Proprietary trading refers to when a financial firm uses its own money to invest for its own gain rather than trading on behalf of their clients. Also known as prop trading, it occurs when a company decides to profit from trading in the market instead of depending on commissions earned in processing client transactions.
Investment banks and other financial institutions usually engage in proprietary trading, as they believe they have the tools and knowledge of the market to gain a competitive advantage.
Prop trading offers financial companies several benefits. First is an increase in profits. Investment banks or brokerage firms trading on behalf of their clients earn revenues from their trades in the form of commission. These are usually small percentages of the transactions. Prop trading allows firms to benefit 100% from their own investments.
Second, prop trading allows institutions to stockpile security inventories. This enables firms to easily offer clients stocks in speculative inventory when appropriate, while buffering the institutions against illiquid markets.
Third, prop trading empowers financial institutions to become influential players in the market through providing liquidity on securities.