In very basic terms, prop trading (proprietary trading) is when a bank makes trades using their own money instead of clients’. Many prefer this method because it gives them all the profit instead of only a commission. Financial institutions that engage in this trading method use software for an advantage. It is a risky style of money-making, and it comes with benefits and disadvantages.
Benefits of Prop Trading
The initial advantage of using this style of trading is the increase in profits. Normally, banks or financial institutions act as a broker and only earn a commission on the earnings. Proprietary trading maximizes income, but that is not the only benefit companies find. Another way this style of interchange is used is by purchasing securities to use at a later point. They build an inventory that their clients will later purchase, or used as loans in short sales. You have access to a lot more capital, allowing more money to be made.
Disadvantages of Prop Trading
While there is a lot of money to be made through proprietary trading, there are significant drawbacks. When you are using your firm’s finances, you must share the profits with the entire company. In addition, you must follow whatever rules they put in place for trading. These may include licensing requirements and loss limits. Finally, if you are terminated or leave the firm, you no longer have access to the money earned.
Prop Trading vs. Hedge Fund
The biggest difference between proprietary trading and hedge funds is the money source. Hedge funds use finances from their clients. Therefore, they answer to their clients when money is gained or lost. However, with proprietary, the company is aiming to strengthen its bank registry. Risks are taken, especially if they believe they have a competitive advantage. Most importantly, traders only answer to the firm, and clients do not receive any benefit.
Both the hedge fund and proprietary trading are held to rules set by the Consumer Protection Act. One such regulation is the Volcker rule, named after Paul Volcker. Volcker was the former chairman of the Federal Reserve and is designed to protect against speculation. In short, banks are restricted from making investments that do not benefit the investors and are based on pure speculation. He proposed the bill following the global financial crisis and aimed it at the commercial banks practicing high-risk trading using increased derivatives. With the rule in place, banks must use a separate fund to trade. While the separation assists in maintaining objectives in the trading, banks still benefit from all the profits. This regulation has caused some banks to cease offering trades, but most have created standalone services. Many believe it has taken a source of liquidity away through government interference, but the American population like the safeguards.
Stock trading is a successful method of creating profits for companies. Banks and other financial institutions rely on sites, like the 5 best proprietary trading firms, to provide updated information. Regardless of the method used, keep the Volcker rule in place to stay on the right side of the law.