Proprietary Trading Definition

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          Proprietary Trading occurs when a firm trades securities (stocks, options, futures contracts, currencies, bonds, interest rates, etc.)[i] or other financial instruments with the firm’s capital as opposed to brokering the transaction for a client using the client’s capital.[ii] The vast majority of the global academic community are still extremely unfamiliar with the proprietary trading industry. Along with the development of high-speed data transfer technologies came a new generation of highly-sophisticated financial services software developers and proprietary trading systems implementing lightning quick algorithmic-based decision making and order-execution. A challenge is posed when attempting to identify the technologies associated with proprietary trading. Due to the nature of the field, strategies and algorithms are highly-secured[iii] and many firms take additional steps to minimize the risk of exposing the strategies to others.                                                             

            Most securities are traded on exchanges, which introduce buyers to sellers. In the United States, equities (commonly referred to as stock) are traded on the New York Stock Exchange, AMEX & NASDAQ exchanges. The financial services firms are divided into banking & brokerage organizations and proprietary firms. Banks are organizations that assist industry transact across long distances, manage financial risk, and raise investment capital.  Doing so with many clients requires a large number of securities trading transactions, however, because they are often required to make a market to facilitate the services they provide (i.e. trading equities, options, bonds, and loans in capital raising, trading currencies and interest rates, commodities, and their derivatives to help companies manage risks) a conflict of interest may exist.[iv] Regulators have been challenged in identifying the most efficient methods of bringing transparency to firms participating in both proprietary trading practices as well as securities brokerage services under the same roof without unduly burdening open and low-cost access to markets.[v]

            Proprietary Trading occurs when a firm or individual trades securities risking their own capital for profits instead of commission dollars from processing trades of the clients the firm manages.[vi] In 1932, the repeal of the Glass-Steagall Act of 1932  removed the separation that existed between organizations issuing and facilitating transactions (investment banks and securities brokerages) and proprietary firms trading their own capital for a return.[vii]

            Some of the underlying technologies contributing to high frequency trading include user-friendly Application Programming Interfaces (APIs) allowing for trading strategies to be automated based on input data criteria.[viii] A common strategy is the use of  moving average crossovers to signal trends in equities markets. [ix]

            Information systems and data management consume much of the resources of the industry. In many cases, latency is so important to a strategy that firms will pay tens of thousands of dollars per month to locate their servers in the same building as the servers of the exchange. [x]The general consensus has yet to draw a line between proprietary trading activities conducted by private individuals and firms, who stand to gain from profitable trades, and the larger institutions whom stand to gain from conflicts of interest between executing customer orders and front-running those orders through proprietary trading and designated market-maker activities. In both cases, while high frequency trading poses a threat to the stability of the market, the larger threat exists in the case of larger financial institutions such as investment banks who underwrite and issue the same securities they actively trade. An example of this potential conflict of interest was during the early and mid 2000’s investment banks were bundling up loans into collateralized debt obligations (CDOs) and selling the investment vehicles to clients while possibly have maintained net short positions on the same securities during the same time period, betting that their value would go down.  [xi]


[i]  The official definition of a security given really in the Securities Exchange Act of 1934 is: “Any note, stock, treasury stock, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit, for a security, any put,call, straddle, option (finadeposit), or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered in o on a national securities exchange relating to foreign currency, or in general, any instrument commonly known as a “security”; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing; but shall not include currency or any note, draft, bill of exchange, or banker’s acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited.”

[ii] “Guide to Broker-Dealer Registration (April 2008).” U.S. Securities and Exchange Commission (Home Page). Web. 13 Feb. 2012. <http://www.sec.gov/divisions/marketreg/bdguide.htm>.

[iii]Narang, Rishi K,. “Chapter 1.” Inside the Black Box: The Simple Truth about Quantitative Trading. Hoboken, NJ: Wiley, 2009. Print.

[iv] Benoit, David. “Volcker on Volcker: The Letter From Paul – Deal Journal – WSJ.” WSJ Blogs – WSJ. Web. 13 Feb. 2012. <http://blogs.wsj.com/deals/2012/02/13/volcker-on-volcker-the-letter-from-paul/>.

[v] Hopkins, Cheyenne. “U.S. Volcker Rule Faces Harsh Critics – Bloomberg.” Bloomberg – Business & Financial News, Breaking News Headlines. Web. 13 Feb. 2012. <http://www.bloomberg.com/news/2012-02-14/u-s-volcker-rule-faces-harsh-global-critics-months-before-it-takes-effect.html>.

[vi] “Guide to Broker-Dealer Registration (April 2008).” U.S. Securities and Exchange Commission (Home Page). Web. 13 Feb. 2012. <http://www.sec.gov/divisions/marketreg/bdguide.htm>.

[vii] ” “Mr. Weill Goes To Washington – The Long Demise Of Glass-Steagall | The Wall Street Fix | FRONTLINE | PBS.” PBS: Public Broadcasting Service. Web. 13 Feb. 2012. <http://www.pbs.org/wgbh/pages/frontline/shows/wallstreet/weill/demise.html>.

[viii]  “Trading Platforms, Professional Trading.” Sterling Trader – Trading Platforms, Online Trading, Stock Market. Web. 13 Feb. 2012. <http://www.sterlingtrader.com/trading_platforms/trading_platforms2.html>.

[ix] Narang, Rishi K,. “Chapter 1.” Inside the Black Box: The Simple Truth about Quantitative Trading. Hoboken, NJ: Wiley, 2009. Print.

[x] “NASDAQ Co-Location.” NASDAQtrader.com Home Page. Web. 13 Feb. 2012. <http://www.nasdaqtrader.com/Trader.aspx?id=colo>.

[xi] 24, Oct. “SEC Charges Goldman Sachs With Fraud in Structuring and Marketing of CDO Tied to Subprime Mortgages; 2010-59; April 16, 2010.” U.S. Securities and Exchange Commission (Home Page). Web. 13 Feb. 2012. <http://sec.gov/news/press/2010/2010-59.htm>.

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