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Traders traditionally make their money through a range of fees from clients, primarily a ‘brokerage fee’ which is for the pleasure of the institution facilitating the trade on behalf of the client. The second is what is known as the “spread”.
In stock trading, this is the difference between the current bid and ask prices for a stock (the bid/ask or bid/offer spread). In futures trading, this is the price difference between delivery months for the same commodity or asset. In bond trading, it is the difference between yields of bonds with similar quality and different maturities, or of different quality and the same maturity.
In underwriting, it is the difference between what the issuer receives from the underwriter and what the underwriter receives from the public (underwriting spread).[1]
Therefore, as the above definition from the Financial Times suggests, it is the difference between whatever financial instrument costs to acquire for the broker or institution and what they on-sell it to the client for.
Proprietary trading test differs in that it uses the internal, institutional cash to profit from opportunities in the marketplace, without clients being involved.
However, it must be noted before we move too far forward into the benefits of proprietary trading, that it is seen as a risky form of trading, albeit one of the most profitable operations of a commercial or investment bank. During the financial crisis of 2008, prop traders and hedge funds were among the firms that were scrutinized for causing the crisis[1] in the first place.
When it comes to the specific benefits for the clients of the institutions that engage in proprietary trading, there are a number of key qualities in favour of this style of trading which are outlined below:
Proprietary trading allows a financial institution to become an influential market maker by providing liquidity on specific security or group of securities.[2]
In reality, the client benefits are only that the banks and institutions that conduct proprietary trading, in theory, should be more liquid, and have access to assets in potential markets which don’t favour their client's position. The means that trader can be in a state to assist them to buy or sell the asset as they require, not to mention being a market ‘maker’ or influencer’ which could further assist their client's position.
It is no secret that proprietary trading has the primary goal of making money for its institution.
[1] https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/proprietary-trading/
[2] https://www.investopedia.com/terms/p/proprietarytrading.asp
When trading with client’s money, in a fund or as part of a managed investment scheme, although the risks are minimised, in large part the profits (and losses) are enjoyed by the client, while the firm who has done the majority of the work, research and applied their expertise only enjoy their fee as well as the spread charged to the client.
Propriety trading allows firms to wave the fees, not apply the spread to the trade as well as the benefit from all the in-house knowledge, skills and expertise to profiteer from and add to the bottom line.
There are the risks that institutions around the world where the Volcker rule does not apply that banks will not apply sufficient rules and regulations around propriety trading which could, in theory – and in practice – collapse companies and economies around the world should they not be managed efficiently.
From the credit default swaps of the 2008 financial crisis, through to mortgage-backed securities of today, there is a range of financial instruments –, especially derivatives - that promote a winner takes all mentality that banks simply should avoid to stave off a future global financial crisis.
Only in the case of unethical behaviour in which a firm takes a position against that of a fund under their management – for reasons not as a hedge for a fund itself – or bets against the position taken by the fund should an investor be affected.
As an investor, it is important to understand about proprietary trading and its purpose, however, unless you have involved in fund management yourself, as a retail investor you will have little contact with the features, advantages and benefits of proprietary trading.
