Propriety trading is when a financial firm or commercial bank invests for its own direct market gain. In this type of trade, the firms or banks do not invest to earn commission by trading on behalf of the clients.
People sometimes also call it as prop trading. It usually happens when a financial firm decides to gain profit from market activity rather than the small commissions they get from client trading activity. This type of trades can involve trading stocks, commodities, bonds, currencies, or other financial instruments.
How does Proprietary Trading Works?
This type of trading happens when a trading desk in a financial institution, investment bank, brokerage firm, hedge fund, or liquidity source uses the firm capital and balance sheet to do self-promoting financial transactions. The trades naturally are speculative. The trades are executed in a variety of derivatives and other complex investment vehicles.
The Benefits It Offers
For financial institutions and commercial banks, propriety trading provides various benefits. One of the biggest benefits is higher quarterly and annual profits.
If a brokerage firm or investment bank trades on behalf of the clients, then its profit comes from the commissions and fees. That income, commonly, represents a very small percentage from the total fund invested or the profit generated. Yet, the institutions can realize 100% of the gain earned from the investment.
The second benefit is the institutions can stockpile inventory of securities. There are two ways that the inventory of securities helps the institution. First, that speculative inventory can help the institutions offer unexpected advantages for the clients.
Second, that can also help the institution prepare for down or illiquid markets. That is the time when it is harder to buy or sell securities in the open market.
The last benefit is related to the second benefit. Propriety trading lets the financial institutions to be influential market makers. That is because they provide liquidity for a particular security or group of securities.