A proprietary trading firm is a specialized firm within an investment company or bank that chooses to invest its own money instead of simply investing the money of its clients. In this way, the institution that employs the firm is risking its own capital in the stock market rather than simply earning money based on the commissions it gains from investors. Most investment firms include a division that is devoted to proprietary trading containing skilled investment experts. This practice is somewhat controversial, as some industry analysts feel that a proprietary trading firm may gain useful information from their clients and engage in insider trading, helping the firm while harming investors.
The normal practice of investment companies is to take the money that's given to them by their clients and invest it in the stock market. These companies may give advice to their clients or simply act as the passive agent that makes the investments, making their money from the commissions paid by clients for enacting these transactions. A proprietary trading firm is so-called because it is investing its own money, in addition to its clients money, in stock transactions and thus invoking all of the risk and reaping all of the rewards of these trades.
This practice began from banks or investment companies looking for excellent investment opportunities for their clients. By employing investment experts who could find profitable opportunities in the market, they could then draw more investors and gain more in commissions. These institutions soon realized that they could capitalize on these profitable opportunities for their own benefit, and, in this way, proprietary trading began to take hold.
Large banks often utilize proprietary trading as a type of hedge against volatile interest rates, earning money to make up for any potential losses. These banks will often focus on a type of trading known as arbitrage, which is a generally low-risk venture based on price discrepancies that arise when certain securities are bought and sold. Merger arbitrage, which occurs when stock prices react to one company buying another, is another popular target of a typical proprietary trading firm.
Also known as prop trading, proprietary trading has come under increased scrutiny during the global financial crisis of the past few years. Many analysts, experts, and politicians accused banks of making needless risks with their own money, thus endangering the financial stability of both the banks and their clients. Others feel that a proprietary trading firm can use insider information to gain an unfair and even illegal advantage when it comes to making their own trades.