The Volcker Rule Ban on Prop Trading: A Step Closer to Reality (2024)

FAQs

What is the Volcker Rule for proprietary trading? ›

The Volcker Rule generally restricts banking entities from engaging in proprietary trading and from owning, sponsoring, or having certain relationships with a hedge fund or private equity fund.

The Volcker Rule was part of the Dodd-Frank Act enacted into law by the Obama administration in 2010 as a response to the Global Financial Crisis. It prohibits banks from engaging in proprietary trading, or from using their depositors' funds to invest in risky investment instruments.

The Volcker rule generally prohibits banking entities from engaging in proprietary trading or investing in or sponsoring hedge funds or private equity funds.

The final rule prohibits banks from engaging in short-term proprietary trading of certain securities, derivatives, commodity futures and options on these instruments, for their own account. The final rule also imposes limits on banks' investments in, and other relationships with, hedge funds or private equity funds.

Institutions such as brokerage firms, investment banks, and hedge funds frequently have proprietary trading desks. However, there are restrictions against large banks engaging in prop trading, designed to limit the speculative investments that contributed the 2007-2008 financial crisis.

A bank may be excluded from the Volcker Rule if it does not have more than $10 billion in total consolidated assets and does not have total trading assets and liabilities of 5% or more of total consolidated assets.

Relaxation, 2020-present

On June 25, 2020, the Volcker Regulators relaxed part of the rules involving banks investing in venture capital and for derivative trading.

Personal Risk: One of the significant drawbacks of prop trading is the potential personal financial risk. If a trader doesn't perform well, they may lose their deposit, and in some cases, their job. Loss Limitations: Prop firms often implement daily loss limits to protect their capital.

Prop trading firms are less heavily regulated than regular brokerages and broker-dealers. However, if such laws apply, you must still properly register your business and get licensed.

While prop trading is one of the most profitable opportunities, it is affected by asymmetric risk. This means that the profit-sharing ratio may be from 75% to 90%, but you bear 100% of the risk of your trades. When becoming a prop trader, you often need to deposit an amount of money known as your risk contribution.

Can you prop trade stocks? ›

Proprietary trading firms, or prop firms, are specialized financial entities that engage in trading assets with their own capital across various financial markets. These can include stocks, currencies, commodities, crypto-assets, and other financial instruments.

Proprietary trading firms often provide evaluation accounts where you prove your trading skills. Usually, you pay a one-time fee to enter this “challenge.” If you lose money during this evaluation, you won't owe anything beyond the initial fee.

The Volcker Rule generally prohibits a banking entity from entering into transactions with a related fund that w ould be a covered transaction under section 23A of the Federal Reserve Act if the banking entity w ere a member bank and the fund w ere its affiliate.

Loosely put, the Rule defines a covered fund as anything considered an investment company in the Investment Company Act, including private equity and hedge funds, as well as commodity pools with certain exclusions, and funds sponsored by a US banking entity where the affiliate holds ownership interests.

Conflicts of Interest in Proprietary Trading

Another conflict that might occur is that when the proprietary traders buy securities that have been performing badly. In this instance, the investment bank might instruct their institutional sales staff to call clients to try and convince them to purchase these securities.

The Volcker Rule on Proprietary Trading

The rule aims to restrict banks from making certain speculative investments that do not directly benefit their depositors. The law was proposed after the global financial crisis when government regulators determined that large banks took too many speculative risks.

Proprietary Trading is the practice of a firm trading its own money, rather than that of its clients, to profit from market movements. Financial institutions engage in proprietary trading by deploying their own funds to actively participate and profit from financial markets.

Proprietary trading, commonly referred to as prop trading, involves financial firms, especially those specializing in securities, equities, derivatives, forex, and the futures markets, trading their own money for direct profit, rather than earning commission by trading on behalf of clients.

Proprietary trading (also known as prop trading) occurs when a trader trades stocks, bonds, currencies, commodities, their derivatives, or other financial instruments with the firm's own money (instead of using depositors' money) to make a profit for itself.