Market Overview

Will New Regulations Destroy the Prop Trading Industry?

Are prop traders in trouble? As many traders may remember, proprietary trading used to be a very profitable venture for investment banks and other Wall Street institutions. Nowadays, many proprietary trading operations are being run by independent traders, often working remotely from their own homes. Given Dodd-Frank and other legislations requiring $25K margin requirements and Series 7, 56, and 63 licenses, will the field of finance ever be the same?

Over the last several years, the proprietary trading landscape has changed rapidly, forever affecting employees on the Street as well as retail investors. After several Wall Street banks nearly destroyed their shareholders' capital, the US Federal Government took action and signed into law various regulations, limiting proprietary trading to a select few institutions.

Much of these regulations have cramped pattern day traders and other professional trading outfits. While traders were able to join firms in the past without Series Exam certification or significant start-up capital, they are unable to do so today. Although day traders are looking for the best avenues to be profitable, will the future manage to be as positive as the past?.

How Have Prop Traders Grown the Last Few Years?

While some firms tried to leverage their expertise in a disingenuous fashion during the 1980s and early 1990s, many maintained high ethical standards. Up until the 2008 housing crash, Wall Street firms limited insider trading and stock manipulation. To retain lucrative trading revenues, however, securities dealers relied on two things: leverage and exotic products. Over the last decade, Credit Default Swaps and Collateralized Debt Obligations transformed modern financial markets. Both products started trading in an illiquid fashion, but rapidly grew to trillion dollar markets.

The highly profitable trading operations were being realized by investment banks as well as independent brokerage houses and securities firms, and traders had to find another way to maximize profits for their firms as well as themselves. With massive movements to deregulate certain markets, including but not limited to commodity futures, foreign exchange, and fixed income, traders suddenly were able to lever their usual trades 10 to 50 times.

Where did Prop Traders Screw Up?

Leverage not only provided traders with amplified profits, but also with amplified losses. Tiny movements in the markets could quickly amount to millions of dollars in losses for any given position. Certain institutions also placed themselves at risk by significantly exposing themselves to limited markets; for example, Lehman Brothers and Bear Stearns both operated with high levels of leverage and high exposure to the retail housing market.

Since the housing market downfall in 2008, the United States Federal Government has attempted to reign in financial institutions by tightening regulation around many of their activities. One of the prime targets for the government has lied in proprietary trading; traders can see the material effects within the groundbreaking Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in 2010. Within the Dodd-Frank Act, the Volcker Rule prevents institutions from making speculative trades that do not directly and obviously add value to shareholders and customers.

The Future of Prop Trading

While large institutions will be able to adapt quickly to future regulations, independent traders who have worked with smaller proprietary trading operations will have to cope with new restrictions. In the past, day traders had to have a minimum of $25,000 in equity capital to successfully day trade. Many smaller prop firms would pool money together in order meet these requirements, and would even offer substantial leverage to traders who desired increased profits and independence.

One of the primary regulations, effective in 2011, is that pattern day traders have to achieve Series 56 Certification. The Series 56 exam is targeted to proprietary trading, and will also thin out the day trading competition. Many brokerages have also restricted the amount of leverage for traders. While 100:1 may have been common a few years ago, many traders are currently only able to lever themselves 40:1 or even 20:1. These two restrictions have disbanded many proprietary trading platforms and have left many independent traders to operate without any assistance.

In today's markets, independent traders have to find ways to maximize their operations in the easiest way possible. Whether this means that they need to find the rare broker willing to provide 100:1 leverage or a broker who has alleviated trading commissions and other fees, traders everywhere are scrambling to find the most accommodating brokerage house.

Ultimately, proprietary trading will become a very niche industry, only attracting those who have a true passion for the financial markets and are willing to take significant risks in order to support their livelihoods. Traders will have to become licensed in order to pursue their goals, and will also have to find the easiest source of capital to maximize profits. The government and regulating bodies may very well pass further legislation that makes the proprietary trading landscape tougher to traverse, but there will always be some solutions that let traders be at ease and breathe a sigh of relief.

Follow me on Twitter at @MakinMarkets

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