Understanding Proprietary Trading

By  //  May 5, 2022

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Proprietary trading or prop trading as it is more commonly known happens when a firm or bank trades commodities, derivatives, bonds, stocks, or any other type of financial instruments through its own account and using its own money rather than that of their clients. Operating this way allows the firm to earn all of the profits from every trade that it makes, as opposed to just getting the commission off of its clients. 

Financial institutes and banks do this type of trading with the sole aim of making a decent profit. They have an edge over normal investors because of the sheer amount of market information that they possess. They also have the advantage that they use highly sophisticated trading and modeling software. Some of the best PROP TRADING FIRMS out there are listed on that website.

Proprietary trading versus hedge funds

Hedge funds operate by using their clients’ money to invest in the financial markets. Their clients pay them to produce gains on investments. Proprietary traders work with the money of their frim to make investments within various financial markets and so are able to keep the full 100 percent of the profits made. Hedge funds, however, have to answer to their clients and are subject to the Volcker Rule and so there are limits in place as to the level of risk that financial institutions are allowed to take. 

The aim of proprietary trading is to strengthen the balance sheet of the firm through making investments in the financial markets. As a result, traders are able to take much more risk than if they were dealing with the funds of clients. Many firms get into proprietary trading with the idea that they will have a competitive edge and access to a wealth of valuable information which can be used to help them earn big profits.

The traders working are only answerable to the senior managers in their firm. There are no clients that benefit from the profit that is made from proprietary trading. 

Proprietary trading and the Volcker Rule

This rule is a part of the Dodd Frank Wall Street Reform and Consumer Protection Act. It gets its name from the former chairman of the Federal Reserve called Paul Volcker. It exists to stop banks from performing speculative investment trades that are not in the direct benefit of their clients. It was first proposed after the worldwide financial crash when government regulators established that large banks and financial institutions took way too many speculative risks. 

It was argued by Paul Volcker that large commercial banks had engaged in large speculation investments that affected the overall stability of the world wide financial systems. Those commercial banks that partook in proprietary trading greatly increased the use of derivatives as a means of mitigating risk. Unfortunately though, this led to an increased risk in other areas.

Within the financial industry, the Volcker Rule is viewed somewhat unfavorably as it is a counterproductive and unnecessary interference by the government.