Proprietary Trading Definition

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Proprietary Trading Definition

What is Proprietary Trading?

A financial business or commercial bank that invests for direct market gain rather than generating commission money by trading on behalf of customers is said to engage in proprietary trading. This sort of trading activity, often known as “prop trading,” happens when a financial business decides to benefit from market activities rather by thin-margin fees collected from client trading activity. Stocks, bonds, commodities, currencies, and other items may be traded in proprietary trading.

Financial businesses or commercial banks who participate in proprietary trading think they have a competitive edge that will allow them to outperform index investing, bond yield appreciation, or other investment methods.

Key Takeaways

  • Index arbitrage, statistical arbitrage, merger arbitrage, fundamental analysis, volatility arbitrage, technical analysis, and/or global macro trading are all market methods that proprietary traders might use.
  • Market experts recognize that huge financial institutions distort information on proprietary vs. non-proprietary trading operations on purpose to disguise actions that promote corporate self-interest.

How Does Proprietary Trading Work?

Proprietary trading, commonly known as “prop trading,” happens when a trading desk at a financial institution, brokerage business, investment bank, hedge fund, or other liquidity source conducts self-promoting financial transactions using the firm’s capital and balance sheet. These transactions are often speculative in nature, carried out using a variety of derivatives or other complicated investment instruments.

Benefits of Proprietary Trading

There are various advantages that proprietary trading give a financial institution or commercial bank, most notably larger quarterly and yearly earnings. When a brokerage firm or investment bank trades on behalf of clients, it earns revenues in the form of commissions and fees. This income can represent a very small percentage of the total amount invested or the gains generated, but the process also allows an institution to realize 100% of the gains earned from an investment.

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The second benefit is that the institution is able to stockpile an inventory of securities. This helps in two ways. First, any speculative inventory allows the institution to offer an unexpected advantage to clients. Second, it helps these institutions prepare for down or illiquid markets when it becomes harder to purchase or sell securities on the open market.

The final benefit is associated with the second benefit. Proprietary trading allows a financial institution to become an influential market maker by providing liquidity on a specific security or group of securities.

An Example of a Proprietary Trading Desk

In order for proprietary trading to be effective and also keep the institution’s clients in mind, the proprietary trading desk is normally “roped off” from other trading desks. This desk is responsible for a portion of the financial institution’s revenues, unrelated to client work while acting autonomously.

However, proprietary trading desks can also function as market makers, as outlined above. This situation arises when a client wants to trade a large amount of a single security or trade a highly illiquid security. Since there aren’t many buyers or sellers for this type of trade, a proprietary trading desk will act as the buyer or seller, initiating the other side of the client trade.

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