Proprietary trading

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Proprietary trading (also known as prop trading) occurs when a trader trades stocks, bonds, currencies, commodities, their derivatives, or other financial instruments with the firm's own money (instead of using depositors' money) to make a profit for itself. [1] Proprietary trading can create potential conflicts of interest such as insider trading and front running. [2] [3] [4]

Contents

Proprietary traders 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. [5] Many reporters and analysts believe that large banks purposely leave ambiguous the proportion of proprietary versus non-proprietary trading, because it is felt that proprietary trading is riskier and results in more volatile profits.

Arbitrage

One of the main strategies of trading, traditionally associated with banks, is arbitrage. In the most basic sense, arbitrage is defined as taking advantage of a price discrepancy through the purchase or sale of certain combinations of securities to lock in a market-neutral profit. The trade will remain subject to various non-market risks, such as settlement risk and other operational risks. 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 or merger arbitrage, evolved in the 1980s. When a company plans to buy another company, often the share price of the buyer falls (because the buyer will have to pay money to buy the other company) and the share price 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

There are a number of ways in which proprietary trading can create conflicts of interest between a bank's interests and those of its customers. [2]

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, especially since the Enron scandal, these have come under closer scrutiny. One example of an alleged conflict of interest can be found in charges brought by the Australian Securities & Investments Commission against Citigroup in 2007. [3]

Another source of conflicts of interest is potential front running, in which case the buy-side clients suffer from significantly higher trading costs. Front running per se is illegal, but there are circumstances under which a broker that operates a proprietary trading desk gains advantage over its clients based on inferences from order book data. [4]

Famous traders

Famous proprietary traders have included Ivan Boesky, Steven A. Cohen, John Meriwether, Daniel Och, and Boaz Weinstein. Some of the investment banks most historically associated with trading were Salomon Brothers and Drexel Burnham Lambert. Trader Nick Leeson took down Barings Bank with unauthorized proprietary positions. UBS trader Kweku Adoboli lost $2.3 billion of the bank's money and was convicted for his actions. [6] [7] [8]

Armin S, a German private trader, sued BNP Paribas for 152m EUR because they sold to him structured products for 108 EUR each which were worth 54 00 EUR. [9]

Notable proprietary trading firms

See also

Related Research Articles

In economics and finance, arbitrage is the practice of taking advantage of a difference in prices in two or more markets – striking a combination of matching deals to capitalise on the difference, the profit being the difference between the market prices at which the unit is traded. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the possibility to instantaneously buy something for a low price and sell it for a higher price.

In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the underlying. Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets.

Long-Term Capital Management L.P. (LTCM) was a highly leveraged hedge fund. In 1998, it received a $3.6 billion bailout from a group of 14 banks, in a deal brokered and put together by the Federal Reserve Bank of New York.

<span class="mw-page-title-main">Investment banking</span> Type of financial services company

Investment banking pertains to certain activities of a financial services company or a corporate division that engages in providing advisory-based services on financial transactions for clients, such as institutional investors, corporations, and governments. Traditionally associated with corporate finance, such a bank might assist in raising financial capital by underwriting or acting as the client's agent in the issuance of debt or equity securities. An investment bank may also assist companies involved in mergers and acquisitions (M&A) and provide ancillary services such as market making, trading of derivatives and equity securities, FICC services or research. Most investment banks maintain prime brokerage and asset management departments in conjunction with their investment research businesses. As an industry, it is broken up into the Bulge Bracket, Middle Market, and boutique market.

<span class="mw-page-title-main">Day trading</span> Buying and selling financial instruments within the same trading day

Day trading is a form of speculation in securities in which a trader buys and sells a financial instrument within the same trading day, so that all positions are closed before the market closes for the trading day to avoid unmanageable risks and negative price gaps between one day's close and the next day's price at the open. Traders who trade in this capacity are generally classified as speculators. Day trading contrasts with the long-term trades underlying buy-and-hold and value investing strategies. Day trading may require fast trade execution, sometimes as fast as milli-seconds in scalping, therefore direct-access day trading software is often needed.

In finance, a futures contract is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The asset transacted is usually a commodity or financial instrument. The predetermined price of the contract is known as the forward price or delivery price. The specified time in the future when delivery and payment occur is known as the delivery date. Because it derives its value from the value of the underlying asset, a futures contract is a derivative.

A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.

In financial services, a broker-dealer is a natural person, company or other organization that engages in the business of trading securities for its own account or on behalf of its customers. Broker-dealers are at the heart of the securities and derivatives trading process.

Fixed-income arbitrage is a group of market-neutral-investment strategies that are designed to take advantage of differences in interest rates between varying fixed-income securities or contracts. Arbitrage in terms of investment strategy, involves buying securities on one market for immediate resale on another market in order to profit from a price discrepancy.

Algorithmic trading is a method of executing orders using automated pre-programmed trading instructions accounting for variables such as time, price, and volume. This type of trading attempts to leverage the speed and computational resources of computers relative to human traders. In the twenty-first century, algorithmic trading has been gaining traction with both retail and institutional traders. A study in 2019 showed that around 92% of trading in the Forex market was performed by trading algorithms rather than humans.

<span class="mw-page-title-main">Stock trader</span> Person or company involved in trading equity securities

A stock trader or equity trader or share trader, also called a stock investor, is a person or company involved in trading equity securities and attempting to profit from the purchase and sale of those securities. Stock traders may be an investor, agent, hedger, arbitrageur, speculator, or stockbroker. Such equity trading in large publicly traded companies may be through a stock exchange. Stock shares in smaller public companies may be bought and sold in over-the-counter (OTC) markets or in some instances in equity crowdfunding platforms.

<span class="mw-page-title-main">Auction rate security</span> Debt instrument with a long-term nominal maturity with a regularly reset interest rate

An auction rate security (ARS) typically refers to a debt instrument with a long-term nominal maturity for which the interest rate is regularly reset through a Dutch auction. Since February 2008, most such auctions have failed, and the auction market has been largely frozen. In late 2008, investment banks that had marketed and distributed auction rate securities agreed to repurchase most of them at par.

In finance, a dark pool is a private forum for trading securities, derivatives, and other financial instruments. Liquidity on these markets is called dark pool liquidity. The bulk of dark pool trades represent large trades by financial institutions that are offered away from public exchanges like the New York Stock Exchange and the NASDAQ, so that such trades remain confidential and outside the purview of the general investing public. The fragmentation of electronic trading platforms has allowed dark pools to be created, and they are normally accessed through crossing networks or directly among market participants via private contractual arrangements. Generally, dark pools are not available to the public, but in some cases, they may be accessed indirectly by retail investors and traders via retail brokers.

Delta one products are financial derivatives that have no optionality and as such have a delta of one – meaning that for a given instantaneous move in the price of the underlying asset there is expected to be an identical move in the price of the derivative. Delta one products can sometimes be synthetically assembled by combining options. For instance, you can be long a forward on WTI crude oil at price X by buying an X strike call and selling an X strike put. This is known as put call parity. Delta one products often incorporate a number of underlying securities and thus give the holder an easy way to gain exposure to a basket of securities in a single product.

<span class="mw-page-title-main">UBS</span> Multinational investment bank headquartered in Switzerland

UBS Group AG is a multinational investment bank and financial services company founded and based in Switzerland. Headquartered in Zürich, it maintains a presence in all major financial centres as the largest Swiss banking institution and the largest private bank in the world. UBS client services are known for their strict bank–client confidentiality and culture of banking secrecy. Because of the bank's large positions in the Americas, EMEA, and Asia Pacific markets, the Financial Stability Board considers it a global systemically important bank.

<span class="mw-page-title-main">2011 UBS rogue trader scandal</span> Unauthorized trading incident

The 2011 UBS rogue trader scandal caused a loss of over US$2 billion at Swiss bank UBS, as a result of unauthorized trading performed by Kweku Adoboli, a director of the bank's Global Synthetic Equities Trading team in London in early September 2011.

Kweku Adoboli is a Ghanaian investment manager and former stock trader. He was convicted of illegally trading away US$2 billion as a trader for Swiss investment bank UBS. While at the bank he primarily worked on UBS' Global Synthetic Equities Trading team in London, where he engaged in what would later be known as the 2011 UBS rogue trader scandal. After serving a prison sentence, he lost several appeals against the UK Home Office decision to deport him to Ghana.

The forex scandal is a 2013 financial scandal that involves the revelation, and subsequent investigation, that banks colluded for at least a decade to manipulate exchange rates on the forex market for their own financial gain. Market regulators in Asia, Switzerland, the United Kingdom, and the United States began to investigate the $4.7 trillion per day foreign exchange market (forex) after Bloomberg News reported in June 2013 that currency dealers said they had been front-running client orders and rigging the foreign exchange benchmark WM/Reuters rates by colluding with counterparts and pushing through trades before and during the 60-second windows when the benchmark rates are set. The behavior occurred daily in the spot foreign-exchange market and went on for at least a decade according to currency traders.

A fat-finger error is a keyboard input error or mouse misclick in the financial markets such as the stock market or foreign exchange market whereby an order to buy or sell is placed of far greater size than intended, for the wrong stock or contract, at the wrong price, or with any number of other input errors.

Armin S. is a German independent securities trader. He achieved international recognition in 2017 when he filed a lawsuit against BNP Paribas for its continued refusal to deliver €163 million in securities he had purchased in December 2015, one of the largest civil cases brought by a private investor in Germany.

References

  1. Heather Stewart (21 January 2010). "What is 'proprietary trading'?". The Guardian .
  2. 1 2 Pitt, Harvey L. (2005-02-22). "Conflict of Interest Lessons From Financial Services". Compliance Week . Archived from the original on 2014-10-17. Retrieved 2014-10-11.
  3. 1 2 Johnston, Tim (2007-03-23). "Citigroup challenges Australian commission's conflict of interest ruling". New York Times . Retrieved 2014-10-11.
  4. 1 2 "A Front-Running Smile?". Traders Magazine. 26 May 2005. Retrieved 18 January 2022. A broker who operates a proprietary trading desk can significantly increase the buyside's implicit trading costs. In the past couple of years, some investment banks' quarterly gains from principal trading alone have approached $1 billion. In certain cases, the assets of individual bank's hedge funds have exceeded the combined assets of all of the bank's customers.
  5. "Proprietary Trading: What It Is & Related Trading Firms". DayTradeTheWorld. 28 September 2020.
  6. [Kweku Adoboli jailed for fraud over £1.4bn UBS loss "Kweku Adoboli jailed for fraud over £1.4bn UBS loss"]. bbc.{{cite web}}: Check |url= value (help)
  7. dzawu, moses (22 January 2020). "After Losing $2.3 Billion at UBS He Now Seeks Redemption in Ghanaian Bonds". Bloomberg.com.
  8. dalton, samantha (20 November 2012). "Kweku Adoboli: From 'rising star' to rogue trader". BBC News.
  9. Binham, Caroline (2018-12-20). "BNP failed to book traders in Germany for a week". Financial Times.