page title icon Are prop trading firms regulated?

The most honest answer is: only to the degree that they want to be. By definition, proprietary trading firms are only trading their own money, which puts them beyond the reach of regulators in many cases. Some proprietary firms register with securities associations, but many do not.

A proprietary trading firm must register with the Securities and Exchange Commission as well as a registered national securities association such as the Financial Industry Regulatory Authority (FINRA) only if they are also operating as a broker-dealer. 

Prop trading firms that choose not to operate as broker-dealers and don’t “conduct securities transactions and business with the investing public in the United States” are not required to join FINRA. The key word is “public,” meaning that firms with their own private funds are exempt.

Even some prop firms that do operate as broker-dealers can get around the SEC’s requirements to join a securities association as long as they meet certain exemption clauses. 

The type of proprietary trading firms that offer funded accounts to any traders that can demonstrate successful strategies also skirt regulators. These prop firms don’t consider themselves financial institutions and often use demo accounts with their traders, which keeps them from being subject to securities regulations.

The only place proprietary trading is regulated is at large banks. Large banks, which once had their own prop trading desks, have been prohibited from proprietary trading as a result of their role in the 2008 financial crisis. 

Regulatory exemptions for proprietary trading firms

The Securities Exchange Act of 1934 still provides the backbone for much of the financial regulation in the US. As markets have evolved, it has been amended many times over, but some stubborn clauses never seem to change.

Such is the case for Section 240.15b9-1. For many years, it has been the exemption found in this clause that has allowed many prop firms to remain unregulated. It allows firms that are acting as broker-dealers to remain without affiliation to a securities association as long as they are members of a national securities exchange and carry no customer accounts.

Proprietary trading firms typically don’t have customer accounts, since they are trading their own money, so they meet that clause, and it is fairly simple to become a member of a securities exchange. 

The SEC lists more than 20 exchanges that qualify as a national securities exchange, including ones you know, like NASDAQ and the New York Stock Exchange (NYSE) and some you probably don’t, like the Miami International Securities Exchange.

The law was intended to provide an exemption for exchange specialists and floor traders who were almost entirely focused on one exchange and would therefore be beholden to the regulations of that exchange. Member firms were supposed to only trade on the exchange in which they were members. If they had an annual gross income of more than $1,000 due to trades made on a different exchange, they lost the exemption.

However, an additional clause made the $1,000 limit pretty toothless. Section 240.15b9-1 paragraph b states that the $1,000 limit does not apply to profits made with the firm’s own account via a broker-dealer that is actually registered as such.

Many proprietary trading firms have taken full advantage of this loophole, known as Rule 15b9-1 and don’t become FINRA members. 

The bottom line is that a proprietary trading firm trading from its own account only needs to establish a membership with one of the securities exchanges and use a registered broker-dealer to execute its trades in order to avoid regulation under the Securities Exchange Act. 

Proposed regulatory changes 

In 2015, the SEC proposed rule changes that would have tightened up the exemptions listed above. 

The SEC discovered that specialized prop trading firms were using the loophole to avoid regulation, but were conducting countless trades using high-frequency trading strategies across many different markets.

These firms were having a substantial impact on different markets but were not subject to any regulation.

The proposed rule change would tighten up the exemptions so that they only applied to exchange specialists, the original target group. The amendments, therefore, would require proprietary trading firms to finally subject themselves to the regulation of a national securities association.

Despite the strong recommendations of the SEC, to date, the proposed rule amendment has not been enacted. 

Regulations for prop firms that offer funded accounts

Recently, a new type of proprietary trading firm has become very popular. These prop firms don’t actually hire proprietary traders as employees, instead they offer funded accounts to any independent prop traders who can prove they have a successful, safe trading strategy.

They will offer anywhere from $10,000 up to $2 million worth of trading capital to traders, usually after they’ve passed an evaluation phase and paid a one-time beginners fee or a monthly subscription fee.

These proprietary trading firms have also largely escaped regulation. 

Many of these firms consider their main business to be financial education rather than trading activities. Industry leader FTMO, for example, clearly states in their Articles of Association that their main income-generating activity is the “organisation of events for the general public focused on increasing financial literacy…”

FTMO, along with other prop firms of this ilk, also use “demo accounts” for their independent proprietary traders rather than actual trading accounts. FTMO traders are actually using “virtual funds” that are somehow connected to the firm’s capital. These measures keep this type of prop firm free of any sort of regulation from the SEC or anyone else.

Even firms that offer real funds to their traders claim they are exempt from regulation. The 5%ers, a leading prop trading firm that offers funded accounts, says this in their FAQ: “However, there is no regulation clause to what we do, because we are not a financial institute and do not provide any financial services. We trade using our fund’s capital, with the support of our competent funded traders.”

Read the fine print on the websites of any of these types of prop trading firms and you will find a very similar message, if they bring up regulation at all.

Regulations for prop trading at commercial banks  

So where is proprietary trading actually regulated? Only at large financial institutions that act as commercial banks. In 2015, federal regulators started enforcing the Volcker Rule which essentially prohibited prop trading at major banks.

Prior to 2008, every investment bank had a proprietary trading desk. They were huge profit sources, but each proprietary trading desk also brought with them a degree of risk. Bad trades sometimes led to disastrous consequences.

Leading up to the financial crisis, many traders had enormous positions in financial instruments related to the US housing market. When the housing market collapsed, other financial markets followed suit.  Suddenly it seemed like every investment bank was a bankruptcy risk and the global recession was in full swing.

Regulators wanted to make sure history didn’t repeat itself so they passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. The law included the Volcker Rule which prohibits banks from engaging in any sort of proprietary trading. It also prevents investment banks and some other financial institutions from owning hedge funds and some private equity funds.

Investment banking was never the same. 

In 2020, an amendment to the Volcker Rule was enacted that softened the rules a bit for the banks. They were now allowed to own certain funds including credit funds and some venture capital funds. 

Proprietary trading remains decidedly off limits and no less than five federal agencies keep tabs on whether banks are following the rules. Independent prop trading companies don’t face nearly the same level of scrutiny. 

Leave a Comment