What is Proprietary Trading
Proprietary trading is when a firm or bank invests for its own direct market gain instead of earning commission dollars by trading on behalf of its clients. This type of trading occurs when a firm decides to profit from the market rather than from the thin-margin commissions it makes from processing trades. Firms or banks that engage in proprietary trading believe that they have a competitive advantage that will enable them to earn excess returns.
BREAKING DOWN Proprietary Trading
Proprietary trading, also known as prop trading, happens when a trading desk at a large financial institution — often a brokerage firm or an investment bank — uses the organization's own capital and balance sheet to conduct financial transactions. These trades are usually speculative in nature, and the products are often derivatives or other complex investment vehicles.
Benefits of Proprietary Trading
There are many benefits that proprietary trading gives a financial institution, most notably increased profits. When a brokerage firm or investment bank trades on behalf of its clients, it earns revenues in the form of fees and commission dollars. These dollars can either be soft or hard, but they are normally a very small percentage of the total amount invested or the gains generated. Proprietary trading, on the other hand, allows an institution to realize 100% of the gains earned from an investment.
The second benefit is that the institution is able to stockpile an inventory of securities. This helps in two ways. First, any speculative inventory allows the institution to offer it to its clients when it might not have had it otherwise. Second, it helps these institutions prepare for down or illiquid markets when it becomes hard to purchase securities on the open market.
The final benefit is associated with the second. Proprietary trading allows a financial institution to become an influential market maker by providing liquidity on a specific security or group of securities.
An Example of a Proprietary Trading Desk
In order for proprietary trading to be effective and also keep the institution's clients in mind, the proprietary trading desk are normally secluded from other trading desks. This desk is responsible for a portion of the financial institution's revenues unrelated to any client work and acts somewhat autonomously.
However, proprietary trading desks can function as a market maker, as outlined above. This situation arises when a client wants to trade a large amount of a single security or trade a highly illiquid security. Since there aren't many buyers or sellers for this type of trade, a proprietary trading desk will act as the buyer or seller, initiating the other side of the client trade.