Proprietary trading or prop trading, is a term used to describe financial institutions that use their own funds to invest and trade in stocks, bonds, commodities, currencies, and other financial instruments. Usually, financial institutions use client funds to trade and invest in the capital markets, earning money through commissions and fees. Prop trading allows them freedom, as the returns they generate remain with them because the funds they use are theirs. Financial institutions can leverage their expertise in analysing and predicting stock and bond market movements to make substantial returns and increase their value.
How does proprietary trading work?
Prop trading in India, the United States, the United Kingdom, and other countries works almost the same way. Financial institutions invest capital in financial instruments of their choice with the hope of profiting from price movements. Different firms use different investing and trading strategies: Some use high-frequency trading, which means making thousands of transactions per day, while others pick traditional approaches based on fundamental analysis of companies and economies. Statistical arbitrage, which exploits discrepancies between related financial instruments, and event-driven strategies, which seek to capitalise on price movements caused by significant events such as mergers, acquisitions, or earnings announcements, are two other popular strategies used by prop trading firms in India.
Importance of proprietary trading
With the meaning of proprietary trading and its working clarified, let us also understand why it is important in a financial market:
- Improving financial performance
For financial institutions, proprietary trading is a way to use their capital to trade in multiple asset classes. Decoding opportunities to make profits in the market, such institutions can enhance their financial performance through proprietary trading. - Risk minimisation
Another important role of proprietary trading is to hedge the risks that arise from volatility in business operations, such as market-making and underwriting. Eyeing profits from the financial market through proprietary trading, businesses can efficiently offset potential losses. - Increasing market liquidity
Financial institutions also enhance the overall market liquidity by trading in financial assets. This, in turn, contributes to the smooth and successful operations of the financial market. - Get market insights
Through proprietary trading, financial institutions can stay on top of the dynamic market landscape, tracking trends and making well-informed decisions. Financial institutions also analyse trading operations to gain insights into the market landscape. Armed with these insights, proprietary trading enables a firm to generate profits and manage its capital more efficiently. Due to the ever-present market risks, it is also crucial for financial institutions to design and implement rules for risk management and place stringent controls to minimise losses.
Hedge fund vs Prop trading
Prop trading companies and hedge funds are both important market participants. However, the two have significant differences in their goals, activities, and structure. Let us examine each of these one by one and understand the differences in greater detail:
Hedge funds
- Objective: Hedge funds work towards generating profits for their investors, who are called limited partners. This is achieved through active portfolio management.
- Investor base: Institutional investors are the primary source of capital for hedge funds. The investor base also consists of HNIs (high-net-worth individuals) and, at times, retail investors.
- Managing risk: A hedge fund usually incorporates hedging strategies in trading to manage its risks. This includes trading with a combination of short and long positions and derivatives, among other things, to control exposure in the market and minimise losses.
- Assets: Hedge funds can, more often than not, freely invest across asset classes. This can include bonds, stocks, derivatives, commodities, or even other investment avenues like real estate and private equity.
- Fees: With active management, there would also be a corresponding fee. Typically, these companies charge investors fees that go towards portfolio management. Moreover, depending on the fund's performance, there is also a performance fee. The fees are structured so that 2% goes towards management and 20% is based on performance.
Proprietary trading
- Objective: A financial institution that undertakes proprietary trading remains solely focused on turning a profit for itself, utilising its funds as well.
- Source of capital: Financial institutions use their funds instead of relying on external investments.
- Risk management: The proprietary trading department of a financial institution actively works towards hedging its risk through trading strategies and measures to control risk, generate maximum profits, and minimise losses.
- Trading focus: Desks that oversee proprietary trading at financial institutions are primarily focused on trading activities by leveraging strategies like arbitrage, market making, and event-driven trading.
- Regulatory considerations: Proprietary trading takes place under a set of regulatory guidelines and oversight. Stringent regulations are in place to minimise risks and ensure long-term stability.
A key difference between proprietary trading and hedge funds is that the latter works with external investors, while the former entails an institution investing in the market with its own money to generate profit for itself.
Also read: Derivative trading
Benefits of proprietary trading
Most financial institutions engage in proprietary trading because it offers unique benefits. Let us take a look at the primary benefits of proprietary trading:
- Profit generation
Proprietary trading is aimed at making a profit for the given financial institution. As these companies utilise their funds and rely on trading strategies, they can earn handsome returns. Investing themselves and for themselves can lead to significantly higher returns than doing it for clients. - Research and innovation
Firms can leverage their subject knowledge and research capabilities to directly profit from investments in assets like gold, stocks, and bonds. In a financial institution, the desk overseeing proprietary trading often invests significantly in technology and research to gain market insights. This not only helps the company make higher profits but also adds to the existing financial market knowledge and understanding in general. - Risk control
With proprietary trading, financial institutions can directly manage their trading activity and exposure to risk. While in the traditional trading method, institutions place trades in the market for their clients, in proprietary trading, they can rely on active portfolio management to effectively manage risk. - Talent attraction
Proprietary trading often attracts top talent from the industry as it is challenging yet incredibly rewarding. Given the lucrative nature of trades in proprietary trading, even experienced and highly skilled market traders are drawn to it. - Market liquidity
Proprietary trading also increases liquidity in financial markets, making it easier for other participants to participate. By providing more buying and selling opportunities, prop trading desks, especially the ones that undertake market making, help maintain an efficient and orderly market. - Revenue diversification
Financial institutions can diversify their revenue streams through prop trading. Firms can derive income directly from their trading activities instead of relying solely on client fees and commissions. Evolving beyond the traditional dependency on client-based activities, this diversification can be particularly beneficial in times of market downturns or when traditional revenue sources underperform.
An example of a proprietary trading desk
Consider a proprietary trading desk within a leading financial institution in India. This desk has state-of-the-art technology and experienced traders and analysts with deep knowledge of the stock as well as money markets. They utilise several trading strategies, such as day trading to swing trading, relying on both quantitative models and qualitative assessments of market conditions. While these desks specialise in the Indian equity markets, they also have expertise in global markets, trading overseas equities, bonds, and derivatives. These traders have a singular goal: Capitalise on market movements and generate profits for the financial firm.
Also read: Equity trading
Why do firms engage in proprietary trading?
It is easy to see why many financial institutions have prop trading desks. The potential for profits is high as financial institutions have a team of analysts, who have deep expertise of the stock as well as money markets. Unlike client-based trading, where firms earn a commission regardless of the trade's outcome, prop trading allows firms to capture the entire profit from successful trades. This high-reward setup incentivizes firms to develop sophisticated trading strategies and invest in top-tier talent and technology.
Additionally, prop trading in India gives firms the freedom to create and execute strategies without the need for client approval. This autonomy can lead to innovative trading approaches and ensure swifter and more efficient use of market opportunities.
Can banks engage in proprietary trading?
Banks in India can engage in proprietary trading unlike their counterparts in the United States. However, prop trading by banks in India is regulated to ensure proper risk management. The Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI) have guidelines and frameworks in place to govern proprietary trading activities of banks. This ensures they maintain adequate capital reserves and adhere to risk management practices.
Conclusion
Proprietary trading is a vital component of the financial sector. It helps drive profits for financial firms and contributes to market liquidity and efficiency. With its potential for high rewards, it attracts some of the brightest minds and most sophisticated technologies in the finance industry. As regulations evolve and markets become more interconnected, the strategies and approaches of proprietary trading desks will continue to advance, remaining a vital part of the global financial ecosystem.
