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Proprietary Trading refers to the trading of the bank and firms in the financial instruments present in the market using their own money and in their own account with the motive of earning the profits for their own instead of investing client money for the investment and earning commission on that.
What Is Proprietary Trading?
- Proprietary trading is also called as prop trading. When a bank trades stocks, derivatives, bonds, commodities, and other financial instruments directly from its own account, it is called proprietary trading.
- When the bank handles its client’s account and trade on behalf of its clients, then the bank earns only commission from the clients. The commission is just the handling fees and not a pretty big amount for a big entity like a bank.
- The same activity if the bank does for its own sake and handles all its own trading, then the bank won’t need to get satisfied with the commission only. They can keep the whole chunk of profits they would make for trading directly.
- Plus bank not only has all the skill-sets to handle the trading activity (since the bank handles all its clients’ trading activities), it also has information that no investment can get access to. As a result, a bank can trade much effectively than an investor ever could.
- And that’s why prop trading is such a popular concept among banks.
Proprietary traders use various equity trading strategies to maximize their profits. Here are the few that are commonly used –
- Volatility Arbitrage
- Merger Arbitrage
- Global Macro Trading
- Index Arbitrage
The Volcker Rule
The Volcker Rule is an important rule for prop trading.
In the year 2008, the global economy crashed. The American economist and ex-United States Federal Reserve Chairman, Paul Volcker opined that the global economic crash was a result of speculative investments done by investment banks.
And as a result, he restricted the banks in the US from making certain types of speculative investments that are not meant for the benefit of their customers.
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This rule is called the Volcker Rule and it is the part of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
The rule came into effect from 21st July 2015. After a year, the major banks requested to offer them a 5-year room to pare down the illiquid investments.
Benefits of Proprietary Trading
Even if there are restrictions of the Volcker Rule, there are real benefits of proprietary trading.
Let’s have a look at these benefits –
- The first and the most important benefit of all is the percentage of profits banks make by involving themselves in proprietary trading. By doing their own trading, they’re able to keep all their money. It means the banks are making and keeping 100% of profits from proprietary trading.
- The second benefit of going for prop trading is that the firms/banks can stock the securities for future use, and at a later day the banks can sell these securities to the clients who would like to buy them.
- The third benefit of prop trading is that the bank can quickly become the key players in the market. Since the banks have access to the information no investors would have access to, the full benefit would only be exploited by the banks.
- The fourth benefit of proprietary trading is that prop traders can use advanced and sophisticated technology and automated software which the investors may not afford to use.
Hedge funds vs proprietary trading
The financial analysts claim that the global economic crash happened because of two types of trading – hedge funds trading and prop trading.
That’s why it’s always prudent to understand the difference between them.
- The basic difference between hedge funds and proprietary trading is a matter of ownership. In the case of hedge funds, the fund manager and his colleagues manage the fund on behalf of the investors. And in the case of prop trading, the whole fund is being managed by the bank itself.
- As a result, in the case of hedge funds, the fund manager charges a high commission from the investors who have invested in the hedge funds. On the other hand, proprietary traders keep 100% of profits.
- In the case of hedge funds, the risk on the part of the fund manager is limited. Since he needs to think about his clients’ success and failure, he can take the risk to a certain extent. But for prop traders, the success or failure is all their responsibility. As a result, the proprietary traders can take as much risk as they want to take. And naturally, more risk often turns out to be more profits than hedge fund managers.
This has been a guide to What is Proprietary Trading, how it works, benefits of prop trading and its differences between hedge fund vs prop trading. You may also have a look at the following articles to learn more –