Prop Trading: Is It Legal?
Jun 20, 2022 3 minute Read
As the stock market has become more accessible in recent years, many people have gotten interested in day trading. But even for experienced traders, it can be hard to know where to start when it comes to becoming a prop trader and navigating the legal landscape surrounding that career path.
I’m here to help you navigate the ins and outs of prop trading, from how to works to how legal it is. So put away your textbooks, grab a pencil and some paper (or just a good pair of headphones), and get ready for a lesson on prop trading 101.
With the advent of mobile and always-on connectivity, trading on the go has never been easier.
Traders now have access to exchanges via their smartphones, laptops, and tablets—and even smartwatches. With this type of connectivity, day traders can place trades at a moment’s notice whether they’re on the bus, taking a shower, or at the gym.
Trading is no longer confined to your desk during trading hours either—you can trade during any time of day or night from anywhere in the world as long as you have an internet connection and access to an exchange or market making partner (or even another trader willing to let you borrow their trading account).
But with the appeal of trading also comes a lot of risk, especially when it comes to legally becoming a prop trader.
The legal aspect of prop trading comes with a need for risk management. Some things you can look out for as a proprietary trader include:
- The risk of losing money: This is the obvious one. In most cases, you will likely lose more than you gain in this business unless you are very lucky or very talented.
- The risk of losing your job: If a trade goes bad, it’s easy to see that losing your job is a possible outcome. But it could also stem from a conflict of interest. Whether you work for a commercial bank, at a trading desk, or as your own financial institution/trader, your business could come under fire from the Commodity Futures Trading Commission (CFTC), the Federal Deposit Insurance Corporation (FDIC), and the Securities and Exchange Commission. There’s a lot of legal risk here from several regulatory agencies and if you’re not careful, your actions could be considered a financial liability.
- The risk of losing your license: There’s market risk in every aspect of trading, but when it comes to proprietary trading the risk is greater. While being licensed isn’t obligatory, it does provide a level of security for those who use your financial service. That security could be put to the test if things go wrong.
To mitigate some of this risk, try to home in on some proven trading strategies and create fiduciary relationships with clients and insurance companies for better protection.
So what is prop trading?
In the simplest terms, prop trading is the buying and selling of stocks and other securities using “proprietary” capital. Propriety refers to a fund’s ability to invest its own money into securities without being required to disclose its holdings to clients.
The term “trading” refers to the buying or selling of securities for profit, as opposed to investing in them for capital appreciation or interest income. It’s kind of like trading at liquidity where the initial funds are illiquid or most (if not all) of a security. Then, the trade takes profitable arbitrage opportunities, makes a ton of money (in theory), and takes a bit of ownership interest.
Proprietary trading is a form of speculation that is not conducted on behalf of clients, but rather as an investment in its own right. Proprietary traders take risks in the financial market with their own capital and often have little or no client business to fall back on if a trade goes wrong.
Proprietary trading has been largely unregulated in the United States until the financial crisis is 2008, when it was identified as a source of excessive risk taking that contributed to the collapse of Bear Stearns and Lehman Brothers.
The Volcker Rule, which comes from 2010’s Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) bans banks from engaging in proprietary trading, but allows them to make markets in securities for clients as long as they are not making a profit on those trades.
A proprietary trader (or “prop trader”) makes financial decisions as an employee or representative of a firm.
Prop trading is a type of trading that is done by a trading firm for its own benefit. In other words, the firm takes on risk in order to make money. The employees who do this are called proprietary traders (or “props”).
There are two types of prop trading:
- directional prop trading, which involves making bets on whether a trading asset will increase or decrease in value; and
- non-directional prop trading, which involves buying and selling assets without predicting their price movements.
Prop traders are typically hired by banks and hedge funds or by firms that specialize in proprietary trading.
They’re responsible for using the bank’s (or bank holding company’s) capital to make money on a variety of financial instruments — such as stocks, bonds, commodities, covered funds, and currencies.
The pay is good, but the risk is high.
In the world of finance, this can mean that a prop trader works for a banking entity, hedge fund or investment firm. Prop traders work with other traders to generate profits for their employers.
Prop traders typically work under two different scenarios: first as independent contractors and second as employees of an investment bank or hedge fund.
Independent contractors work for multiple clients and have more freedom than employees because they’re not tied down to one specific company, industry, or derivative. Employees are typically more specialized and don’t have much choice about where they can take their career next.
Essentially, prop traders are part of a firm’s capital and are charged with making money for that firm.
Proprietary trading is a form of trading that is done by a firm using its own capital. The firm is responsible for the capital it uses, as well as the risks and gains that result from using that capital.
When it comes to prop trading, there isn’t a strict legal precedent for how you become an independent prop trader — just as there aren’t any specific rules against independent prop trading.
There are no rules for how to become an independent prop trader. There are also no specific rules against it, nor any laws or regulations that govern the practice of independent prop trading. The only thing that matters is whether you’re offering your services as a trader and making trades for clients.
The lack of legal precedent around independent prop trading makes it hard to determine what constitutes “independent.” For example, if you work at a prop firm but trade your own money in addition to managing other people’s private equity funds, would you be considered an independent trader? Or if you just trade your own funds instead of managing money for others — again would this make you an independent trader?
It’s important to note that new regulations introduced in 2010 have severely limited the size and scope of many prop trading operations, so “independent” is often used loosely.
The Volcker Rule, named after Paul Volcker, former Federal Reserve chairman and architect of the rule, was meant to limit proprietary trading by banks and issuers: no more playing the financial system by making risky investments with customer funds.
But the rules are so vague that some firms have simply stopped doing prop trading altogether while others still trade on their own accounts but are unwilling to take any risk of breaking them (or being accused of breaking them).
Some people are able to trade independently from home by using their own capital and reaching an agreement with the firms that execute their trades.
Some people are able to trade independently from home by using their own capital and reaching an agreement with the firms that execute their trades. Others operate through small local firms that don’t always make their training programs clear to potential traders. Still others work for larger investment houses and use institutional money.
The first two options present a host of legal issues due to the nature of the transactions involved, but there are benefits as well—namely, the ability to do your homework without having access to all kinds of proprietary information (and even more importantly, leverage) that comes with working at an established firm like Goldman Sachs or Morgan Stanley.
Others operate through small local firms that don’t always make their training programs clear to potential traders.
Some prop traders work independently from home, using their own capital and reaching an agreement with the firms that execute their trades. Others operate through small local firms that don’t always make their training programs clear to potential traders.
Prop trading is a lucrative field, but it’s also one where fraud and other illegal trading activity are common; this makes it vital to choose your broker or brokerage carefully.
Starting your own business as a prop trader? Let’s get your payments ecosystem squared away.
Whether you’re trading from a bank or hedge fund, as an independent prop trader, or through a smaller firm in your area, the good news is that there are many ways to get involved with prop trading.
The final rule of thumb is to learn as much about market conditions and trading options before you start putting your money on the line. Prop trading is risky business — but when done well and with care, it can pay off big time.
If you’re looking to add prop trading to your skillset as an investment adviser or trader, you need to bolster your payments backend.
You need a payments ecosystem that supports this level of risk. DPN can help. Get in touch with our team to start the underwriting process for a high-risk merchant account and payment processor today so you can start doubling those trades ASAP.