Is prop trading Illegal?

The very short answer is no, proprietary trading is not illegal, unless you are a trader at one of the large banks.

Thanks to the billions of dollars of losses they suffered during the 2008 financial crisis, banks are no longer allowed to proprietary trade.

The ban on prop trading only applies to large financial institutions because as the Great Recession proved, when major banks fail, the entire global financial system is at risk.  

What is prop trading?

Proprietary trading occurs whenever a firm trades from its own account to try to generate profits. 

For years, most prop trading occurred at investment and commercial banks. They had trading desks that handled client funds as well as proprietary trading desks that traded on behalf of the bank itself. These prop desks were responsible for billions of dollars of profits, and, at times, billions of dollars of losses. 

Is prop trading dead?

Not at all! After banks gave up their prop trading desks, proprietary trading simply moved to other venues. Prop trading still occurs in hedge funds, specialized prop trading firms and many other wealth management firms.

In recent years, new proprietary trading firms that are open to any traders with an internet connection and a sound trading strategy have made prop trading even more popular than ever. 

Is prop trading bad?

In principle, no, absolutely not. Markets might cease to exist without prop traders. But proprietary trading certainly can be bad when traders risk more than they can afford to lose. 

Prop trading took the bulk of the blame for the financial crisis after traders lost big on investments related to mortgage-backed securities. When the American housing bubble popped, banks were left holding billions of dollars of suddenly worthless derivatives. 

The losses completely bankrupted several large investment banks and brought financial markets to the brink of collapse.  

That’s pretty bad. But if prop traders at Lehman Brothers and Bear Stearns and the other investment banks had been more conscious of the risks they were taking, we wouldn’t be having this conversation.

Why were banks forced to give up prop trading?

The financial crisis proved that the risk management programs investment banks had in place were not sufficient. We also learned just how devastating a bank’s collapse can be to the financial system as a whole. The consequences of some bad trades made by a small group of prop traders affected the lives of tens of millions of people.

Banks were also essentially betting customer deposits on speculative investments without sharing the profits. If a prop trader made substantial profits, the bank itself and the trader were the only ones to benefit. But in the event of large losses, the bank would have to cover those losses with customer deposits, which are insured by the Federal Deposit Insurance Corporation (FDIC). That means that US taxpayers are on the hook when trades go bad, which they obviously did in 2008. 

How is proprietary trading by banks regulated?

In the aftermath of the financial crisis, the Dodd Frank Act was enacted to prevent such a collapse in the future. The Volcker Rule, which applied to proprietary trading, was a part of that act. The Volcker Rule went into effect in 2014, and banks had a year to come within full compliance. 

The Volcker Rule prohibits banks from engaging in any proprietary trading, or maintaining ownership interests in “covered funds” such as hedge funds, private equity funds and some other investment funds. 

Essentially, the government wanted to eliminate banks’ ability to make speculative investments of any kind. Banks are still allowed some trading activities such as market making and certain types of hedging and brokerage services, but beyond that they can’t trade the bank’s money.

The Volcker Rule is enforced by five federal agencies, the Securities and Exchange Commission (SEC), the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), the Commodity Futures Trading Commission (CFTC) and the Office of Comptroller of Currency.

Banks are responsible for maintaining and reporting detailed compliance logs. Should they violate the Volcker Rule, they are given a chance to unwind positions and come back into compliance.

Penalties for violating the Volcker Rule are very rare, but involve fines. In 2017, Deutsche Bank was fined $157 million for violations, but that remains the only substantial penalty levied to date.

In the years following the enactment of the Volcker Rule, the large banks have pushed back, arguing that the burden of compliance is too high and that the ban on proprietary trading has led to illiquidity for certain financial instruments. 

To some extent the regulators have agreed and the Volcker Rule remains a frequently amended work in progress. In 2020, the responsible federal agencies approved a relaxing of some parts of the Volcker Rule. Further exemptions to what are considered covered funds were granted and banks can now invest in some venture capital funds and credit funds.

Are independent prop trading firms regulated?

Some are, many aren’t.

Many independent proprietary trading firms in the US register with the Security Exchange Commission as broker-dealers and therefore fall under the watchful eye of the SEC. Many also become members of the Financial Industry Regulatory Authority (FINRA).

FINRA is not a government agency, but any firm or individual who plans to “conduct securities transactions and business with the investing public in the United States” must be registered with FINRA. FINRA holds its members to a high standard of conduct and offers a very handy broker check tool that allows you to see if a particular prop trading firm has registered and is in compliance. 

However, since many proprietary trading firms don’t interact with the investing public because they are simply trading their own funds, they can avoid FINRA and face few regulations.

Proprietary trading firms based outside the US are obviously subject to the regulatory bodies in their own countries and many don’t make an effort to comply with US regulations, even if they participate in US markets.  

There are also a number of proprietary trading firms that offer “funded accounts” to anyone who can demonstrate a reliable trading strategy. These firms often keep their funded traders on demo accounts, meaning they too can avoid regulation.