Proprietary trading, often shortened to prop trading, is the buying and selling of financial instruments by a firm using its own capital and for its own account. The firm keeps the gains and bears the losses. This sets it apart from agency business, in which a broker executes orders for clients and earns a commission, and from asset management, in which a manager invests money that belongs to outside investors.
The activity is carried out by specialist proprietary trading firms, by trading desks inside banks where the law allows it, and by some commodity and energy companies. It covers shares, bonds, currencies, commodities and derivatives. Because no client money is involved, such firms face lighter investor-protection rules than fund managers, but they are still subject to exchange rules, capital requirements and market-conduct law.
How proprietary trading firms operate
A proprietary trading firm is usually a private partnership or company funded by its owners and retained profits. Traders or trading teams are given a capital allocation and risk limits, and are paid a share of the profit they generate. Losses reduce the firm's own equity, so position limits, daily loss limits and a firm-wide risk management system are central to the business.
Many of the largest firms are heavily automated. They invest in fast connections to exchanges, in colocation of their servers and in research staff who design and test strategies. Well-known examples include Jane Street, Optiver, DRW, Jump Trading, Susquehanna, IMC and Hudson River Trading. Several of these firms account for a large share of daily volume in exchange-traded funds, listed options and futures.
Common strategies
- Market making. The firm quotes prices at which it will buy and sell, and earns the bid-ask spread while managing the inventory it accumulates. Market making is the largest single activity of modern prop firms.
- Arbitrage. The firm trades related instruments whose prices have moved out of line, as in index arbitrage between a futures contract and the shares in the index.
- Statistical and quantitative strategies. Models are used to find small, repeatable patterns across many instruments, as in statistical arbitrage.
- Directional and event trading. Traders take positions on the expected direction of a market, or on events such as mergers, earnings and central bank decisions.
Much of this is done at very short holding periods through high-frequency trading, although some firms hold positions for days or months.
Banks and the Volcker Rule
Until the 2008 financial crisis, large investment and commercial banks ran substantial proprietary desks alongside their client businesses. Losses on trading positions during the crisis led lawmakers to question whether institutions that hold insured deposits and have access to central bank support should take such risks.
In the United States the answer was the Volcker Rule, section 619 of the Dodd-Frank Act of 2010, named after former Federal Reserve chairman Paul Volcker. It generally prohibits banking entities from short-term proprietary trading in securities, derivatives and commodity futures, and limits their investments in hedge funds and private equity funds. Exemptions cover market making, underwriting, risk-mitigating hedging and trading in government securities. The implementing regulations were adopted by five federal agencies in December 2013 and were simplified in 2019. Most large banks closed or spun off their stand-alone proprietary desks, and many of the traders moved to hedge funds and independent firms.
Retail prop firms
The term is also used for businesses that offer individual traders access to a funded account after they pay a fee and pass a trading evaluation. The trader receives a share of any profit and the firm sets strict loss limits. In many of these programs the evaluation and early trading take place in a simulated account, and the firm's income comes largely from fees. Regulators in several countries have warned consumers to check how such programs work, and the model is distinct from the institutional firms described above.
Risks and criticism
A proprietary firm is exposed to market risk on its positions, to technology failures and to errors in its models. The collapse of Knight Capital in August 2012, when a faulty software release caused a loss of about $440 million in under an hour, is the standard example of operational failure at an automated trading firm. The use of leverage magnifies both gains and losses.
Supporters argue that proprietary firms supply liquidity and narrow spreads for other investors. Critics reply that this liquidity can vanish in stressed markets, that speed advantages come at the expense of slower participants, and that a firm trading for itself while also handling client orders has a conflict of interest.