What Is Proprietary Trading?
When a financial institution or commercial bank engages in proprietary trading, they invest for direct market gain as opposed to making commission-based trades on behalf of customers. This kind of trading activity also referred to as “prop trading,” takes place when a financial institution decides to make money off market activity rather than thin-margin commissions received through client trading activity.
The trading of stocks, bonds, commodities, currencies, and other financial products can all be a part of proprietary trading. Proprietary trading is a strategy used by financial institutions or commercial banks that hope to get a competitive edge that will allow them to outperform index investing, bond yield appreciation, and other investment strategies in terms of annual return.
How Does Proprietary Trading Operate?
A trading desk at a financial institution, brokerage company, investment bank, hedge fund, or other liquidity source engages in proprietary trading, commonly referred to as “prop trading,” when it uses the firm’s money and balance sheet to carry out financial transactions that are intended to promote itself. These transactions, which are frequently speculative, are carried out via various derivatives or other sophisticated investment instruments.
Pros
- The institution can accumulate a stockpile of securities. It benefits in two ways. First, any speculative inventory gives the institution a surprise benefit to customers. Second, it assists these institutions in preparing for sluggish or unstable markets, which makes it more challenging to buy or sell stocks on the open market.
- The second benefit is connected to the third benefit. Through proprietary trading, a financial institution can establish itself as a key market maker by supplying liquidity for a particular security or class of securities.
Example
The proprietary trading desk is typically “roped off” from other trading desks for proprietary trading to be successful and keep the institution’s clients in mind. A percentage of the financial institution’s income is generated by this desk, which operates independently and unconnected to customer activities.
But as was mentioned before, Proprietary trading desks can also serve as market makers. When a client wants to trade a big quantity of a single security or a highly illiquid security, this circumstance occurs. A proprietary trading desk will act as the buyer or seller and start the other side of the client trade because there are few buyers or sellers for this kind of deal.
Why Do Companies Use Proprietary Trading?
Financial organisations use proprietary trading to increase their profits and take advantage of alleged competitive advantages. Proprietary trading allows businesses to take on higher amounts of risk without having to answer to their customers because it employs company capital rather than client funds.
Can Banks Trade in Their Stocks?
Large banks are prohibited from utilizing their accounts for short-term proprietary trading of securities, derivatives, and commodity futures, as well as options on these instruments, under the Volcker Rule, which was put in place in reaction to the financial crisis of 2007–2008. The rule forbids banks from undertaking the speculative investments that caused the Great Recession to protect customers.
Conclusion
Proprietary trading is when a financial organization trades with its funds as opposed to trading on behalf of its customers. By keeping all of the investment profits from private transactions, the technique enables financial institutions to maximize their revenues. Proprietary trading desks are typically found in organizations like brokerage houses, investment banks, and hedge funds. Prop trading is prohibited for large banks, nevertheless, to curtail the speculative investments that contributed to the financial crisis of 2007–2008.
