Proprietary trading is a term used in the context of a bank or other financial institution wherein the bank or financial institution engages in trading stocks, futures, options, commodities, currencies & other derivative instruments with its own money & on its own account.
Traditionally banks & other financial institutions are engaged in accepting deposits from clients & lending the same at a higher rate to earn an income equivalent to interest rate differentials. Also Investment banks have played a major role in fund raising for its clients. Investment Banks also play a big role in helping their clients to find the buyers for stock issues. Banks have been acting as a guarantor many times for buying the shares of their clients in case the stock issue is under subscribed. Many banks also provide portfolio management services & trading facilities to their client. While providing all these services the bank or other financial institution is engaging in trading on behalf of their clients for which usually it charges fees or commission to the clients.
However, in case of proprietary trading these financial institutions engage in trading activities on their own & with their own funds. They appoint full time dedicated traders to trade for them. The proprietary traders use all the available data & market analysis while making the investment decisions.
The purpose of engaging in proprietary trading is to make a profit with actual market movements as against to earning commissions & fees with trading on behalf of the clients. Many financial institutions also prefer to appoint freelancing traders from across the globe to trade on their behalf & for that they pay handsome amounts usually based on the trading performance.
The topic of proprietary trading is not free from criticism & critics argue that many times there is a conflict of interest in proprietary trading. As per critics the proprietary desks of bank use insider information from their front desks to make a profit & there by affect the customer interest. Also the front desk may trigger a buy signal to their client for stocks the proprietary desk has already purchased to put a buying pressure & earn a profit from the existing positions.
Legally the proprietary trading desk is not supposed to know the customers’ trading data & the front desk & the proprietary desk should be separate.
As per latest development, U.S. President has proposed to put a ban on proprietary trading by depositories & requires that Federal banks keep high reserves in case they wish to engage in proprietary trading. The conflict of interest arising out of proprietary trading may jeopardize the interest of the clients who are investing as per bank’s advice or the investors in general investing on their own.
Proprietary traders use different trading strategies while trading like statistical arbitrage, index arbitrage, risk arbitrage, volatility arbitrage etc. I would discuss those strategies in my coming article.
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