When a firm trades for direct gain instead of commission dollars. Essentially, the firm has decided to profit from the market rather than from commissions from processing trades.
Investopedia Says:
Firms that engage in proprietary trading believe that they have a competitive advantage that will enable them to earn excess returns.
Related Links:
- Learn why this type of investment account has come under fire. Fee-Based Brokerage: The Latest Target For Regulators
- The way a professional is compensated can affect quality of service. Learn more here. Paying Your Investment Advisor - Fees Or Commissions?
- Smart investors don't give away more money than necessary in commissions and fees. Find out how to save. Don't Let Brokerage Fees Undermine Your Returns
- Discover how these two groups work together to keep the market functioning properly. Traders And Investors' Roles In The Marketplace
Proprietary trading is a term used in investment banking to describe when the firm's traders actively trade stocks, bonds, options, commodities, derivatives or other financial instruments with its own money as opposed to its customers' money, so as to make a profit for itself. Although investment banks are usually defined as businesses which assist other business in raising money in the capital markets (by selling stocks or bonds), in fact most are also involved in trading for their own accounts as well. They may use a variety of strategies such as index arbitrage, statistical arbitrage, merger arbitrage, fundamental analysis[??: Is fundamental analysis a way of trading?I don't understand--this reader], volatility arbitrage or macro trading, much like a hedge fund. Many reporters and analysts believe investment banks purposely leave ambiguous the amount of non proprietary trading they do versus the amount of proprietary trading they do because it is felt that proprietary trading is riskier and results in more volatile profits.
The relationships between trading and investment banking
Investment banks are defined as companies that assist other companies in raising financial capital in the capital markets, through things like the issuance of stocks and bonds. Trading has almost always been associated with investment banks[,] however, because they are often required to make a market in the stocks and bonds they help issue.
For example, if General Store Co. sold stock with an investment 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 in order to find 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 investment banks has come to the point whereby banks employ multiple desks of traders devoted solely to proprietary trading with the hopes of earning added profits above that of market-making trading. These desks are often considered internal hedge funds within the investment bank, performing in isolation away from client-flow traders. Proprietary desks routinely have the highest value at risk among other desks at the bank. Investments banks such as Goldman Sachs, Deutsche Bank, Merrill Lynch, and [something omitted] are known to earn a significant portion of their quarterly and annual profits through proprietary trading efforts.[citation needed]
Arbitrage
One of the main strategies of trading traditionally associated with investment banks is arbitrage. In the most basic sense, arbitrage is defined as taking advantage of a price discrepancy through the purchase/sale of certain combinations of securities to lock in a profit.
Many people confuse arbitrage with what is essentially a normal investment. The difference between arbitrage and a typical investment is the amount of risk: the risk in what is known as arbitrage today (to distinguish it from theoretical arbitrage, which effectively does not exist) is market neutral. From the second the trade is executed, a profit is locked in. Investment banks, which are often active in many markets around the world, constantly watch for arbitrage opportunities.
- One of the more notable areas of arbitrage, called risk arbitrage, evolved in the 1980's.
Conflicts of interest in proprietary trading
There are a number of ways in which proprietary trading can create conflicts of interest between a trader's interests and those of its customers.[1]
Some suspect that traders engage in "front running", buying shares in companies the traders' customers are buying so as to profit from the price increase resulting from the customers' purchases and thereby harming the customers' interests.
Some suspect that investment bank salesmen (who encourage customers to buy particular securities) assist their firm's proprietary traders by encouraging customers to buy securities performing poorly after the proprietary traders have bought them for the firm.
Lastly, because investment banks are key figures in mergers and acquisitions, a possibility exists that the traders could use prohibited 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, dating most recently back to the Enron saga, these have come under great 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.[2]
Famous trading banks and traders
Famous proprietary traders have included Robert Rubin, Steven A. Cohen, Edward Lampert, and Daniel Och. Some of the investment banks most historically associated with trading was Salomon Brothers and Drexel Burnham Lambert, and currently Goldman Sachs. 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.
References
- ^ "Conflict of Interest Lessons From Financial Services". 2005-02-22.http://www.complianceweek.com/article/1562/conflict-of-interest-lessons-from-financial-services. Retrieved on 2009-01-13.
- ^ "Citigroup challenges Australian commission's conflict of interest ruling".http://www.iht.com/articles/2007/03/23/business/citigroup.php.
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