Reviewed by Aug 27, 2020| Updated on
Meaning of Proprietary Trading
Property trading refers to a financial firm or commercial bank that invests for direct market gain versus earning commission by trading on behalf of customers. Also known as "prop trading," this type of trading activity occurs when a financial firm chooses to take advantage of market activities rather than thin-margin commissions obtained through trading with clients. Property trading may involve bonds , stock, currencies, commodities, or other instruments.
Financial firms or commercial banks engaged in proprietary trading believe they have a competitive benefit that will allow them to earn an annual return that exceeds bond yield appreciation, index investing, or other investment types.
How Does Proprietary Trading Function?
Proprietary trading, also called "prop-trading," happens when a trading desk at a financial company, brokerage company, investment bank, hedge fund or other source of liquidity utilizes the company's resources and balance sheet to execute financial transactions that benefit itself. In general, these trades are speculative in nature, carried out through a range of derivatives or other complex investment vehicles.
Advantages of Proprietary Trading
There are many benefits, most notably higher quarterly and annual profits, that proprietary trading provides to a financial institution or commercial bank. It generates revenue in the form of commissions and fees when a brokerage firm or investment bank trades on behalf of clients. Such revenue may reflect a very small percentage of the overall amount invested or the earnings produced, but the mechanism also helps an organization to realize 100 percent of the earnings from an investment.
The second advantage is that the institution can stockpile securities inventories. This is aiding in two ways. First, any speculative inventory allows the institution to offer clients an unforeseen advantage. Second, when it becomes harder to buy or sell securities on the open market, it helps these institutions prepare for down- or illiquid markets.
The end benefit is related to the second benefit. By providing liquidity on a specific security or group of securities, proprietary trading allows a financial institution to become an influential market maker.