Updated October 30, 2023
What is Proprietary Trading?
Trading is an essential area of Financial Markets and a good income generation source for companies in the Banking and Financial Service Industry.
Banks, brokerage houses, Investment Banks, and Financial Institutions (collectively referred to as Banks here) perform trading activities on behalf of their clients by executing their buy or sell orders through the platforms available at their end and also by providing advisory services to them related to hedging strategies, arbitrage opportunities, etc. and receive commission payments in lieu of the services offered by them. The organization acts on behalf of clients, with the risk of significant gain or loss resting with the clients. Banks engage in Prop Trading to enhance their income as these services generate limited income for financial institutions. Now we learn the Proprietary Trading concept.
It refers to trading under which banks (including Banks, Brokerage Houses, Investment Banks, and Financial Institutions) trade in their account and invest their capital for their direct gain/loss. Usually, such trading positions are taken in stocks, bonds, currencies, derivatives, etc. In short, the bank’s trading desk takes trading positions using the bank’s capital, which results in huge gains or losses for the bank. Since prop trading involves much of the bank’s capital, it carries a huge risk. In the unlikely event that adverse movement happens in the trading positions (which means stocks purchased by the company started falling in value), organizations face huge losses that can wipe off their capital and put depositors’ money at very high risk.
Why do Banks Pursue Proprietary Trading?
It is a high-risk, high-return proposition for large banks. Due to the vast amount of capital, these banks have at their disposal, sophisticated advanced technology, and superior market information, large banks usually take a huge position in their Proprietary Trading desks, which enables them to boost their profits and deliver better performance for their shareholders and large bonus payouts for staff. It has been observed that Traders at Large banks insist on taking leveraged positions, which results in magnifying gains/losses for these institutions if such leveraged positions fail to deliver the desired outcome.
However, it is pertinent to note a few essential points in this regard:
- Trading positions taken by banks for Prop trading expose them to huge losses that can wipe off their Regulatory Capital and jeopardize public money.
- Trading positions held by Banks attract Market Risk Capital charges as per Basel Norms, and the bank has to keep additional capital for that purpose.
- Proprietary trading can result in huge gains for the banks; it compels traders to take more risk as their bonuses are linked to the performance and make a bank riskier.
It is done by Banks either in the capacity of Market makers or purely based on Speculative reasons (based on superior information):
- Market Makers: This sizeable financial institution acts as a market maker (liquidity provider) for large Corporations and helps increase liquidity for a particular security/scrip by purchasing and selling such security. Large banks buy/sell, as the case may be huge quantities of stocks of large corporations, and provide liquidity in the market, which results in better price discovery and more liquidity in the stocks of such corporations. However, since banks buy large quantities as market makers, if the value declines, they stare at huge losses due to losses in their investment in such stocks.
- Speculative Trades: Large Banks take huge positions through derivative instruments or by purchasing direct equities, bonds, etc., based on the analysis (Fundamental and Technical) and superior information available.
Let’s Understand a Few Examples
ABC Bank has a dedicated prop Trading desk that performs Proprietary Trading on behalf of the bank. Based on thorough research and market information, the Trading desk decided to purchase a large quantity, say 1o million shares of Rs 100 each, of Insync International, a company operating in the Automobile space. In such a case, ABC Bank is investing a large sum of Rs 1 billion and will produce magnifying returns in case Insync International scrip goes up; however, the loss amount will also be very high in case the price of scrip goes down in case of deterioration of fundamentals of the company or adverse policies for the company. Thus, indulging in Proprietary Trading ABC Bank in its pursuit of making big profits is also increasing the risk side of the bank.
Proprietary Trading Acting as Market Maker Through Another Example
Chrome International is a Proprietary Trading firm that is a market maker for various Corporations planning to offload many shares of their Corporations. One of the corporations, L International, appoints Chrome International as a market maker to assist them in offloading a large number of shares in the market. In this case, Chrome International takes the other side (buy-side) and purchases all the shares offloaded by L International without much change in the price of the scrip of L International and later on sells the purchased shares in small quantities to other investors at higher prices thereby making a profit for Chrome International. However, acting as a market maker, the risk of huge losses stays with Chrome International in case of adverse price movements.
Thus, we can see that Prop Trading is a high-risk business done by large banks using their capital for big gains; however, such trading also makes banks risky and leads to instability of the Financial System. Since banks are using the money deposited by the general public, it jeopardizes public money. Various countries around the globe have restricted Proprietary Trading by Banks. The Dodd-Frank Wall Street Reform introduced the Volcker Rule among its notable measures in response to the financial crisis of 2007-10. The rule prohibits banks and related entities from engaging in short-term proprietary trading of securities and derivatives strategy on such securities for their account. It restricts banks from holding ownership up to a certain percentage in hedge funds and Private Equity.
This is a guide to Proprietary Trading. Here, we have discussed the basic concept, why banks pursue proprietary trading, and a few examples. You may also have a look at the following articles to learn more –