Proprietary trading (prop trading) is when a financial institution trades and invests their own money to generate profits, rather than charging fees and commission from trading and investing on behalf of their clients’ money.
Higher potential revenue is a key benefit of proprietary trading, but it can also provide additional benefits for a firm, such as allowing them to become market maker (and therefore help set the price of the asset in question), or to build up a stockpile of an asset to provide liquidity for their clients.
How does proprietary trading work?
Financial firms (such as banks and asset management firms) that undertake proprietary trading have the opportunity to generate larger gains than by simply taking fees, but the risk is much higher too.
In simplistic terms, imagine a company with £10 million in cash reserves. They’re considering an investment that could potentially make gains of 10% over the next year, which would mean generating revenue of £1 million.
That’s significantly higher than what the company would generate in interest if they left the funds in cash. For example, Barclays currently offer interest of 1.85% on their business savings accounts for balances over £10m.
While proprietary trading is generally regarded as something that mainstream banks and financial firms do ‘on the side’ of their normal client trading activities, there are some investment companies such as Jane Street Capital and Citadel Securities (known as prop trading firms) who’s sole focus is trading their own funds and acting as market makers.
Is proprietary trading illegal?
No, proprietary trading is not illegal. In the UK proprietary trading is an allowable component of any company’s business model, as long as they meet the usual regulatory conditions such as capital adequacy and transparency.
With that said, firms that do it also have to be very careful not to end up on the wrong side of the law for other, related offences, like insider trading.
How is proprietary trading regulated?
Proprietary trading had a part to play in the 2008 global financial crisis as banks and other big firms made speculative bets on assets like mortgage backed securities.
The UK’s approach has been not to ban proprietary trading specifically, but to instead focus on strengthening the overall regulatory requirements for a strong financial sector. In simple terms, they don’t mind firms taking higher risks in certain areas of their business (e.g. prop trading desks), as long as that is balanced out by the overall risk of the bank as a whole.
That’s in contrast to the US, where the ‘Volcker Rule’ effectively prop trading until the regulations were relaxed slightly in 2020.
What’s the difference between proprietary trading and hedge funds?
A hedge fund invests client money in exchange for fees and commissions, whereas proprietary trading is when a company invests its own money.
Does Goldman Sachs do proprietary trading?
Goldman Sachs used to operate significant proprietary trading desks prior to the passing of the Volcker Rule. The bank had stated that up to 10% of its revenue was generated through prop trading strategies, but closed down its ‘principal strategies desk’ in 2010.
Why do some people consider proprietary trading to be bad?
Proprietary trading creates an environment for conflicts of interest, illegal activity like insider trading, as well as high risk strategies which could potentially put client funds at risk. This isn’t to say that all proprietary trading is bad, but it does come with greater risk than typical financial firms operations.
Do banks still do proprietary trading?
Yes, outside of the United States prop trading is a common banking practice in major economies such as the UK, European Union, Canada and Australia.