Prop Trading Firms

There is undoubtedly going to be a lot about Proprietary Trading firms in the news for a while and there’s a lot of questions about what and who they are and what they do exactly. It’s actually easy to understand: a trader is given a line of credit within his/her firm to trade for the purpose of generating trading profits. It is the firm’s own capital. The trader has one client: the firm – and in this case we’re talking about publicly traded firms that are under scrutiny. And they aren’t exclusively prop trading firms, they have what are called Prop trading desks.

I think a prop trading firm in the purest sense would be like the few I’ve mentioned in an earlier post, DE Shaw and Schonfeld. Another is Susquehanna Investment Group.

On the prop trading desk, the trader is typically given a monthly draw as salary, but that is not their main compensation, nor is it their motivation. I’d say all Proprietary traders are working for their bonus, which is a share in the profits they’ve generated for their firm. Those net profits go to the firm’s bottom line and are counted in EPS. If the trader fails to make money, they usually get fired. Most professional traders are excellent in playing superb defense – small or smaller losses are easier to overcome financially and emotionally speaking.

There have been some pretty stellar Prop trading desks over the years. Marc Rich’s first employer Philip Brothers (now Phibro) was a big trader in the day. So was their owner, Salomon Brothers. Another thing we can blame Sandy Weill for is killing Phibro and all the prop trading inside Solly. Trading profits can be volatile and neither Sandy nor Jamie wanted that type of risk on their balance sheet.

I’d have to look at the dates, but Commodities Corporation comes to mind as probably one of the first, if not THE first Proprietary trading outfit. I’ll have more on this in the next month. Goldman Sachs has always traded their own capital. They’ve also done merchant banking and investment banking and to my knowledge have never been too afraid to put their own capital on the line.

There has been some concern over the years about the concept of the Chinese Wall – the flow of information from the Agency desk to the prop desk and it’s not supposed to happen. Front running is putting your orders ahead of your clients. But what is it when you trade alongside that same client?

Here’s an example:

The Munderous Inter-net-of-my-fees Mutual Fund A (aka weapon of mass destruction) (Ticker:MFUXU) calls the floor of the NYSE and needs 1MM shares of MNO stock. You only trade 50M shares at a clip. Obviously, 1MM shares of buying pressure will put some wind in your sails if you’re long the 50M before the million share order gets filled. Doing so would be front running.

Buying the 50M shares (or another 1MM) alongside your client is called being a Specialist.