock by hiding actual facts about its decline. This is done to sell the poorly performing stocks that they have already bought.

Legal Restrictions

In order to prevent a crisis due to proprietary trading, the Financial Industry Regulatory Authority (FINRA) proclaimed new regulation in April 2010. This regulatory reform is named the “Volcker Rule.” As per the new restrictions, a prop trader can leverage in relation to the amount deposited by the trading firm with the SEC (Securities and Exchange Commission). Prop trading firms should set up a separate sub-account to carry out the prop trading transactions. Such a sub-account has to be separately mentioned for taxation and other reporting.

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