Proprietary Trading

What is proprietary trading?

Proprietary trading (or “prop trading”) is when a financial firm uses its own capital and balance sheet to trade financial instruments for its own profit, rather than executing trades on behalf of clients. Instruments can include stocks, bonds, commodities, currencies, derivatives and other complex vehicles.

How it works

A proprietary trading desk within a brokerage, investment bank, hedge fund, or other liquidity provider executes speculative or hedging strategies using the firm’s money. These desks are typically separated (“roped off”) from client-focused trading to limit conflicts of interest and maintain operational autonomy. Because the firm supplies the capital, it keeps 100% of any gains — and bears all losses.

Common strategies

Proprietary traders may use a wide range of strategies, including:
* Index arbitrage
* Statistical arbitrage (quantitative trading)
* Merger arbitrage
* Volatility arbitrage and options strategies
* Technical and fundamental analysis
* Global macro trading

Benefits

• Potentially higher profits: The firm retains all investment gains rather than earning only client commissions or fees.
• Inventory and liquidity: Firms can hold inventories of securities to support client needs or to provide liquidity in illiquid markets.
• Market-making influence: Proprietary desks can act as market makers for specific securities, facilitating large or illiquid client trades.

Risks and regulation

Proprietary trading is often speculative and can expose firms to significant losses and balance-sheet risk. To limit systemic risk and conflicts between client and proprietary activities, regulators have imposed restrictions. A notable example is the Volcker Rule, which restricts large banks from engaging in short-term proprietary trading of securities, derivatives, and commodity futures that contributed to systemic risk during the 2007–2008 financial crisis.

Example: proprietary desk acting as market maker

When a client wishes to buy or sell a large block of an illiquid security, a proprietary trading desk may step in as the counterparty — buying from the client or selling to them — to complete the trade. The desk can later unwind the position in the market, but while holding it it provides liquidity and helps the firm manage client execution needs.

Key takeaways

• Proprietary trading uses firm capital to pursue profits rather than earning client commissions.
• It enables higher potential returns for the firm but increases exposure to speculative losses.
• Proprietary desks often operate separately from client trading to reduce conflicts of interest.
• Regulatory measures, such as the Volcker Rule, limit certain proprietary activities by large banks to reduce systemic risk.