Proprietary trading

Proprietary trading is a term used in investment banking to describe when the firm's traders actively trade stocks, bonds, options, commodities, or other items with its own money as opposed to its customers' money, so as to make a profit for itself. Although investment banks are usually defined as businesses which assist other business in raising money in the capital markets (by selling stocks or bonds), in fact most are more likely to be involved in a scenario where a customer wants to sell a large amount of stock, which if sold through a stock broker couldn't be sold all at once and could possibly trigger a decline in the value due to flooding the market. The Investment Bank would agree to buy the entire amount of stock at a discount with the belief that it could sell pieces over time. The profit comes not from selling the stock at present value, but buying it at a discount. This is known as "block trading". In the bond and other over-the-counter markets, it is much more likely that an investment bank will be a middleman in the transaction, holding the security for a period and attempting to make a profit from the small difference between what it bought it for and what it sold it for. For this reason the majority of trading profits usually comes from bond and commodity trading (often four times as much).Fact|date=February 2007

Many reporters and analysts believe investment banks purposely leave ambiguous the amount of non proprietary trading they do versus the amount of proprietary trading they do because it is felt that proprietary trading is riskier and results in more volatile profits.

The relationships between trading and investment banking

Investment banks are defined as companies that assist other companies in raising financial capital in the capital markets, through things like the issuance of stocks and bonds. Trading has almost always been associated with investment banks however, because they are often required to "make a market" in the stocks and bonds they help issue.

For example, if General Store Co. sold stock with an investment bank, whoever first bought shares would possibly have a hard time selling them to other individuals if people are not familiar with the company. The investment bank agrees to buy the shares sold in order to find a buyer. This provides liquidity to the markets. The bank normally does not care about the fundamental, intrinsic value of the shares, but only that it can sell them at a slightly higher price than it could buy them. To do this, an investment bank employs traders. Over time these traders began to devise different strategies within this system to earn even more profit independent of providing client liquidity, and this is how proprietary trading was born.

The evolution of proprietary trading at investment banks has come to the point whereby banks employ multiple desks of traders devoted solely to proprietary trading with the hopes of earning added profits above that of market-making trading. These desks are often considered internal hedge funds within the investment bank, performing in isolation away from client-flow traders. Proprietary desks routinely have the highest value at risk among other desks at the bank. Investments banks such as Goldman Sachs, Deutsche Bank, Merrill Lynch, and Credit Suisse are known to earn a significant portion of their quarterly and annual profits through proprietary trading efforts.Fact|date=February 2008

Arbitrage

One of the main strategies of trading traditionally associated with investment banks is arbitrage. In the most basic sense, arbitrage is defined as taking advantage of a price discrepancy through the purchase/sale of certain combinations of securities to lock in a profit.

Many people confuse arbitrage with what is essentially a normal investment. The difference between arbitrage and a typical investment is the amount of risk: the risk in what is known as arbitrage today (to distinguish it from theoretical arbitrage, which effectively does not exist) is market neutral. From the second the trade is executed, a profit is locked in. Investment banks, which are often active in many markets around the world, constantly watch for arbitrage opportunities.

One of the more notable areas of arbitrage, called risk arbitrage, evolved in the 1980's. When a company plans to buy another company, often the price of a share in the capital of the buyer falls (because the buyer will have to pay money to buy the other company) and the price of a share in the capital of the other company rises (because the buyer usually buys those shares at a price higher than the current price). When an investment bank believes a buyout is imminent, it often sells short the shares of the buyer (betting that the price will go down) and buys the shares of the company being acquired (betting the price will go up).

Conflicts of interest in proprietary trading

There have been many criticisms over the diverse conflicts of interest possible through proprietary trading. Who|date=February 2008

Some suspect that traders engage in "front running", buying shares in companies the traders' customers are buying so as to profit from the price increase resulting from the customers' purchases and thereby harming the customers' interests.

Some suspect that investment bank salesmen (who encourage customers to buy particular securities) assist their firm's proprietary traders by encouraging customers to buy securities performing poorly after the proprietary traders have bought them for the firm.

Lastly, because investment banks are key figures in mergers and acquisitions, a possibility exists that the traders could use prohibited inside information to engage in merger arbitrage. Investment banks are required to have a Chinese wall separating their trading and investment banking divisions, however in recent years, dating most recently back to the Enron saga, these have come under great scrutiny. Former New York Attorney General Eliot Spitzer discovered that analysts at Merrill Lynch helped recruit new investment banking clients -- and were paid to do so. According to court documents, the head of the equity division at Merrill sent an email to the bank's analysts noting: "We are once again surveying your contribution to investment banking ... please provide complete details on your involvement .. paying particular attention to the degree your research played a role in originating ...banking business." [ [http://www.cfo.com/article.cfm/3004344?f=related Wall? What Chinese Wall? - This Week in Capital Markets - CFO.com ] ]

Famous trading banks and traders

Famous proprietary traders have included Robert Rubin, Steven Cohen, Edward Lampert, and Daniel Och. Some of the investment banks most historically associated with trading was Salomon Brothers and Drexel Burnham Lambert, and currently Goldman Sachs.
Nick Leeson took down Barings Bank with unauthorized proprietary positions. Another trader, Brian Hunter brought down the hedge fund Amaranth Advisors when his massive positions in natural gas futures went bad.

References

External links

None [1] http://www.cfo.com/article.cfm/3004344?f=related [2] http://www.trading-lab.com/forums/introduction_proprietary_trading-t305.html