Proprietary trading is also known as prop trading, and it is relate d mostly to the banking field. Such type of trading occurs when firms or banks are up to trading. The trading can be of derivatives, stocks, bonds, or commodities. Many other financial instruments are also involved in such types of trading. Before you learn how to do prop trading firms work, we will give a brief detail about prop trading and why it is needed.
The financial firms or banks usually use the clients’ money for trading purposes. But in Proprietary Trading, the bank or the specific firm uses its own money. As a result, the firms earn more profit directly through trading. In this process, they do not get profit from the commission that is used to process trades through clients.
Why Prop Trading is needed, and what are the strategies used by the traders?
Banks and firms need the excess profits to keep the system running. So, the prop trade is made to make more profits. In these scenarios, the banks and firms have the edge over the average investors. There are various strategies used by prop traders so they can maximize their returns. These include index arbitrage, merger arbitrage, global macro-trading, and volatility arbitrage. The propriety trades also use pools and sophisticated software to make critical decisions.
Prop Trading Word Map
Prop trading is one of the most profitable operations when viewing it from a commercial angle or investment bank. But it is quite risky. So firms have to make sure that they are using the right ways to take appropriate steps. In 2008, the financial crisis occurred, and the main reason behind this crisis was the prop traders. But then the Volcker rule was introduced that showed how to do prop trading.
The main theme was to take commercial firms and banks, but not the involvement of the individual traders was considered as they do not help in making profits.
How Do Prop Trading Firms Work?
The main question is how prop trading eventually works. Well, this whole process of trading is taken place when a brokerage firm, financial institution, or hedge fund uses the capital or finances of the firm rather than the individuals’ funds.
To conduct the financial transaction, the balance sheet and total capital are used, and in this way, transactions are promoted.
There are different derivates and vehicles that drive these trades as they are mostly speculative.
The Volcker Rule on Prop Trading
Most propriety trading firms make money by taking a cut of the profits made by trading on behalf of a prop firm or a bank. Returns are then multiplied by the amount of extra capital that is provided by any bank or a trading firm. Many prop traders and firms offer a base salary, and additionally, they pay a performance-based bonus.
According to Dodd-Frank Wall Street Reform and Consumer Protection Act, the Volcker rule was introduced by Paul Volcker. He was the former chairman of the Federal Reserve. According
to this rule, the banks are restricted to not making any investments that are not beneficial for investors or depositors.
Commercial banks make high investments that eventually affect stability and cause financial crises. Thus, the Volcker Rule bans the institutes and banks that engage in prop trading or participate in a private equity fund. As we know that banks keep the commissions and make compensations over them to make the customers happy. But according to prop trading, the commissions are not considered, and banks take the whole profit.
By separating the functions, the banks meet the objective to both benefits the customer and also limiting the conflict of interest. Many prop trading firms offer the services of prop trading to help the firms and banks.