What is Proprietary Trading?

Proprietary trading is a term used in investment banking to describe when the firm's traders actively trade stocks, bonds, options, commodities, or other items 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 (cf. stock brokerage companies) are more likely to be involved in a scenario where a customer wants to sell a large amount of stock, which if sold through a stock broker couldn't be sold all at once and could possibly trigger a decline in the value due to flooding the market. The Investment Bank would agree to buy the entire amount of stock at a discount with the belief that it could sell pieces over time. The profit comes not from selling the stock at present value, but buying it at a discount. This is known as block trading. In the bond and other over-the-counter markets, it is much more likely that an investment bank will be a middleman in the transaction, holding the security for a period and attempting to make a profit from the small difference between what it bought it for and what it sold it for. For this reason the majority of trading profits usually comes from bond and commodity trading (often four times as much).

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, resulting in a lower stock price relative to profits.

The relationship 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 aren't 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 doesn't care about the absolute 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, 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. Proprietary desks routinely have the highest VaR among other desks at the bank. Investments banks such as Goldman Sachs and Deutsche Bank are known to earn a significant portion of their quarterly and annual profits through proprietary trading efforts.

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: arbitrage has none. 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 evolved in the 1980's, which is called risk arbitrage. When a company plans to buy another company, often the buyers stock price would go down (because it has to pay money to buy another company) and the acquired shares go up (because the buyer most often buys at a price higher than the current price). When an Investment Bank believes a buyout is imminent, it often sells short the shares of the buyer (betting that the price will go down) and buys the shares of the acquired (betting the price will go up).

Conflicts of interest in proprietary trading

There have been many criticisms over the diverse conflicts of interest possible through proprietary trading. A common suspicion is that the traders will buy when they have found out that their customers are buying in order to profit from the price increase that the customer' buys might create. This practice is known as "front running", and can hurt the customer.

Another conflict that is alleged to occur is that when the proprietary traders have bought securities that have been performing badly, they may instruct the investment bank salesmen (who call customers to get them to buy something) to instruct their customers to take the investments off of their hands.

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. However, this is not typically an issue because investment banks are required to have a Chinese wall separating their trading and investment banking divisions.

Famous Trading Banks and Traders

Famous traders have included Robert Rubin. One of the investment banks most historically associated with trading was Salomon Brothers.

Nick Leeson took down Barings Bank with unauthorized proprietary positions.