Defining propriety trading
Commercial banks or financial firms have various ways to generate gains. They can get a commission from the clients when they trade for them. They can also focus more on direct markets to generate income. The latter is what we call propriety trading, also known as “prop trading.”
When we say propriety trading, we are talking about various asset trading. For instance, it may involve stocks, bonds, currencies, commodities, and more. In this type of trading, profits come from market activities instead of commissions with a thin margin from client trading activities.
Why do entities choose to engage with propriety trading?
The most common entities that do propriety trading include financial institutions, brokerage firms, investment banks, etc. These entities participate in propriety trading when they firmly believe that they have an edge in the competition. They think that this type of trading will help them generate an annual return that is more than what they can earn from other investment styles like bond yield appreciation and index investing.
Trading desks of the entities we have mentioned maximize their capital and balance sheet to self-promote financial transactions. These trades involve a lot of speculation. Hence, they can only be executed using complex investment vehicles or various derivatives.
Should a company or a firm engage in propriety trading?
There are three main benefits that a financial institution or a commercial bank can gain from propriety trading.
- Profits. If we look more closely, the profits that come in every quarter and every year are higher. Entities that trade for clients earn revenues from commissions and fees. If we look at the total profits generated, we will see that this income is only a tiny portion. However, the process itself makes the institution get 100% of the profits from the investment.
- Inventory. Propriety trading helps the institution have a securities inventory stockpile. If you are wondering what good can that bring to the institution, there are two ways. One is the fact that the institution can offer sudden edges to the clients with the help of any speculative inventory. In another scenario, sometimes, markets are not liquid enough. Hence, it is a challenge to buy or sell in the open market. Propriety trading can is helpful in these situations.
- Liquidity. As we have mentioned, there are times when the market is not liquid enough. Propriety trading can provide more liquidity on one security or a group of securities. Hence, the institution becomes a more significant market maker.
Let us cite an example to cap it off.
An institution can have multiple trading desks. Hence, they can have desks for clients alone. On the other hand, they can also assign a specific desk that will solely and independently work for propriety trading. This desk will only answer a portion of the institution’s revenues and not be involved with clients.
Some clients will want to trade on a massive amount on only one security. There will also be clients who want to trade very illiquid securities. In this case, the institution’s propriety trading desk can work as a market maker because clients like these are not typical. Hence, the propriety trading desk will stand as the buyer or the seller that will initiate the other side of the trade.