INTERNATIONAL POLICY DIGEST

Here’s a helpful guide to understanding the historic arch of proprietary trading.

Prop trading is the act of trading securities, foreign exchange, commodities, and other instruments by specific prop firms and financial institutions using their own capital for direct profits rather than on behalf of clients. Like the rest of the financial world, prop trading is a relatively new phenomenon, having emerged only in recent decades. Still, one must grasp its evolution from early financial houses to modern, algorithmically driven trading to appreciate the world of contemporary finance and its multitude of risks and complex machinations. This article will discuss the key milestones in the evolution of prop trading and its impact on international markets.

Early Days and the Rise of Investment Banks (pre-1980s)

The historic forms of prop trading were based on the primitive activities of financial institutions. In the world of partnerships and early investment banks, prop trading was rampant, as they frequently crossed the boundaries between trading for clients and trading their own accounts as a speculative play. For example, merchant banks, while primarily focused on trade finance and underwriting, also took speculative positions in commodities and currencies during the 18th and 19th centuries. Prop trading’s initial forms were more rudimentary and geographically limited, with core operations initially centered in emerging financial centers such as London and Amsterdam.

The Deregulation Era and Expansion (1980s – 1990s)

The latter part of the 20th century, particularly the 1980s and 1990s, witnessed the proliferation and further segmentation of proprietary trading following deregulation. The “Big Bang” in London in 1986, along with other deregulation initiatives in the U.S. and abroad, eliminated fixed commissions, thereby increasing competition. Investment banks began creating dedicated proprietary trading desks with the goal of profit-making through market speculation. These desks leveraged new and complex financial instruments, such as derivatives and intricate arbitrage systems.

The Quant Revolution and Technological Advancements (Late 1990s – 2008)

The late 1990s and the first decade of the 21st century were marked by unprecedented technology and the “quant revolution.” Mathematicians, physicists, and computer scientists began creating complex quantitative models, which have become central to many proprietary trading strategies. The advent of high-frequency trading (HFT) was marked by the development of super-low-latency trading systems and algorithms that exploited pricing discrepancies across various markets. Technology became a major investment focus for proprietary trading firms and desks within investment banks. While they made substantial profits during this time, a newer systemic risk in the form of high-speed interconnected algorithmic trading took root.

The Post-Financial Crisis Landscape and Regulatory Scrutiny (2008 – Present)

Proprietary trading desks came under intense scrutiny during the aftermath of the 2008 global financial crisis. People began to recognize excessive risk as a major contributor to the systemic fragility underpinning these activities. Blaming algorithmic trading for lack of speed controls, regulators in the U.S. and elsewhere started significant reforms around proprietary bank trading. This culminated in the Volcker Rule of the Dodd-Frank Act, which placed restrictions on short-term profit trading using bank capital. Other jurisdictions quickly followed suit to plug competitive vulnerabilities and insulate taxpayer-funded institutions from risky speculative trading. This change in regulations led to a marked shift, as skilled traders and large amounts of capital began to move from bank-affiliated proprietary trading desks to independent prop trading firms and hedge funds, which were often governed by different regulatory frameworks.

The Evolving Landscape and Future Trends

The domain of proprietary trading continues to adapt to shifting regulations and evolving market conditions. Prop trading remains a competitive business, driven by technology, advanced data analytics, artificial intelligence, and machine learning that are being used more frequently to find and implement trading strategies. Although the magnitude and organization of proprietary trading in large banks have been impacted by regulations, independent prop firms still actively foster liquidity and trading on a global scale.

Conclusion

The evolution of proprietary trading on a global scale has been characterized by continuous change, driven by technological advancements, policy shifts, and a relentless pursuit of profit. During its early stages, proprietary trading evolved into simpler, less specialized forms within financial institutions. Now, it has evolved into sophisticated operations involving advanced prop trading technology.