What is Proprietary Trading?

Proprietary trading occurs when a large financial institution, particularly an investment bank, trades in the financial markets with its own money. A large investment bank often designates a division, known as the prop desk, in which sophisticated traders invest the firm's money in order to generate an additional revenue stream. Prop traders typically are among the most talented investors that the industry has to offer and have the potential to earn or lose large sums of a bank's money.

Investment banks are among the largest financial institutions in the economy and have various sources of income. These firms have large balance sheets, which means that have a lot of assets and often large amounts of liabilities. Investment banks are in the business of taking risks, and they do this in several ways.

One primary function of an investment bank is to raise money in the capital markets. A way they do this is by lending large amounts of money to other businesses in a region. They also become responsible for selling equity shares on behalf of other companies in a stock offering, and they have a wealth management division in which money managers oversee clients' wealth. Proprietary trading is different from all of these functions in that it does not center on clients. Instead, it is an internal moneymaking initiative that can be mysterious to the outside world.

Traders on the prop desk can be active across a host of asset classes, including stocks, bonds, commodities or regional currencies. In order to facilitate trading, an investment bank will devote large sums of money to the proprietary trading desk. Traders will then use that internal capital to purchase shares of a security in hope of turning around and selling those assets for a profit. Proprietary traders often will adhere to complex trading strategies, such as merger arbitrage, a method that attempts to profit from changes in stock prices as a result of an announced merger. These strategies are similar to what other professional money managers, including hedge funds, use when they trade.

There are opportunities for conflicts of interest at large investment banks. There is a proprietary trading desk selling securities and a capital-raising group of professionals who give advice on mergers and recommend buying opportunities for clients. With awareness and influence on both sides of a trade, there must be proper risk controls in place at these large institutions to guard against unethical practices.

Compensation for traders on the proprietary trading desk can be quite lucrative because this division historically has generated the largest percentage of profits at a firm over periods of time. As long as a trader is generating lofty profits for a firm, this professional is paid in accordance with that performance in a salary and a yearly bonus. It is an incentive-driven business, and making more money for the firm translates into a larger paycheck for that trader.