The definitions overlap ever so slightly and people use the phrases interchangeably. But, there are reasons I think these three main trading roles get confused, but one thing stands out is that clearly in all these types of trading is they all have exposure to P/L.
Nothing speaks as loudly as your account statements and a summary of your P/L metrics (number of winning/losing trades; average size of winners/losers; breakdowns by long and short trades; etc.)
First let's review terminology: A proprietary trading group is a group of traders that trades the capital of the firm. The firm puts up the trading capital and provides risk management, computer (IT) support, office space, and brokerage arrangements. A proprietary group typically generates its income from a split of trading profits, as well as by charging fees for overhead ("desk fees") and commissions. Meaning: “Most prop traders have little administrative, operational, or business management experience. They’ve had the institutional framework of a bank at their beck and call, as well as generous, but tightly controlled, access to capital.”
Also, the difference is that in proprietary trading it is the purpose of the business (you have an idea, you risk the firms capital on it), and also, prop desks often trade multiple products. Vs principal trading, where exposure is a primarily a byproduct of the business (you can't take the other side of a clients trades to earn a spread w/o having exposure - however temporarily) but is also an option for the business (trader liking the market and choosing to be net long his product) -- with this later part being very much like prop trading, except limited to the specific product expertise of the trader.
This is in contrast with a trading arcade, which office space, computer support, and brokerage, but does not provide trading capital. It is a group environment for trading your own money. An arcade often acts as broker and makes its money from fees and commissions, but--because the trader is trading his/her own capital--does not typically take a large share of trading profits.
The retail trader rather than trade sitting alone in an office or at home in their pajamas, a growing number are choosing to work in electronic trading “arcades” or “prop shops” (trading firms that pay them a salary and a slice of profits) offering computers, real-time news streams and the company of other traders, even if they are competitors.
Technically speaking, a proprietary trader's primary purpose (99%) is to seek profit potential for the firms account INDEPENDENTLY of the commission/spread based trading that defines the flow and main focus of principal traders (75+%). That is, their profits and positions are driven by the success of proprietary trade ideas/models and NOT by arbitrage and re-positioning around client driven trade execution.
Prime/Principal/Agency Trading: You simply execute orders for the client – you’re merely an “agent” doing what he/she wants and do not have (much) freedom.
Prop/Retail Trading: You are the principal and can make whatever trades you want, using your own money – within your trading mandate and risk limits.
This is is a very good link on Proprietary Trading and Retail Brokers, What Every Trader Should Know.
What is the Volcker Rule?
The so-called “Volcker Rule”, designed to curb risk-taking by US investment banks, has resulted in many firms scaling back their proprietary trading activities.
When pressed by US Congress to define proprietary trading, Paul Volcker, former chairman of the Federal Reserve, said that “every banker” he speaks with “knows very well what ‘proprietary trading’ means”.
Volcker, speaking before Congress in February, was reinforcing his calls to ban commercial banks from running proprietary trading operations and restrict them from owning or investing in hedge funds or private equity funds. His proposals form part of the Dodd-Frank Act - Cheat Sheet and Summary of the Dodd-Frank Wall Street Reformand Consumer Protection Act, Enacted into Law on July 21, 2010 that is working its way through Congress.
The proposals are vague, according to Thomas Pax, a partner and head of the US regulatory practice at law firm Clifford Chance. He said: “We haven’t heard how proprietary trading is actually going to be defined in the Volcker Rule. The definition of proprietary trading leaves an awful lot to be desired.”
It could be four years before the provisions come fully into play, according to Pax. But what is clear, he said, is that banks will not be allowed to invest more than 3% of their tier one capital in hedge funds or private equity funds. Some of the prop traders hitting the marketplace are being picked up by other firms: Kohlberg Kravis Roberts, the US buyout firm, hired nine members of Goldman’s US principal strategies team, led by Bob Howard. Many others are, like Flamand, setting up on their own.
Dodd-Frank in One Graph
Securities 56 Testing
A new regulatory exam is hanging over the heads of market makers, proprietary traders and floor brokers called the Series 56, also known as the Proprietary Trader Exam. The exam tests traders’ knowledge of the securities markets, trading and reporting practices, investment strategies and anti-fraud provisions as they pertain to the proprietary trading role.
Proprietary TradersQualification ExaminationContent Outline and Securities 56 - Cheat Sheet
Conclusion
“Trading” is a nebulous term. These are the extremes – no choice, and 100% choice. In between is a generic area termed flow trading where there’s some element of Prime/Principal/Agency trading but also some Prop/Retail trading involved.
