What is Proprietary Trading? Difference Between Hedge Fund and Proprietary Trading
Proprietary Trading Meaning: An Overview
Many investors have a tendency to believe that retail individual investors account for the majority of the stock market trading volume. But nothing could be further from the truth than that. In addition to ordinary traders, a number of organizations, businesses, and corporations also take part in daily stock market activity.
In fact, stockbroking firms with whom investors have trading accounts frequently engage in trading and investing in the stock market. This is what is prop trading. Check out the article to learn more about proprietary trading.
What is Proprietary Trading?
In order to make profits for themselves instead of utilizing client money for the investment and receiving commission on it, banks and other businesses engage in proprietary trading with the financial instruments available on the market. It is the act of trading and investing in the stock market by a financial services company like a commercial bank, a broking business, an investment bank, or a hedge fund. This type of action is often commonly termed "prop trading" by stock market specialists.
When a trader from a financial institution, brokerage company, investment bank, hedge fund, or other liquidity source uses the firm's money and balance sheet to execute self-promoting financial transactions, this is referred to as proprietary trading, sometimes known as "prop trading." These transactions, which are frequently speculative in nature, are carried out via various derivatives or other sophisticated investment instruments.
A variety of tactics are employed by a prop trader to increase profits. They use techniques including volatility arbitrage, index arbitrage, global macro-trading, and merger arbitrage. In order to aid them in making important judgments, prop traders have access to advanced tools and informational databases.
Example of Proprietary Trading Desk
The proprietary trading desk is usually “roped off” from other trading desks to ensure proprietary trading continues smooth operations and to keep the institution’s clients’ in mind. This desk works autonomously and is responsible for a portion of institutions’ financial revenues albeit of clients’ works. These desks can work as market markers as well.
A proprietary trading desk acts as buyer or seller as this situation arises when a client wants to trade a highly illiquid security amount or a large amount of single security. The desk initiates the client trade from the other side.
Why do financial institutions engage in proprietary trading?
Financial institutions take part in proprietary trading for corporate self-interest. Due to stiff competition in the market, these institutions operate on thin margins for services and products. The revenue generated might not be sufficient and hence indulgence in proprietary trading and investment in the stock market.
The revenue collected helps in the sustenance of business and helps in working towards their goals and objectives. Engaging in prosperity trading also helps in developing dominance over the financial sector. Organizations have more investment capital as well as access to exclusive information. The trading helps the institution to enjoy a high rate of return as compared to term deposits and investments in bonds.
Which segments do firms focus on?
Financial firms engaging in properties trading focus on derivatives including futures and options. The reason behind increased trading activity on futures and options is because the trades made are purely speculative and the proprietary traders have to use several trading strategies to gain the upper hand in the market. These strategies include various arbitraries, fundamental analysis and technical analysis.
What is the Purpose of Volcker Rule?
For prop trading, the Volcker Rule is a crucial regulation. The world economy collapsed in 2008. The former chairman of the United States Federal Reserve and American economist Paul Volcker said that speculative investments made by investment banks were to blame for the worldwide economic crisis.
The Dodd-Frank Wall Street Reform and Consumer Protection Act incorporates the Volcker rule. The regulation tries to prevent banks from engaging in specific speculative transactions that do not directly benefit their depositors. According to the Volcker Rule, banks and organizations that hold banks are not allowed to engage in proprietary trading, own hedge funds, or participate in private equity funds. Banks prioritize satisfying consumers from a market-making perspective, and revenue is based on commissions. However, from the perspective of proprietary trading, the consumer is unimportant, and the banks take home all the money.
Separating the two roles will make it easier for banks to maintain objectivity when engaging in customer-focused operations and preventing conflicts of interest. Major banks have either totally shut down or split their proprietary trading functions from their core business operations in reaction to the Volcker regulation. Specialized prop firms now offer proprietary trading as a stand-alone service.
Difference between Hedge Fund and Proprietary Trading
Financial researchers assert that two forms of trading, namely hedge fund trading and prop trading, were responsible for the worldwide economic crisis. It is therefore typically advisable to be aware of their distinctions.
Ownership is the fundamental distinction between proprietary trading and hedge funds. When managing a hedge fund, the fund manager and his associates act as the investors' agents. Whereas, in the case of prop trading, the bank itself is in charge of managing the whole fund. As a result, in the case of hedge funds, the fund management bills the investors who have made investments in the hedge funds a large commission. Proprietary traders, on the other hand, keep all profits.
In the case of hedge funds, the fund manager's risk is constrained. He may accept the risk to a certain level since he must consider both the success and failure of his customer. Prop traders, however, are solely accountable for their success or failure. Therefore, the proprietary traders are free to take any amount of risk they choose. Naturally, more risk generally results in greater earnings than those of hedge fund managers.
Advantages of Prop Trading
Now that we’ve understood the proprietary trading meaning, let’s understand the advantages of this type of trading phenomenon.
- The percentage of earnings banks make by engaging in proprietary trading is the first and most significant advantage. They are able to keep all of their money via trading. It implies that all gains from proprietary trading are earned by and retained by the banks.
- The second advantage of using prop trading is that businesses and banks may store the securities that they invest in for later usage and then sell them to customers who want to purchase them. This feature benefits both the bank and the customers.
- The majority of proprietary firms only allow their traders to utilize their in-house trading platforms. Corporations gain significantly from owning the trading software, whereas ordinary traders do not.
- The next aspect that is advantageous to prop trading is that traders have access to advanced technology and automated tools that investors might not be able to buy.
Since the companies don't have to answer to their clients as they use their own money for prop trading, they may assume more risk. They are required to bear the entire cost of any profits or losses they incur. Nevertheless, the prop trading software that is not accessible to the general public is utilized by prop trading organizations. Additionally, they utilize automated and algorithmic trading systems for high-frequency trading. They have a distinct advantage over common retail traders and investors because of this.
Are there any other benefits to Proprietary Trading?
Practically, the market participants really benefit from the presence of proprietary traders. They may readily make massive transactions since they are supported by a sizable investing capital fund. The counter receives a significant infusion of liquidity as a result, making it simpler for investors to purchase and sell shares. The ability of enterprises to stockpile company shares as inventory is another significant advantage of proprietary trading.
What kind of trades do proprietary traders focus on?
Although financial institutions do participate in the equity market, their primary concentration is on derivatives like futures and options. The fact that these businesses' trades are virtually always entirely speculative is one of the main causes of the rising trading activity on futures and options. A variety of trading tactics, including fundamental research, technical analysis, and other arbitrages, are integrated by proprietary traders.
What is the reason for a financial institution to indulge in Proprietary Trading?
Financial institutions engage in prop trading only for their own financial gain. Financial institutions and stockbroking organizations operate on razor-thin margins for their goods and services as a result of the intense competition they encounter. Their principal sources of income might not be sufficient to support them over the long term. They engage in proprietary trading as a result in order to make money off of stock market trading and investment.
What is a trading desk?
A trading desk is defined as the physical location where transactions take place. Here, transactions for buying and selling securities take place. A trading desk can include traders trading for their own proprietary account, brokers acting as agents and also a crowd that includes both. Also known as dealing desks, trading desks can be found in most financial institutions that are involved in facilitating trade executions.