Proprietary trading
Encyclopedia
Proprietary trading occurs when a firm trades stock
s, bond
s, currencies, commodities, their derivatives
, or other financial instruments, with the firm's own money as opposed to its customers' money, so as to make a profit for itself. They may use a variety of strategies such as index arbitrage
, statistical arbitrage
, merger arbitrage
, fundamental analysis
, volatility arbitrage
or global macro
trading, much like a hedge fund
. Many reporters and analysts believe that large 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.
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.
. 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 reward: the risk in what is known as arbitrage today (to distinguish it from theoretical arbitrage, which effectively does not exist) is market neutral. 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, called risk arbitrage
, evolved in the 1980s. When a company plans to buy another company, often the price of a share in the capital of the buyer falls (because the buyer will have to pay money to buy the other company) and the price of a share in the capital of the purchased company rises (because the buyer usually buys those shares 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 company being acquired (betting the price will go up).
between a trader's interests and those of its customers.
As investment banks are key figures in mergers and acquisitions, it is possible (though prohibited) for traders to use inside information to engage in merger arbitrage. Investment banks are required to have a Chinese wall
separating their trading and investment banking divisions; however, in recent years, dating most recently back to the Enron
saga, these have come under great scrutiny.
One example of an alleged conflict of interest can be found in charges brought by the Australian Securities and Investment Commission against Citigroup
in 2007.
, Edward Lampert
, Daniel Och
, and Boaz Weinstein
. Some of the investment banks most historically associated with trading was Salomon Brothers
and Drexel Burnham Lambert
, and currently Goldman Sachs
.
Nick Leeson
took down Barings Bank
with unauthorized proprietary positions. Another trader, Brian Hunter
, brought down the hedge fund Amaranth Advisors
when his massive positions in natural gas
futures went bad.
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
s, bond
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
s, currencies, commodities, their derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
, or other financial instruments, with the firm's own money as opposed to its customers' money, so as to make a profit for itself. They may use a variety of strategies such as index arbitrage
Index arbitrage
Index arbitrage is a subset of statistical arbitrage focusing on index components.The idea is that an index is made up of several components that influence the index price in a different manner.For instance, there are leaders...
, statistical arbitrage
Statistical arbitrage
In the world of finance and investments, statistical arbitrage is used in two related but distinct ways:* In academic literature, "statistical arbitrage" is opposed to arbitrage. In deterministic arbitrage, a sure profit can be obtained from being long some securities and short others...
, merger arbitrage
Risk arbitrage
Risk arbitrage, or merger arbitrage, is an investment or trading strategy often associated with hedge funds.Two principal types of merger are possible: a cash merger, and a stock merger. In a cash merger, an acquirer proposes to purchase the shares of the target for a certain price in cash...
, fundamental analysis
Fundamental analysis
Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...
, volatility arbitrage
Volatility arbitrage
In finance, volatility arbitrage is a type of statistical arbitrage that is implemented by trading a delta neutral portfolio of an option and its underlier. The objective is to take advantage of differences between the implied volatility of the option, and a forecast of future realized volatility...
or global macro
Global macro
Global Macro is defined as the strategy of investing, on a large scale, around the world using economic theory to justify the decision making process...
trading, much like a hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
. Many reporters and analysts believe that large 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
Volatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
profits.
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
Market maker
A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be...
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
Var
Var, VAR, VAr, VaR or var can mean:VAR* Varna Airport IATA airport code* Vacuum arc remelting, a process for production of steel and special alloys...
among other desks at the bank. Investment banks such as Goldman Sachs
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
, Deutsche Bank
Deutsche Bank
Deutsche Bank AG is a global financial service company with its headquarters in Frankfurt, Germany. It employs more than 100,000 people in over 70 countries, and has a large presence in Europe, the Americas, Asia Pacific and the emerging markets...
, and the late Merrill Lynch
Merrill Lynch
Merrill Lynch is the wealth management division of Bank of America. With over 15,000 financial advisors and $2.2 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York...
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.
Arbitrage
One of the main strategies of trading, traditionally associated with banks, is arbitrageArbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
. 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 reward: the risk in what is known as arbitrage today (to distinguish it from theoretical arbitrage, which effectively does not exist) is market neutral. 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, called risk arbitrage
Risk arbitrage
Risk arbitrage, or merger arbitrage, is an investment or trading strategy often associated with hedge funds.Two principal types of merger are possible: a cash merger, and a stock merger. In a cash merger, an acquirer proposes to purchase the shares of the target for a certain price in cash...
, evolved in the 1980s. When a company plans to buy another company, often the price of a share in the capital of the buyer falls (because the buyer will have to pay money to buy the other company) and the price of a share in the capital of the purchased company rises (because the buyer usually buys those shares 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 company being acquired (betting the price will go up).
Conflicts of interest in proprietary trading
There are a number of ways in which proprietary trading can create conflicts of interestConflicts of Interest
"Conflicts of Interest" is an episode from the fourth season of the science fiction television series Babylon 5.-Arc significance:* Garibaldi begins to work for William Edgars. In the process Garibaldi is reintroduced to his ex-girlfriend, Lise, who is currently married to Edgars.* The "Voice of...
between a trader's interests and those of its customers.
As investment banks are key figures in mergers and acquisitions, it is possible (though prohibited) for traders to use inside information to engage in merger arbitrage. Investment banks are required to have a Chinese wall
Chinese wall
In business, a Chinese wall or firewall is an information barrier implemented within a firm to separate and isolate persons who make investment decisions from persons who are privy to undisclosed material information which may influence those decisions...
separating their trading and investment banking divisions; however, in recent years, dating most recently back to the Enron
Enron
Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. Before its bankruptcy on December 2, 2001, Enron employed approximately 22,000 staff and was one of the world's leading electricity, natural gas, communications, and pulp and paper companies, with...
saga, these have come under great scrutiny.
One example of an alleged conflict of interest can be found in charges brought by the Australian Securities and Investment Commission against Citigroup
Citigroup
Citigroup Inc. or Citi is an American multinational financial services corporation headquartered in Manhattan, New York City, New York, United States. Citigroup was formed from one of the world's largest mergers in history by combining the banking giant Citicorp and financial conglomerate...
in 2007.
Famous trading banks and traders
Famous proprietary traders have included Steven A. CohenSteven A. Cohen
Steven "Steve" A. Cohen is an American hedge fund manager. He is the founder of SAC Capital Advisors, a Stamford, Connecticut-based hedge fund focusing primarily on equity market strategies....
, Edward Lampert
Edward Lampert
Edward S. "Eddie" Lampert is an American businessman and investor. He is the chairman of Sears Holdings Corporation and founder, chairman, and CEO of ESL Investments. Until May, 2007 he was a director of AutoNation, Inc. He previously served as a director of AutoZone, Inc...
, Daniel Och
Daniel Och
Daniel Och is the Chairman and Chief Executive Officer of Och-Ziff Capital Management Group, a global hedge fund and alternative asset management firm....
, and Boaz Weinstein
Boaz Weinstein
Boaz Weinstein is a notable derivatives trader and hedge fund manager. He was born to Israeli and American parents. He first enrolled in a chess workshop at the age of five and earned the title of National Master by the time he was sixteen. He is also a skilled poker and blackjack player. In...
. Some of the investment banks most historically associated with trading was Salomon Brothers
Salomon Brothers
Salomon Brothers was a bulge bracket, Wall Street investment bank. Founded in 1910 by three brothers along with a clerk named Ben Levy, it remained a partnership until the early 1980s, when it was acquired by the commodity trading firm Phibro Corporation and then became Salomon Inc. Eventually...
and Drexel Burnham Lambert
Drexel Burnham Lambert
Drexel Burnham Lambert was a major Wall Street investment banking firm, which first rose to prominence and then was forced into bankruptcy in February 1990 by its involvement in illegal activities in the junk bond market, driven by Drexel employee Michael Milken. At its height, it was the...
, and currently Goldman Sachs
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
.
Nick Leeson
Nick Leeson
Nicholas "Nick" Leeson is a former derivatives broker whose fraudulent, unauthorized speculative trading caused the collapse of Barings Bank, the United Kingdom's oldest investment bank, for which he was sent to prison...
took down Barings Bank
Barings Bank
Barings Bank was the oldest merchant bank in London until its collapse in 1995 after one of the bank's employees, Nick Leeson, lost £827 million due to speculative investing, primarily in futures contracts, at the bank's Singapore office.-History:-1762–1890:Barings Bank was founded in 1762 as the...
with unauthorized proprietary positions. Another trader, Brian Hunter
Brian Hunter (trader)
Brian Hunter is a Canadian natural gas trader for the now closed Amaranth Advisors hedge fund. Amaranth, which had over $9 billion in assets, collapsed in 2006 after Hunter's gamble on natural gas futures market went bad.-Early life:...
, brought down the hedge fund Amaranth Advisors
Amaranth Advisors
Amaranth Advisors LLC was an American investment adviser managing multi-strategy hedge fund founded by Nicholas Maounis and headquartered in Greenwich, Connecticut. The firm had up to $9 billion in assets under management and collapsed in September 2006 after losing in excess of $5 billion on...
when his massive positions in natural gas
Natural gas
Natural gas is a naturally occurring gas mixture consisting primarily of methane, typically with 0–20% higher hydrocarbons . It is found associated with other hydrocarbon fuel, in coal beds, as methane clathrates, and is an important fuel source and a major feedstock for fertilizers.Most natural...
futures went bad.
External links
- http://www.cfo.com/article.cfm/3004344?f=related
- http://www.trading-lab.com/forums/introduction_proprietary_trading-t305.html
- http://www.ft.com/cms/s/0/44f593ee-06a7-11df-b426-00144feabdc0.html
- http://faculty.fuqua.duke.edu/~charvey/Teaching/BA453_2004/Muller_Proprietary_trading.pdf Proprietary trading: truth and fiction