What is Proprietary Trading?

Published by Thomas Herold in Economics, Investments, Trading

'Proprietary Trading' is explained in detail and with examples in the Economics edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Proprietary Trading refers to a type of trading in which the bank or other financial institution invests its own funds for its own benefit. They do this instead of investing the money of and for their clients and gaining a commission fee for trading for their customers. Such trading happens as a firm makes the choice to engage in market profiteering instead of existing on the tiny commissions which they realize for taking and processing others’ trades.

Those banks and companies which pursue such proprietary trading feel certain they enjoy some from of competitive advantage. It is this which provides them with the confidence in their own abilities to make outsized returns versus other traditional investors.

Proprietary trading is actually a dangerous and risky type of trading. Rather than safely carrying out the orders of their clients and collecting their fair commissions, the bank traders take on real positions using the capital of the company. In other words, they will enjoy the entire profit or suffer from the brunt of the full loss of such a position. These firms will do this entirely electronically to boost their speed of execution. They will employ the firms’ own leverage in order to multiply the size of their positions as well as the hoped for returns or actually realized losses which they incur.

This actually occurs because the company’s own trading desk at these huge financial institutions decides they can do it for themselves. These companies are typically investment banks or brokerage firms. They will then utilize their own corporate balance sheet and capital of the company in order to make transactions in the financial or stock markets. Such trades are commonly speculative. The products in which they trade are commonly complicated and dangerous investment vehicles such as derivatives and credit default swaps.

Naturally these financial companies receive benefits from proprietary trading on their own behalf. The biggest one is that they often do enjoy higher profits, at least until a financial crisis hits like with the one in 2007-2009 that nearly overthrew most of the American, British, and continental European banking system financial institutions. With these proprietary trades, the brokerage firm or investment bank gets to keep all of the investment gains which they realize from their investments.

A second benefit which these large financial firms enjoy is that they will be capable of inventorying an impressive array of securities. It allows them to offer their speculative inventory directly to their clients who could not have obtained it any other way. It also helps the institutions to be well-supplied with securities in the event of illiquid or declining markets when it is more difficult to buy such securities on the free markets.

The last benefit pertains to the second one. With such proprietary trading, financial firms can evolve into an important market maker. They gain the ability to offer liquidity for a particular security or even range of securities through dealing in such investments. They can realize profitable spreads and fees when acting in this capacity.

The ugly truth is that this proprietary trading has led to enormous losses for the investment banks in particular. Thanks to the likes of such one time investment banking firms as Merrill Lynch, Bear Stearns, Lehman Brothers, and others engaging in such dangerously over-leveraged proprietary trading schemes before the outbreak of the financial crisis, they nearly brought down the entire financial system.

The Lehman Brothers moment refers to the point where the company failed completely. All other investment banks began to crater at this point. Bear Stearns ceased to be a going concern. Merrill Lynch the one-time largest investment bank and brokerage had to be bought out by Bank of America in order to survive. Both Morgan Stanley and Goldman Sachs, the only remaining two of the big five, were forced to change into traditional banks, backstopped by the FDIC, This helped them to stave off total collapse at the height of the Global Financial Crisis of 2008/2009.

Because of these unmitigated disasters, the Dodd-Frank Legislation and Volcker Rules were passed. These made it increasingly more difficult to engage in such trading for a financial firms’ own benefits and with their leveraged balance sheets and company capital.

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The term 'Proprietary Trading' is included in the Economics edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.