Proprietary Trading - The Relationships Between Trading and Banking

The Relationships Between Trading and Banking

Banks are companies that assist other companies in raising financial capital, transacting foreign currency exchange, and managing financial risks. Trading has almost always been associated with large banks, however, because they are often required to make a market to facilitate the services they provide (e.g. trading stocks, bonds, and loans in capital raising; trading currencies to help with international business transactions; and trading interest rates, commodities, and their derivatives to help companies manage risks).

For example, if General Store Co. sold stock with a bank, whoever first bought shares would possibly have a hard time selling them to other individuals if people are not familiar with the company. The investment bank agrees to buy the shares sold and look for a buyer. This provides liquidity to the markets. The bank normally does not care about the fundamental, intrinsic 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 independent of providing client liquidity, and this is how proprietary trading was born.

The evolution of proprietary trading at 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 bank, performing in isolation away from client-flow traders. Proprietary desks routinely have the highest value at risk among other desks at the bank. Investment banks such as Goldman Sachs, Deutsche Bank, and the late Merrill Lynch are known to earn a significant portion of their quarterly and annual profits through proprietary trading efforts.

The proprietary trading desk is kept separate, by law, from knowledge about customer flow, so they cannot engage in the business of front-running a customer's order.

There often exists confusion between proprietary positions held by market-making desks (sometimes referred to as warehoused risk) and desks specifically assigned the task of proprietary trading.

Because of the impending financial regulation (Volcker Rule in particular), major banks have spun off their prop trading desks or shut them down all together. However, prop trading is not gone. It is carried out at specialized prop trading firms and hedge funds. Some notable prop trading firms are Jump Trading LLC, GETCO LLC, Optiver, First New York Securities and DRW Trading Group. The prop trading done at these prop trading firms is usually highly technology driven, utilizing complex quantitative models and algorithms.