What is Proprietary Trading?
Proprietary trading occurs when companies use their own funds to trade for their own gain, rather than using the money of depositors. For example, some financial services companies will not only facilitate trading for people. They will also engage in markets directly and make their own trades. Many brokers rely on fees collected from traders. Some proprietary trading firms though will also make profits off of their own investments.
Prop trading can be a great way for companies to earn money. Many financial services firms already have expertise in the financial services sector. That’s why it makes sense for them to engage in trading more directly. By using their own funds, and developing their own strategies, firms can produce a substantial amount of profits via markets.
Banks as Prop Trading Firms
You will already know about some propriety trading companies. Many banks, for example, engage directly in trading and are considered prop companies. In fact, these days, banks can actually make more money off of their investments rather than their other financial services. In the past, banks would usually focus exclusively on serving their customers, unless of course they were investment specific firms that focused particularly on investing. Changes in regulations, however, now allow firms to engage in both traditional, customer-facing banking, and investing.
Often, companies engaged in this type of propriety trading, are using “spot” trading. Spot trading means that goods are delivered on the spot. If you’re familiar with investing, you’ll know that many financial transactions are actually futures or derivatives trades. This involve future time lines, though money itself is also exchanged on the spot. Newbies may think that all investing involves spot trading. However, many investments are much, much more complex than simply exchanging money and goods in the present. Understanding how these more complex investments work is a must for newbies as many professional firms are heavily engaged in these more complex vehicles. That is because they allow for more speculation and thus increase the chance of profits (and also losses).
This is not always, the case, however. Prop trading firms can use a wide range of strategies to manage their investment portfolios. Often, the amount of money results in some companies taking more macroviews and trying to profit off of trends, rather than spending precious time studying individual stocks and company performance. Also, some firms are a bit risk adverse because they know that risky investments could put the larger company at risk. Either way, a well-managed firm will be aware of and conscious of all of the risks found in the marketplace.
The Risks Of Proprietary Trading
It should be noted that many financial experts consider propriety trading to be more volatile and riskier than non prop trading. Banks and other companies that engage in this type of trading are leaving their fate to the markets, so to speak. If markets suddenly turn south, they could lose considerable sums of money. Given that client deposits fund many banks, and banks hold money from the public, if these banks fail, it could put said clients at risk.
Prop Trading and the 2008 Financial Crisis
Some people argue that the proliferation of proprietary trading has increased risks in markets. For example, many people believe, at least in part, that traditional banks becoming too involved in investment banking and prop trading caused the 2008 Financial Crisis. When these banks become overexposed, critics argue, it created too many risks and too many liabilities.
Upside of Proprietary Trading
There is another side to this argument, however, and one that investors and financial policy makers must consider. By allowing banks to engage in investing, we allow them to produce more profits. In the long run, this should lead to a more profitable industry, which itself can have many benefits. For example, as banks make more money off of investments, they will be under less pressure to make money off of their financial services they offer to customers. This can result in lower fees. The full benefits of prop trading are quite complex. Suffice to say though that while risks and exposure does increase, there is a strong argument that the benefits outweigh the drawbacks.
Want to learn more about these types of trading and investment groups? You can check out websites like Investopedia and Wikipedia. You can also check out individual firms to learn more about them and how they operate. Another good one to read up on is WTS proprietary trading group. There are tons and tons of resources out there, and countless firms engaged in proprietary trading. So make sure you take the time needed to read up on and learn about the topic.