What is prop trading? Why has it been so fashionable in the retail scene in recent years?
Prop trading is the essence of trading, and was the first real form of trading in financial instruments ever to exist, right after trading in derivatives to hedge commodity risk.
We often hear of prop trading and companies offering positions in this role. What is it? And what recent history has this figure of trading who is one of the most specialized and varied ever?
Prop trading, some examples
Prop trading, better specified as "proprietary trading", is that branch of trading that mainly deals with pure speculation. There is no market making or sales activity, but it is the trading activity as it is known. In fact, the retail trader behaves like a proprietary trader of a large bank, except that he has capital and clearly more limited responsibilities.
Until 2008, before the Lehman crisis, the figure of the prop trader was easily comparable to the top player in football or basketball: a prop trader of a bank was literally a superstar of finance, disputed by various banks and other institutions such as hedge funds, paid several million dollars and famous around the city of London (the main trading hub at European and world level).
Among the famous prop traders, we have the Australian Greg Coffey, former trader for a large investment fund and former trader for an Australian bank, known in the city of London with the nickname “The Wizard of Oz”. for his uncommon skill in juggling trading. This fame put so much pressure on him that it forced him to retire for several years, before returning recently to the world of finance as a manager of a hedge fund of his own.
Another example of a famous prop trader is Anton Kreil, who since a very young age has occupied the desks of large investment banks such as Goldman Sachs, also retired from trading to take a few sabbaticals traveling the world, all before the threshold of 30 years.
Surely, within the panorama of trading and finance in general, we cannot deny that the prop trader is one of the most sought after and most magnetic figures in the panorama.
Prop trading, before and after 2008
2008 was a crucial year for the figure of the prop trader, but first we still have to specify what was done in the big banks before the subprime crisis.
In all the large investment banks, the most well-known ones at least, there was a prop trading desk, that is a room where specialized figures in speculation (maximum 10 people), had a part of balance sheet of the credit institution available to them to trade in full autonomy, both in terms of risk management and instruments.
The pay of these prop traders consisted of a hefty fixed fee, plus the share of performance bonuses, which usually ran into several million dollars annually.
After 2008, with the liquidity crisis and with the balance sheets destroyed, these top traders found themselves without any competitive compensation and bonuses. While some of them jumped along with the performance of the bank they worked for, some decided to get out of the loop of banks and open their prop trading companies, or go to work for family office or investment funds.
2008 marked a fundamental break. Aided by this migration of prop traders from banks to other institutions, it was the closer supervision of banks’ balance sheets and capital requirements to be defined as reliable banks. A bank that allocates a share of its capital to pure speculation is not seen as reliable, or at least it could be considered unstable, albeit efficient.
In essence, the flood of prop trading companies has meant that this job is now on everyone’s lips, so much so that many companies now offer paths to become a prop trader. Prop traders therefore have a very similar approach to that of the retail trader, but there are substantial differences between the two roles.
Prop trading vs retail trading
The prop trader usually works for a prop trading company or an investment fund/family office: this is the first big difference between prop and retail trader. Basically the prop trader, as was done in the bank, uses the company’s resources, ie the capital and the hardware and software infrastructure, to generate profit that is usually "split" between the company and the trader. The operation is therefore very similar to that of banking prop trading.
Some companies negotiate the trading conditions with the trader, i.e. they can offer the infrastructure for free, but ask the trader for a greater split (thus decreasing his percentage share of earnings). Or they can offer the operating desk at a fixed price and give a higher percentage to the trader.
Usually, the more reliable the trader is, the more this percentage grows over time. Also, another difference is the structure: in prop trading companies, software and hardware are used that are hardly used by retail traders. For example Colt connections, connections that never fall, or analysis software, data providers and hardware whose cost is difficult to bear for a trader.
In addition, the capital for the trader is provided by the company and the trader has the sole task of making this capital yield. It is not uncommon to see very good prop traders migrate to family offices or investment funds to operate with greater market power and with better performance conditions. Sometimes, prop trading companies manage to supply traders for investment funds and management companies thus creating a talent market as was the case before 2008.
In a nutshell, the retail trader is very similar to the prop trader but, as we have seen, there are differences that could be substantial. Basically, a retail trader, with good track record and good management, could easily work for such a company and increase their earnings consistently.
Let it be clear that it is not necessary to be a prop trader to work in an investment fund, just a good track record of one’s operations and the demonstration by third parties of the goodness of one’s work. The beauty of the trader’s job is precisely this: the extreme degree of meritocracy, where the best emerges and where no “recommendations” of any kind are needed.
