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Proprietary trading, or “prop trading” as it is also known, refers to when a bank or large financial institution uses its own funds and resources to conduct strategic trades with a view to boosting its balance sheet. If done well, prop trading can lead to large profits and a significant uptick in revenue. However, there are inherent risks involved in trading large amounts of capital, particularly when that capital, and the business behind the investment, has the power to cause serious shifts in the market should it incur a loss.
The benefits of prop trading for a private company are clear. But how will it really be done in 2024? What restrictions exist, what are the risks, and how do businesses remain aligned with the interests of their stakeholders?
How does proprietary trading really work?
Proprietary trading can be hugely beneficial for businesses looking to leverage their own capital and increase their quarterly or yearly revenue. Unlike hedge firms, instead of taking a cut of successful trades made on behalf of clients, proprietary trading departments allow businesses to keep 100% of their earnings. This is counterbalanced by the elevated risk of trading one’s own money. With great power comes great responsibility, and businesses must be prepared to face significant losses in betting their own funds on the market they are trading in.
Proprietary trading desks operate autonomously within a business or financial institution and tend to be physically separated from other departments more closely related to clients. As discussed above, these desks are responsible for generating internal revenue, but they may also act as ‘market makers’ by providing liquidity and profiting from potential sales. Legal limitations exist, such as the Volcker Rule, which aims to address conflicts of interest and clearly distinguish between internal profit generation and client-oriented trades. However, it is not always possible to enforce.
Prop trading and the Volcker Rule
The Volcker Rule, which came into effect on the 1st of April, 2014, was proposed by former Federal Reserve Chairman Paul Volcker to curb the speculative risks taken by commercial banks following the 2008 financial crisis and shield everyday customers from decisions that lead to great losses. In essence, it restricts banks from engaging in proprietary trading or owning hedge funds and private equity funds. However, the financial industry criticized the rule for eliminating an important source of liquidity, as banks were forced to separate or close down their proprietary trading desks.
In the face of grave criticism, on 25th of June 2020, the Federal Deposit Insurance Corp. (FDIC) announced that they would loosen the Volcker Rule’s restrictions, freeing up billions of dollars and making it easier for banks and financial institutions to invest large amounts into venture capital and similar funds. Today, as things currently stand, the Rule allows banks to engage in ‘market making,’ hedging, trading government securities, insurance company activities, offer hedge funds, and act as agents, brokers, or custodians in order to generate profit unless it creates a conflict of interest, exposes them to high-risk assets, or generates any kind of instability.
The risks associated with proprietary trading
There are undoubtedly risks and drawbacks associated with proprietary trading. It is often seen as promoting corporate greed, given banks’ and financial institutions’ already-privileged position regarding market insights and dedicated trading software. Certain decisions made by a business’s prop trading department can cause conflicts of interest with its clients. However, the Volcker Rule, applicable in the U.S., is designed primarily to avoid these kinds of rifts. But generally speaking, the largest risk a business or institution exposes themselves to through prop trading is loss. The higher the stakes, the bigger the loss if things turn sour, with the potential to cause a seismic shift in national or global economies, as evidenced by the 2008 Wall Street crash.
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