Proprietary Trading

Proprietary trading, commonly called prop trading, is when a financial institution, trading firm, or individual trades financial instruments using its own capital rather than on behalf of clients. The profits and losses belong entirely to the firm. There are no client accounts to manage, no fiduciary duties to outside investors, and no client commissions. The firm puts its own money to work and keeps whatever it makes or absorbs whatever it loses.

Think of it as the difference between a casino running a poker room for customers versus the casino playing the games itself.

Who Engages in Proprietary Trading

Proprietary trading happens across a wide range of institutions with very different approaches.

Before the Volcker Rule took effect in 2014, major investment banks including Goldman Sachs, Morgan Stanley, and JPMorgan ran large proprietary trading operations alongside their client businesses. The Volcker Rule, part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, prohibited banks insured by the Federal Deposit Insurance Corporation from engaging in most forms of proprietary trading. Banks responded by spinning out or closing many of their prop trading operations.

Dedicated proprietary trading firms stepped in to fill the space. Jane Street Capital, Citadel Securities, and Virtu Financial are among the largest, running systematic and high-frequency strategies across equities, fixed income, currencies, and derivatives. These firms are not banks and are not subject to the Volcker Rule.

Major Trading Strategies Used in Prop Trading

Proprietary traders use virtually every strategy available to the financial markets.

• Market making: Continuously posting bid and ask prices and profiting from the spread between them. Market makers provide liquidity to other participants and earn small profits on high volume. Jane Street Capital and Virtu Financial are dominant market makers across equity and options markets.
• Arbitrage: Exploiting price discrepancies of identical or related instruments across markets or time periods. Statistical arbitrage uses quantitative models to identify mean-reverting price relationships and trade the deviations.
• High-frequency trading: Using co-located servers and ultra-low-latency connections to execute thousands of trades per second, profiting from small price advantages measured in microseconds.
• Directional trading: Taking long or short positions based on a view that a security is mispriced and will move in a specific direction. This is the most traditional form of trading and requires correctly predicting price movements.
• Global macro: Trading currencies, commodities, and interest rate products based on macroeconomic analysis of central bank policy, economic data, and geopolitical events.

The Volcker Rule and Its Ongoing Complications

The Volcker Rule introduced one of the most complex regulatory regimes in U.S. financial history. The definition of proprietary trading under the rule, and the exemptions for market making, hedging, and underwriting, have generated thousands of pages of guidance, interpretive letters, and enforcement actions since implementation.

The rule contains an exemption for market making because banks still need to facilitate client transactions by holding inventory. Regulators examine whether a bank's inventory holdings reflect genuine market-making activity, with positions turning over rapidly in response to client demand, or whether they represent directional proprietary exposure dressed up as market making.

Prop Trading at Smaller Firms and Funded Accounts

At the other end of the scale, hundreds of boutique proprietary trading firms hire traders and provide them with firm capital, splitting profits. These firms exist outside the banking system and are not subject to the Volcker Rule. Many specialize in a single asset class or strategy, trading equities, futures, or foreign exchange with tight risk controls and technology infrastructure built specifically for their approach.

Sources

• https://www.sec.gov/staff-bulletins/2020/trading-markets
• https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/proprietary-trading/