Proprietary trading (also "prop trading" or PPT) occurs when a firm trades stocks, bonds, currencies, commodities, their derivatives, or other financial instruments, with the firm's own money as opposed to its customers' money, so as to make a profit for itself. They may use a variety of strategies such as index arbitrage, statistical arbitrage, merger arbitrage, fundamental analysis, volatility arbitrage or global macro trading, much like a hedge fund. Many reporters and analysts believe that large banks purposely leave ambiguous the amount of non-proprietary trading they do versus the amount of proprietary trading they do, because it is felt that proprietary trading is riskier and results in more volatile profits.
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Banks are companies that assist other companies in raising financial capital, transacting foreign currency exchange, and managing financial risks. Trading has almost always been associated with large banks, however, because they are often required to make a market to facilitate the services they provide (e.g. trading stocks, bonds, and loans in capital raising; trading currencies to help with international business transactions; and trading interest rates, commodities, and their derivatives to help companies manage risks).
For example, if General Store Co. sold stock with a bank, whoever first bought shares would possibly have a hard time selling them to other individuals if people are not familiar with the company. The investment bank agrees to buy the shares sold and look for a buyer. This provides liquidity to the markets. The bank normally does not care about the fundamental, intrinsic value of the shares, but only that it can sell them at a slightly higher price than it could buy them. To do this, an investment bank employs traders. Over time these traders began to devise different strategies within this system to earn even more profit independent of providing client liquidity, and this is how proprietary trading was born.
The evolution of proprietary trading at banks has come to the point whereby banks employ multiple desks of traders devoted solely to proprietary trading with the hopes of earning added profits above that of market-making trading. These desks are often considered internal hedge funds within the bank, performing in isolation away from client-flow traders. Proprietary desks routinely have the highest value at risk among other desks at the bank. Investment banks such as Goldman Sachs, Deutsche Bank, and the late Merrill Lynch are known to earn a significant portion of their quarterly and annual profits through proprietary trading efforts.
The proprietary trading desk is kept separate, by law, from knowledge about customer flow, so they cannot engage in the business of front-running a customer's order.
There often exists confusion between proprietary positions held by market-making desks (sometimes referred to as warehoused risk) and desks specifically assigned the task of proprietary trading.
Because of the impending financial regulation (Volcker Rule in particular), major banks have spun off their prop trading desks or shut them down all together. However, prop trading are not gone. They are done at specialized prop trading firms and hedge funds. Some of the notable prop trading firms are based in Chicago, including GETCO LLC, Jump Trading LLC and DRW Trading Group. The prop trading done at these prop trading firms are usually highly technology driven, utilizing complex quantitative models and algorithms.
One of the main strategies of trading, traditionally associated with banks, is arbitrage. In the most basic sense, arbitrage is defined as taking advantage of a price discrepancy through the purchase/sale of certain combinations of securities to lock in a profit.
Many people confuse arbitrage with what is essentially a normal investment. The difference between arbitrage and a typical investment is the amount of reward: the risk in what is known as arbitrage today (to distinguish it from theoretical arbitrage, which effectively does not exist) is market neutral. From the second the trade is executed, a profit is locked in. Investment banks, which are often active in many markets around the world, constantly watch for arbitrage opportunities.
One of the more notable areas of arbitrage, called risk arbitrage, evolved in the 1980s. When a company plans to buy another company, often the price of a share in the capital of the buyer falls (because the buyer will have to pay money to buy the other company) and the price of a share in the capital of the purchased company rises (because the buyer usually buys those shares at a price higher than the current price). When an investment bank believes a buyout is imminent, it often sells short the shares of the buyer (betting that the price will go down) and buys the shares of the company being acquired (betting the price will go up).
There are a number of ways in which proprietary trading can create conflicts of interest between a trader's interests and those of its customers.[1]
As investment banks are key figures in mergers and acquisitions, it is possible (though prohibited) for traders to use inside information to engage in merger arbitrage. Investment banks are required to have a Chinese wall separating their trading and investment banking divisions; however, in recent years, dating most recently back to the Enron saga, these have come under great scrutiny.
One example of an alleged conflict of interest can be found in charges brought by the Australian Securities and Investment Commission against Citigroup in 2007.[2]
Famous proprietary traders have included Steven A. Cohen, Edward Lampert, Daniel Och, and Boaz Weinstein. Some of the investment banks most historically associated with trading was Salomon Brothers and Drexel Burnham Lambert, and currently Goldman Sachs. Nick Leeson took down Barings Bank with unauthorized proprietary positions. Another trader, Brian Hunter, brought down the hedge fund Amaranth Advisors when his massive positions in natural gas futures went bad.
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