Proprietary Trading

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Proprietary Trading

Benefits and Risks of Proprietary Trading

Benefits

Investment among financial institutions usually is common because of the numerous benefits banks can derive from such activities. However, proprietary trading is different from other investment activities banks indulge in because, in this case, they trade stocks, derivatives, bonds, and other commodities from their money instead of that of their clients’. Therefore, one of the benefits of proprietary trading is that banks can earn full profits from such activities instead of the usual commission they obtain by using the resources of their clients. Therefore, increased profits are one of the benefits of proprietary trading (Brown, 2012). In this case, banks do not have to share their commissions with their clients because profits are obtained from their investments.

The other benefit of proprietary trading is that banks can stock an inventory of securities to use as securities in the future. In cases where banks buy such securities for speculative purposes, then it can sell them later to clients who need such financial instruments (Lei, et al., 2012). Moreover, through proprietary trading, banks can loan these securities in the short-term for clients in need of such securities.

Through proprietary trading, firms can quickly become critical market markers. For financial institutions dealing with specific kinds of securities, such firms can offer liquidity for their investors using these financial instruments. Banks can purchase these securities using their financial resources and then selling them to interested parties in the future. Nonetheless, if banks purchase securities with their own resources in bulk, and they prove worthless, they are forced to absorb these losses internally. The situation could be worse if banks use their clients’ finances instead of their own money (Brown, 2012). The only risk of this kind of trading is that banks can only benefit if the prices of securities rise or buyers purchase them at the right valuation.

The other benefit of proprietary trading is that such traders can quickly access sophisticated technologies and other automated software to help in this process. These sophisticated electronic trading platforms offer banks access to a wide range of markets as well as the ability to automate processes and participate in high-frequency trading. Banks, as the traders in this situation, can develop a trading idea and evaluate its viability by running demos on their computers. Banks indulging in proprietary trading frequently use exclusive in-house platforms that only traders from a specific financial institution can use (Nabilou, 2013).  hugely helps financial institutions because they can easily own trading software, a luxury many retail traders lack.

While specific issues have arisen regarding the concept of proprietary trading, it is vital to understand the practice is still widely being used, especially in UK-based banks. A 2017 report revealed that banks in this country still employ 26 people to supervise their proprietary trading businesses (Noonan, 2017). This is despite a protracted regulatory crackdown making it progressively complicated for banks to trade on their behalf. The practice has been out of favor with the regulators since the 2008 financial crisis when banks made huge losses by betting on their capital on future market moves. This explains why US banks are particularly constrained under the Volcker rule. This regulation forbids them from trading using their finances, except for certain exceptional circumstances (Noonan, 2017). However, the continued practice of proprietary banking in Europe is an indicator that banks are still deriving many benefits from this practice.

Risks

Even though banks used to derive numerous benefits from this practice in the past, the situation has hugely changed for them in the current years, especially after the 2008 financial crisis. For example, leading financial institutions such as Goldman Sachs have invested in considerable studies to determine whether trading in bitcoins is a worthwhile investment. Even though this trading helps organizations to build their inventories, huge problems have also arisen from such practices (Manasfi, 2013). The problem with such inventories is that they are entirely speculative. Banks that trade in such securities undertake this kind of trading for two reasons. First, they hope that customers will purchase these securities. Second, such financial institutions usually believe that inventory prices will rise. However, by buying such inventories, banks are just placing a bet. In such situations, they can either turn out good or bad based on the market conditions (Fecht, et al., 2018). Therefore, the highly speculative nature of this trading makes it quite a risky investment from a banking point of view.

The most significant conclusion by many finance experts is that indulging in proprietary trading can hugely destabilize banks. Such conclusions were made mainly during the recent financial crisis. Supporters of proprietary trading argued that such bank failures are only one-off phenomena. However, this is not the case because proprietary trading has highlighted some of the more profound structural challenges in the financial system. This is because studies found that before the 2008 financial crisis, banks heavily engaged in this kind of trading. Due to this vast involvement, it became easy for such institutions to misallocate capital, instead of lending given that this is one of their essential functions. However, the problem with proprietary trading is that by indulging in this practice for a while, banks put themselves in precarious positions (Stowell, 2010). For example, significant trading positions encourage risk-shifting that, in turn, leads to failures and financial instability.

While indulging in these proprietary trading activities, banks regularly employ brokers who usually operate within the premises of these financial institutions. Such brokers usually utilize algorithmic trading, insider information, as well as trading strategies to enter into trade situations and realize profits. Given the disruptive nature of these financial markets, numerous elements can go wrong despite the adequate risk management procedures these banks usually have in place (Manasfi, 2013). The risk of proprietary trading is high because about 20% of cash turnovers in many stock exchanges involve proprietary trading. Moreover, 40% of commodity trading emerges from proprietary trading.

Numerous case examples all over the world indicate how proprietary trading has led to problems for financial institutions. Nomura Holdings is one such institution, and the insider trading this organization indulged in led to a substantial financial scandal (Emoto & Lyne, 2012). Due to the company’s engagement in insider trading, some of the staff members involved in this process leaked critical information regarding share offerings to their customers before such information became public. Aside from the issues witnessed at Nomura Holdings, proprietary trading also lead to the fall of Northern Rock despite the securitization that enabled the organization to resell its mortgages on international capital markets. However, this was not the case for this company in August 2007 after the global demand from investors for securitized mortgages fell (O’Connell, 2017). Northern Rock could not repay loans from the money market leading to its downfall.

The Effect of Banning Proprietary Trading in the Banking Industry

As the above discussion shows, proprietary trading has its benefits as well as downfalls. After the 2008 financial scandal, banks have become more cautious in their approach. This has even forced the financial world to change how they operate, and this is witnessed in the new approaches being used today. The Volcker approach is one such strategy, and it centers on the notion of banks being prohibited from indulging in high-risk activities regarding proprietary trading. The rule is stipulated in Section 609 of the Dodd-Frank Act and is one of the elements within the broader financial reforms that occurred after the recent financial crisis (Duffie, 2012). One of the benefits of the Volcker Rule is to prevent banks, especially those receiving federal and taxpayer backing in deposit insurance forms from engaging in risky trading activities.

To many people, the Volcker rule just aims to prohibit proprietary trading. However, the rule becomes critical because it defines what banks can do as far as this trading is concerned. It uses three criteria to define a trading account by focusing on the purpose test, market risk, as well as status test. Therefore, banks are required to hold a position for 60 days to be assigned a trading account (Bao, et al., 2016). Nonetheless, this definition considers trading account to have many broad definitions; thus, other financial activities might be exempted from this prohibition.

The Volcker rule is essential because, aside from prohibiting proprietary trading, it also outlaws trading on covered fund investments. Due to this regulation, banks cannot have an ownership interest in a covered fund. It also uses a three-pronged test to define covered funds (Duffie, 2012). Moreover, this prohibition is vital because it sets other exceptions on these covered fund investments, including foreign public funds as well as joint ventures.

The Volcker rule has also allowed the extension of deadlines for compliance. By July 2015, financial institutions were expected to liquidate their holdings in covered funds. However, the situation changed by December 2014 when the Federal Reserve Board offered extensions to financial institutions to get out of this position until 2017. Others even had their deadlines extended to 2022. The rule was crucial because many banks found their investments in illiquid positions and that they would have to deal with significant losses if this were to happen (Chung, et al., 2020). The extension was necessary because, without it, the ownership interests in hedge funds and private equity funds would have lost substantial value if banks were forced to liquidate them forcefully.

As much as banks are the biggest beneficiaries of this rule, it is also vital for the various clients who enjoy using banking services. First, this rule will make deposits safer because financial institutions cannot use them for high-risk investments (Duffie, 2012). Furthermore, this rule means that clients can heavily rely on banks for financial services assistance. This is because banks are unlikely to find a $700 billion bailout.

Some critics of banks have often stated that these financial institutions, especially the large ones, do not operate within the stated financial realms. With these new rules, big banks cannot own risky hedge funds because this can help them in improving their profits at the expense of their clients’ investments. The rule not only affects large financial institutions because even the local ones will hugely benefit from these regulations. This means local banks have a chance of succeeding because the large ones cannot buy them, thus, providing small businesses with a chance of succeeding (Chung, et al., 2020). During the 2008 financial crisis, Lehman Brothers were among the most affected financial institutions in the world. However, due to the Volcker Rule, it is highly unlikely that such a scenario will ever be witnessed in the banking industry.

While numerous financial reformers have had positive things to say about the Volcker rule, not all banks feel the same about this regulation. According to some experts, this rule will reduce the needed access to capital. However, this is just one of the problems the rule will bring to the banking sector as it seeks to offer the intended solutions. Other experts believe that the Volcker rule would have problems, especially when banks will need these regulations the most (Chatterjee, 2013). Moreover, experts believe that this regulation has numerous loopholes, and due to this, regulators will have trouble enforcing this new rule.

The other problem regarding the Volcker rule is that it purports to eliminate excessive investment risk at financial institutions. However, it does this without evaluating the amount of risk this will cause or the ability of such banks to handle such perils. Therefore, banks cannot tell whether a risk is excessive or not. The problem with this rule is that it tends to focus more on the intent of investment. Due to its subjective and vague approach, the Volcker rule does a poor job in identifying and eliminating excessive investment risk. Moreover, this regulation has been found as costly, even if it can help banks correctly identify risks (Chatterjee, 2013). While some banks might deem it beneficial, the arbitrariness of this regulation combined with its ambiguous definitions, have produced excessive complexity.

Reference List

Bao, J., O’Hara, M. & Zhou, X. (., 2016. The Volcker Rule and Market-Making in Times of Stress. Journal of Financial Economics (JFE).

Brown, O. W., 2012. Proprietary Trading: Regulators Will Need More Comprehensive Information to Fully Monitor Compliance with New Restrictions When Implemented. 1st ed. s.l.: DIANE Publishing.

Chatterjee, R. R., 2013. Dictionaries Fail: The Volcker Rule’s Reliance on Definitions Renders It Ineffective and a New Solution Is Needed to Adequately Regulate Proprietary Trading. International Law & Management Review, Volume 33.

Chung, S., Keppo, J. & Yuan, X., 2020. The Impact of Volcker Rule on Bank Profits and Default Probabilities. SSRN, pp. 1-71.

Duffie, D., 2012. Market Making Under the Proposed Volcker Rule. Rock Center for Corporate Governance at Stanford University, Volume 106.

Emoto, E. & Lyne, N., 2012. Nomura CEO quits as insider trading scandal widens. [Online]
Available at: https://www.reuters.com/article/us-nomura-ceo/nomura-ceo-quits-as-insider-trading-scandal-widens-idUSBRE86P03S20120726 [Accessed 13 August, 2020].

Fecht, F., Hackethal, A. & Karabulut, Y., 2018. Is Proprietary Trading Detrimental to Retail Investors?. The Journal of Finance, 73(3), pp. 1323-1361.

Lei, Q., Rajan, M. & Wang, X., 2012. An empirical analysis of corporate insiders’ trading performance. China Finance Review International, 2(3), pp. 246-264.

Manasfi, J. A. D., 2013. Systemic Risk and Dodd-Frank’s Volcker Rule. Hein Online.

Nabilou, H., 2013. Bank Proprietary Trading and Investment in Private Funds: Is the Volcker Rule a Panacea or Yet Another Maginot Line?. Banking and Finance Law Review, 32(2).

Noonan, L., 2017. UK-based banks still active in proprietary trading. [Online]
Available at: https://www.ft.com/content/c1704966-9f81-11e7-8cd4-932067fbf946 [Accessed 13 August, 2020].

O’Connell, D., 2017. The collapse of Northern Rock: Ten years on. [Online]
Available at: https://www.bbc.com/news/business-41229513 [Accessed 13 August, 2020].

Stowell, D., 2010. An Introduction to Investment Banks, Hedge Funds, and Private Equity. 1st ed. Burlington, MA: Academic Press.