SEC on Proprietary Trading and Covered Funds: Financial Regulation (2013)

• published: 22 Dec 2014
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Proprietary trading (also "prop trading") occurs when a firm trades stocks, bonds, currencies, commodities, their derivatives, or other financial instruments with the firm's own money, as opposed to depositors' money, so as to make a profit for itself. Proprietary traders 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 proportion of proprietary versus non-proprietary trading, because it is felt that proprietary trading is riskier and results in more volatile profits. There are a number of ways in which proprietary trading can create conflicts of interest between a bank's interests and those of its customers.[2] 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, especially since the Enron scandal, these have come under closer 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.[3] Famous proprietary traders have included Ivan Boesky, Steven A. Cohen, John Meriwether, Daniel Och, and Boaz Weinstein. Some of the investment banks most historically associated with trading were Salomon Brothers and Drexel Burnham Lambert, and currently Goldman Sachs. Trader 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. Banks are companies that assist other companies in raising financial capital, transacting foreign currency exchange, and managing financial risks. Trading has historically been associated with large banks, 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 reached the point where many banks employed multiple traders devoted solely to proprietary trading, with the hopes of earning added profits above that of market-making. These proprietary trading desks were often considered internal hedge funds within the bank, performing in isolation away from client-flow traders. Proprietary desks routinely had the highest value at risk among other trading desks at the bank. At times, investment banks such as Goldman Sachs, Deutsche Bank, and the late Merrill Lynch earned a significant portion of their quarterly and annual profits (and losses) through proprietary trading efforts. 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 recent financial regulations like the Volcker Rule in particular, most major banks have spun off their prop trading desks or shut them down altogether.[1] However, prop trading is not gone. It is carried out at specialized prop trading firms and hedge funds. Some notable prop trading firms are Virtu Financial, Tower Research Capital LLC, Jump Trading LLC, KCG Holdings, Inc., Traditum Group LLC, First New York Securities and DRW Trading Group. The prop trading done at these firms is usually highly technology-driven, utilizing complex quantitative models and algorithms. http://en.wikipedia.org/wiki/Proprietary_trading