What is Proprietary Trading?
Trading is an important area of Financial Markets and acts as a good source of income generation for companies operating 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. In all these cases the risk of huge gain/loss rests with the client as the organization is only acting on behalf of the clients; however, such services provide these institutions with a limited amount of income, and to boost their income banks indulge in Prop Trading. Now we learn the Proprietary Trading concept.
It refers to trading under which banks (including Banks, Brokerage Houses, Investment Banks, and Financial Institutions) trades in their own account and invests their own capital for their direct gain/loss. Usually, such trading positions are taken in stocks, bonds, currencies, derivatives, etc. In short, the trading desk of the bank takes trading positions using the bank’s own capital which results in huge gains or losses for the bank. Since prop trading involves a lot of bank’s own capital it carries a huge risk as well. In the unlikely event that adverse movement happens in the trading positions (means stocks purchased by the company started falling in value), organizations face huge losses that can wipe of their capital and can 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 huge 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 enable them to boost their profits and deliver better performance for their shareholders and large bonus payouts for staff. Mostly it has been observed that Trader at Large banks insist on taking leveraged positions which results in magnifying gains/losses for these institutions in case such leveraged positions fail to deliver the desired outcome.
However, it is pertinent to note a few important 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 put public money in jeopardy.
- 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: Under this large financial institution acts as market makers (liquidity providers) for large Corporations and helps in increasing liquidity for a particular security/scrip by indulging in the purchase and sale of 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, in case the value declines, banks stare at huge losses also due to losses in their investment in such stocks.
- Speculative Trades: Large Banks take huge positions either through derivative instruments or by purchasing direct equities, bonds, etc based on the analysis (Fundamental and Technical) and superior information available to them.
Let’s understand a few examples
ABC Bank has a dedicated prop Trading desk that performs Proprietary Trading on behalf of the bank. The Trading desk based on thorough research and market information 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 by indulging in Proprietary Trading ABC Bank in its pursuit of making big profits is also increasing the risk side of the bank.
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Proprietary Trading acting as Market Maker through another example
Chrome International is a Proprietary Trading firm that as a market maker for various Corporations planning to offload a large number of shares of their Corporations. One of the corporations, L International appoints Chrome International as market makers to assist them in offloading a large number of shares in the market. In this case, Chrome International take the other side (buy-side) and purchases all the shares offloaded by L International without much change in the price of 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 that is done by large banks using their own capital for big gains; however such trading also makes banks risky and lead to instability of the Financial System. Since banks are basically using the money deposited by the general public, it results in putting public money in jeopardy. Various countries around the globe have restricted Proprietary Trading by Banks, among the most notable is the Volcker Rule which is part of the Dodd-Frank Wall Street Reform which was introduced after the financial crisis of 2007-10. The rule prohibits banks and related entities from engaging in short-term proprietary trading of securities, Derivatives strategy on such securities for their own account and also put a restriction on banks to hold ownership up to a certain percent in hedge funds and Private Equity.
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