Proprietary trading, also known as prop trading or principal trading, is the practice of trading financial instruments or commodities as principal, using a firm's own capital rather than trading on behalf of a client. The profits and losses from the activity accrue to the firm itself, distinguishing proprietary trading from agency brokerage, asset management, and other client-account activities.[1]
Proprietary trading is carried out by investment banks, broker-dealers, market makers, and independent principal trading firms across markets including equities, fixed income, derivatives, commodities, and the foreign exchange market. It may involve discretionary trading by individual traders, automated or algorithmic trading, statistical arbitrage, high-frequency trading, market-making inventory management, or longer-horizon directional positions. Because market-making and hedging also require a firm to hold positions on its own balance sheet, the distinction between proprietary trading, client facilitation, and risk management is often based on the purpose of the trade rather than the legal form of the transaction.[1][2]
The practice became a prominent part of large-bank trading businesses in the late twentieth and early twenty-first centuries. After the 2007–2008 financial crisis, regulators in several jurisdictions restricted proprietary trading by banks or separated it from deposit-taking activities. The most prominent restriction is the Volcker Rule in the United States, which generally prohibits banking entities from proprietary trading and from sponsoring or investing in covered hedge funds and private-equity funds, subject to exemptions for underwriting, market making, risk-mitigating hedging, and other permitted activities.[3][4]
Definition and scope
In regulatory usage, proprietary trading means trading as principal: the firm buys, sells, or otherwise acquires a financial instrument or commodity for its own account. The Prudential Regulation Authority has defined it as trading in financial instruments or commodities as principal, requiring the use of the firm's capital, liquidity, or both, with profits and losses accruing to the firm rather than to clients.[1] In U.S. banking regulation, the Volcker Rule uses the related concept of trading for the firm's "trading account".[5]
The term is sometimes used narrowly to refer to "classic" proprietary trading: short-term own-account trading intended to profit from changes in market prices and unrelated to customer activity. A broader definition can include market-making positions, client facilitation, liquidity management, and hedging, because these activities also involve a firm acting as principal.[1] This creates a recurring boundary problem for regulators and firms. A market maker, for example, may hold inventory to provide liquidity to clients, while a proprietary desk may hold a similar position to profit from expected price changes. In both cases the firm bears market risk, but the purpose and controls around the position differ.[2]
Proprietary trading is also distinct from asset management, in which a manager makes investment decisions for a fund or client account, and from agency brokerage, in which a broker executes orders for customers without taking the market risk of the position. It is closer in legal form to market making, because both involve principal trading, but market making is generally organised around continuous quoting, customer facilitation, and earning the bid–ask spread, whereas classic proprietary trading seeks trading profit from the firm's own views, models, or arbitrage strategies.[2]
History
Growth within investment banks
Banks and securities dealers have long taken positions for their own accounts, but modern proprietary trading desks became especially visible as large financial institutions expanded their trading businesses in the 1980s, 1990s, and 2000s. Deregulation, the growth of derivatives, securitised products, electronic markets, and global capital flows increased the scale and complexity of trading books at major banks.[6][1]
Proprietary trading could generate large profits during favourable markets, but it also exposed banks to market, liquidity, counterparty-credit, model, and operational risks. These risks were often difficult to separate from risks arising from market making and client-flow trading. Regulators later noted that the same trading infrastructure used for client facilitation could also be used for positions unrelated to customer demand, making intent and controls central to supervision.[1]
Financial crisis and reform
After the 2007–2008 financial crisis, policymakers questioned whether taxpayer-supported banks should be allowed to use insured deposits, access to central-bank liquidity, or implicit public guarantees to support speculative trading. In the United States, this concern led to the Volcker Rule, named after former Federal Reserve chairman Paul Volcker and enacted as section 619 of the Dodd–Frank Wall Street Reform and Consumer Protection Act.[3] In Europe and the United Kingdom, structural-reform proposals examined whether trading activities should be separated from core retail banking and payment functions.[7][8]
Post-crisis capital, liquidity, and conduct rules reduced the attractiveness of classic proprietary trading inside large banks. In its 2020 review, the Prudential Regulation Authority reported that it had not found substantial classic proprietary trading by relevant UK-authorised banks and investment firms, partly because such activity no longer formed a material part of large financial institutions' business models and partly because post-crisis regulation had increased the capital required to support trading activities.[1]
Rise of principal trading firms
As banks reduced some forms of own-account trading and electronic markets expanded, non-bank proprietary trading firms became more important in several markets. Such firms, often called principal trading firms or proprietary trading firms, trade for their own account and may specialise in market making, arbitrage, or high-speed electronic strategies. In a 2018 speech on the U.S. Treasury market, Federal Reserve governor Lael Brainard said that high-frequency activity by proprietary trading firms accounted for a majority of trading on central interdealer Treasury platforms after the 2014 Treasury market "flash rally", while dealers continued to intermediate most Treasury activity overall.[9]
The growth of these firms changed market structure. Banks remained important in dealer-to-client markets, financing, settlement, and prime brokerage, while electronic proprietary firms became prominent in low-latency market making and arbitrage across exchanges and trading venues.[9] The Bank for International Settlements has linked these changes to broader shifts in liquidity provision, including reduced dealer risk-taking capacity, greater use of electronic trading, and concentration of market-making activity in the most liquid instruments.[2]
Organisation and business models
Bank trading desks
Within a bank or broker-dealer, proprietary trading may be conducted through a dedicated desk or embedded within a broader trading book. A proprietary desk historically sought profit from the firm's own trading views, while flow-trading desks focused on executing and facilitating client business. In practice, the boundary could be blurred because traders who facilitate client orders may also hold inventory, hedge, or take residual risk.[1]
Bank-affiliated trading is usually subject to capital requirements, risk limits, compliance monitoring, conduct rules, and restrictions on conflicts of interest. Common controls include position limits, stop-loss limits, independent price verification, stress testing, value at risk measures, and escalation procedures for limit breaches. The PRA identified market risk, counterparty credit risk, and operational risk as major risks arising from proprietary trading and related own-account activities.[1]
Independent proprietary trading firms
Independent proprietary trading firms use their own capital and generally do not accept customer deposits or manage client assets. Many specialise in exchange-traded products such as equities, futures, options, government securities, and exchange-traded funds. Their traders or algorithms may act as market makers, conduct arbitrage across related instruments, or take directional positions. Because they trade for their own account, they are exposed directly to trading losses but usually do not create the same deposit-insurance concerns as banking entities.[9]
These firms may be highly technology-dependent. Low-latency connectivity, automated risk controls, data processing, and quantitative modelling are central to many proprietary trading strategies. The U.S. Securities and Exchange Commission staff has described high-frequency trading as a subset of algorithmic trading associated with high message rates, frequent order cancellations or modifications, small trade sizes, and rapid trading speed.[10]
Retail-funded trading programmes
In consumer finance, the phrase "prop trading" is also used by retail-facing "funded trader" businesses. These programmes typically charge aspiring traders an evaluation fee and promise access to a funded account or profit share if the participant meets trading targets and risk limits. Press coverage has described many such programmes as operating through simulated accounts during the evaluation stage, with critics pointing to fees, low payout rates, and the difficulty of sustaining profitability.[11][12] These retail programmes are distinct from institutional proprietary trading by banks and principal trading firms, although they use similar terminology.
Strategies
Proprietary trading strategies vary by asset class, holding period, technology, and risk appetite. Many firms combine several strategies and allocate risk capital among desks according to performance and limits.
Market making and inventory trading
Market makers quote prices at which they are willing to buy and sell an instrument. They seek to earn the bid–ask spread while managing the risk that inventory changes in value before it can be hedged or sold. In over-the-counter markets, dealer market makers also provide immediacy to clients who want to transact in size without waiting for a natural counterparty.[2]
Market making is often classified separately from classic proprietary trading because it is tied to customer or market liquidity provision. Nevertheless, it involves principal risk: the firm owns the positions it acquires and may profit or lose from subsequent price changes. For this reason, regulation often exempts bona fide market making from proprietary-trading bans while imposing limits intended to prevent firms from disguising speculative positions as customer facilitation.[3][4]
Arbitrage and relative value
Arbitrage strategies seek to profit from price differences between related instruments. Examples include index arbitrage, convertible arbitrage, fixed income arbitrage, volatility arbitrage, merger arbitrage, and basis trades between cash instruments and derivatives. Many of these trades are not risk-free in practice: convergence may be delayed, financing may become unavailable, collateral requirements may change, or a position may become difficult to unwind during stressed markets.
Relative-value strategies often use leverage and hedging to isolate a perceived mispricing. A firm might, for example, buy one bond and sell a related bond, trade the relationship between an exchange-traded fund and its underlying basket, or exploit differences between futures and cash-market prices. These strategies require careful management of liquidity, funding, model, and basis risk.[2]
Quantitative and high-frequency strategies
Quantitative proprietary trading uses statistical models, historical data, and automated execution to identify and trade opportunities. Statistical arbitrage strategies may exploit short-term relationships among securities, while high-frequency strategies may depend on speed, market microstructure, and rapid updating of quotes across venues. High-frequency firms frequently act as electronic market makers, but they may also engage in latency arbitrage, cross-market arbitrage, or event-driven trading around public information releases.[10]
The effects of high-frequency proprietary trading are debated. Studies reviewed by the SEC staff have associated some high-frequency activity with narrower spreads and greater short-term price efficiency, while also identifying concerns about order anticipation, momentum ignition, and the behaviour of high-speed traders during periods of severe market stress.[10] Brainard noted that high-speed market makers can adjust liquidity provision nearly simultaneously across venues, which may complicate liquidity aggregation for large institutional investors during volatile periods.[9]
Directional and macro trading
Some proprietary desks take directional positions based on expectations about interest rates, currencies, equity indices, commodities, credit spreads, or macroeconomic developments. Such strategies may resemble those used by hedge funds, but the capital belongs to the trading firm rather than outside investors. Directional strategies can be discretionary, model-driven, or a combination of both.
Directional trading may generate high returns but can also create large losses if positions are leveraged, concentrated, or difficult to exit. For banks, these risks were a central reason for post-crisis regulatory concern. For non-bank firms, they are usually borne by owners, partners, employees, creditors, and counterparties rather than insured depositors.
Regulation
United States
The main U.S. restriction on bank proprietary trading is the Volcker Rule. Section 619 of Dodd–Frank generally prohibits banking entities from proprietary trading and from acquiring or retaining ownership interests in, sponsoring, or having certain relationships with hedge funds and private-equity funds known as covered funds.[3][5] The rule was implemented jointly by the Federal Reserve Board, the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Securities and Exchange Commission.[3]
The 2013 implementing rules created exemptions for activities including underwriting, market-making-related activity, risk-mitigating hedging, trading in certain government obligations, insurance-company activities, and certain activities conducted outside the United States.[3] Amendments adopted in 2019 revised the definition of trading account, added exclusions from the definition of proprietary trading, streamlined exemptions, and tailored compliance obligations according to the size of a banking entity's trading assets and liabilities.[4] Further amendments in 2020 modified and clarified covered-fund provisions.[13]
The Volcker Rule does not ban proprietary trading by all firms. Independent proprietary trading firms, hedge funds, and other non-bank entities may trade for their own accounts, subject to securities, commodities, market-abuse, capital, clearing, and reporting rules that apply to their activities. The rule is aimed primarily at banking entities and their affiliates because of their access to deposit insurance, the Federal Reserve discount window, and other forms of public support.[3]
United Kingdom
The United Kingdom chose a ring-fencing model rather than a general ban on proprietary trading by all banks. Ring-fencing came into force on 1 January 2019 and requires the largest UK banking groups to separate core retail banking services from investment-banking activities.[8] The regime is intended to protect deposits, payments, and overdraft services for retail and small-business customers from shocks elsewhere in the group and in global financial markets.[8]
The Financial Services (Banking Reform) Act 2013 required the Prudential Regulation Authority to review proprietary trading after ring-fencing began. The PRA's 2020 review concluded that it already had substantial supervisory powers to mitigate risks arising from proprietary trading and related activities, and that it did not need new powers to address those risks.[1]
European Union
In the European Union, the High-level Expert Group on reforming the structure of the EU banking sector, chaired by Erkki Liikanen, recommended in 2012 the mandatory separation of proprietary trading and other high-risk trading activities from deposit-taking within large banking groups.[7] The group also recommended possible additional separation of activities based on recovery and resolution planning, a review of capital requirements for trading assets, and stronger governance and control of banks.[7]
A legislative proposal for EU bank structural reform was later drafted, but it was withdrawn by the European Commission in 2018. The Single Resolution Board has noted that, although the Liikanen structural-reform proposal was not implemented, related concerns about separability, resolution planning, and the orderly wind-down of trading activities have continued through EU bank-resolution policy.[14]
Economic role and criticism
Liquidity and price discovery
Supporters of proprietary trading and principal market making argue that firms willing to commit capital improve liquidity, narrow bid–ask spreads, and support price discovery. Market makers provide immediacy by buying when clients want to sell and selling when clients want to buy, absorbing inventory risk that might otherwise remain with end investors.[2] Electronic proprietary firms can also connect fragmented markets by arbitraging related instruments and updating prices quickly across venues.[10]
The benefits may be uneven. The BIS reported signs of liquidity bifurcation after the financial crisis, with liquidity concentrating in the most liquid instruments while deteriorating in less liquid markets such as some corporate bonds.[2] A Federal Reserve working paper by Jack Bao, Maureen O'Hara and Xing Zhou found that, in the corporate bond market, bonds experiencing stress events became less liquid after the Volcker Rule, with Volcker-affected dealers reducing market-making activity and non-affected dealers only partly replacing it.[15]
Conflicts of interest
A major criticism of proprietary trading is that it can create conflicts between a firm's own positions and the interests of its clients. Conflicts may arise when a bank trades for its own account while advising clients, executing customer orders, making markets, publishing research, or distributing securities. These concerns were central to post-crisis debates about whether deposit-taking institutions should be allowed to conduct speculative trading.[3]
Empirical evidence of such conflicts has been reported in banking research. A 2018 study by Falko Fecht, Andreas Hackethal and Yigitcan Karabulut in The Journal of Finance examined German universal banks and found that banks sold stocks from their proprietary portfolios to retail customers, that those stocks subsequently underperformed, and that retail customers of banks engaged in proprietary trading earned lower portfolio returns than comparable investors.[16]
Systemic and prudential risk
For banks, proprietary trading can increase systemic risk when losses occur inside institutions that perform payment, lending, deposit-taking, or market-intermediation functions. Critics argue that public support for banking, including deposit insurance and central-bank liquidity facilities, may subsidise risk-taking and create moral hazard. The Volcker Rule and UK ring-fencing were designed in part to separate or restrict speculative trading where it could threaten essential banking functions or public backstops.[3][8]
Regulators have also emphasised that proprietary trading is not the only source of trading-book risk. Market making, hedging, and liquidity management can generate similar market, counterparty, and operational risks, even when they are intended to support clients or reduce risk. The PRA therefore concluded that broad restrictions on all principal trading could interfere with useful hedging and liquidity functions, while still recognising the need for supervision of risk limits, controls, and governance.[1]
See also
References
- 1 2 3 4 5 6 7 8 9 10 11 Proprietary Trading Review (PDF) (Report). Prudential Regulation Authority. 21 September 2020. Retrieved 13 May 2026.
- 1 2 3 4 5 6 7 8 Market-making and proprietary trading: industry trends, drivers and policy implications (PDF) (Report). CGFS Papers. Bank for International Settlements, Committee on the Global Financial System. November 2014. Retrieved 13 May 2026.
- 1 2 3 4 5 6 7 8 9 "Volcker Rule". Federal Reserve Board. Retrieved 13 May 2026.
- 1 2 3 "Volcker Rule: Final Rule". Office of the Comptroller of the Currency. 14 November 2019. Retrieved 13 May 2026.
- 1 2 "12 CFR Part 44 — Proprietary Trading and Certain Interests in and Relationships With Covered Funds". Electronic Code of Federal Regulations. National Archives and Records Administration. Retrieved 13 May 2026.
- ↑ Stewart, Heather (21 January 2010). "What is 'proprietary trading'?". The Guardian. Retrieved 13 May 2026.
- 1 2 3 "Liikanen report". European Commission. 2 October 2012. Retrieved 13 May 2026.
- 1 2 3 4 "Ring-fencing". Bank of England. Retrieved 13 May 2026.
- 1 2 3 4 Brainard, Lael (3 December 2018). The Structure of the Treasury Market: What Are We Learning? (Speech). New York: Federal Reserve Board. Retrieved 13 May 2026.
- 1 2 3 4 Equity Market Structure Literature Review: Part II: High Frequency Trading (PDF) (Report). U.S. Securities and Exchange Commission, Division of Trading and Markets. 18 March 2014. Retrieved 13 May 2026.
- ↑ Sor, Jennifer (13 December 2025). "Inside the $12 billion prop trading industry that has Gen Z and millennial investors hooked". Business Insider. Retrieved 13 May 2026.
- ↑ Atkins, Alice (16 December 2025). "Amateur Traders Chase Elusive Profits in Simulated Markets". Bloomberg News. Retrieved 13 May 2026.
- ↑ "Volcker Rule Covered Funds: Final Rule". Office of the Comptroller of the Currency. 31 July 2020. Retrieved 13 May 2026.
- ↑ Westman, Hanna (3 October 2022). "Guest blog: The Liikanen Report and the proposal for a resolution framework – 10 years on". Single Resolution Board. Retrieved 13 May 2026.
- ↑ Bao, Jack; O'Hara, Maureen; Zhou, Xing (2016). The Volcker Rule and Market-Making in Times of Stress (Report). Finance and Economics Discussion Series. Federal Reserve Board. doi:10.17016/FEDS.2016.102. Retrieved 13 May 2026.
- ↑ Fecht, Falko; Hackethal, Andreas; Karabulut, Yigitcan (June 2018). "Is Proprietary Trading Detrimental to Retail Investors?". The Journal of Finance. 73 (3): 1323–1361. doi:10.1111/jofi.12609.
Further reading
- Coates, John C. (2015). "The Volcker Rule as structural law: implications for cost–benefit analysis and administrative law". Capital Markets Law Journal. 10 (4): 444–464. doi:10.1093/cmlj/kmv027.
- Duffie, Darrell (2012). Market Making Under the Proposed Volcker Rule (PDF) (Report). Stanford University.
- Krahnen, Jan Pieter; Noth, Felix; Schüwer, Ulrich (2017). "Structural reforms in banking: the role of trading". Journal of Financial Regulation. 3 (1): 66–88. doi:10.1093/jfr/fjx004.