Question

Prior to the 2010 Dodd-Frank Act, banks employed proprietary traders (aka Prop Traders) whose job was to invest the Bank’s capital in various short-term trading strategies. Prop Traders often took large risks (using leverage) and were rewarded with yearly bonuses worth millions of dollars. Prop Trading was eventually disallowed by the 2010 Dodd-Frank Act.

Explain the moral hazard associated with such proprietary trading activity

Answer 1

Proprietary trading

Proprietary trading refers to a financial firm or commercial bank that invests for direct market gain rather than earning commission dollars by trading on behalf of clients. Also known as "prop trading," this type of trading activity occurs when a financial firm chooses to profit from market activities rather than thin-margin commissions obtained through client trading activity. Proprietary trading may involve the trading of stocks, bonds, commodities, currencies or other instruments.

Benefits of Proprietary Trading

There are many benefits that proprietary trading provide a financial institution or commercial bank, most notably higher quarterly and annual profits. When a brokerage firm or investment bank trades on behalf of clients, it earns revenues in the form of commissions and fees. This income can represent a very small percentage of the total amount invested or the gains generated, but the process also allows an institution to realize 100% of the gains earned from an investment.

The second benefit is that the institution is able to stockpile an inventory of securities. This helps in two ways. First, any speculative inventory allows the institution to offer an unexpected advantage to clients. Second, it helps these institutions prepare for down or illiquid markets when it becomes harder to purchase or sell securities on the open market.

The final benefit is associated with the second benefit. Proprietary trading allows a financial institution to become an influential market maker by providing liquidity on a specific security or group of securities

Financial firms or commercial banks that engage in proprietary trading believe they have a competitive advantage that will enable them to earn an annual return that exceeds index investing, bond yield appreciation or other investment styles.

The Volcker Rule on Proprietary Trading

The Volcker rule is part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. It was suggested by the former chairman of the Federal Reserve, Paul Volcker. 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. Volker argued that commercial banks engaged in high-speculation investments affected the stability of the overall financial system. Commercial banks that practiced proprietary trading increased the use of derivatives as a way of mitigating risk. However, this often led to increased risk in other areas.

The Volcker Rule prohibits banks and institutions that own a bank from engaging in proprietary trading or even investing in or owning a hedge fund or private equity fund. From a market-making point of view, banks focus on keeping customers happy and compensation is based on commissions. However, from a proprietary trading point of view, the customer is irrelevant, and the banks enjoy the full profits. Separating both functions will help banks to remain objective in undertaking activities that benefit the customer and that limit conflicts of interest. In response to the Volcker rule, major banks have separated the proprietary trading function from its core activities or have shut them down completely. Proprietary trading is now offered as a standalone service by specialized prop trading firms.

The Volcker Rule, like the Dodd-Frank Act, is generally viewed unfavorably by the financial industry. It is seen as unnecessary and counterproductive government interference. For example, as noted above, banks’ proprietary trading provided important liquidity for investors. That source of liquidity is now gone.

Moral hazard associated with such proprietary trading activity

• Stress: Trading someone else’s money can be a stressful endeavour. Accounting for losses publicly and actually losing capital that is not yours can be emotionally taxing.
• Job Security: If you do not make money, then you will not be employed for long. It really is that simple!
• Fees/Capital Investment: Many prop shops require fees to be paid for platform, training, and account access. In addition, an initial deposit of capital may be required from the trader to act as a risk “buffer” for the firm.

The dynamic of working for a prop firm is much different than trading from home. The added stress and pressure are very real, as is the public accountability for losses. While these aspects can work to make a trader better, they may also deteriorate the overall quality of life.