Calculation of the market risk capital charge

Proprietary trading

What is proprietary trading?

Trading is an important part of the financial markets and a good source of income for companies in the banking and financial services industries. Banks, brokerage houses, investment banks and financial institutions (hereinafter collectively referred to as banks) carry out trading transactions for their customers by executing their buy or sell orders through the platforms available at their end and also advise them on hedging strategies, arbitrage opportunities etc. and receive commission payments instead of the services they offer. In all of these cases the risk of enormous profit / loss lies with the customer as the organization is only acting on behalf of the customer. However, such services provide limited income to these institutions and encourage prop trading through their high-income banks. Now let's learn the concept of proprietary trading.

It refers to the trade in which banks (including banks, brokerage houses, investment banks and financial institutions) trade for their own account and invest their own capital for their direct profit / loss. Typically, such trading positions are taken in stocks, bonds, currencies, derivatives, etc. In short, the bank's trading desk uses the bank's equity, resulting in huge profits or losses for the bank. Since trading in props involves a lot of equity in the bank, it also carries a great risk. In the unlikely event that there is negative movement in trading positions (i.e., the stocks bought by the company lose value), companies face enormous losses that can destroy their capital and expose depositors' money to very high risk.

Why banks do their own trading

It's a high-risk, high-return offer for large banks. Because of the enormous capital available to these banks, sophisticated cutting edge technology, and excellent market intelligence, big banks tend to occupy a large position on their proprietary trading desks, increasing their profits and performing better for their shareholders and investors can produce large bonuses for staff. Most of the time, it has been observed that Trader's at Large banks insist on taking leveraged positions which will result in larger gains / losses for these institutions if such leveraged positions do not produce the desired result.

However, there are a few important points to consider in this context:

  • Trading positions that banks have taken for prop trading expose them to massive losses that can wipe out their regulatory capital and put public funds at risk.
  • The trading positions held by banks are subject to a market risk capital charge in accordance with the Basel standards and the bank must hold additional capital for this purpose.
  • Proprietary trading can bring huge profits to banks. It forces traders to take more risk as their bonuses are performance tied and add risk to a bank.

It is carried out by banks either as market makers or for purely speculative reasons (based on overriding information):

  • Market Maker: Under this umbrella, a large financial institution acts as a market maker (liquidity provider) for large corporations, helping to increase liquidity for a particular security / stock by encouraging the buying and selling of such a security. Large banks may buy / sell huge amounts of stocks of large companies and provide liquidity in the market, resulting in better pricing and higher liquidity of the stocks of such companies. However, since banks, as market makers, buy large quantities, banks will be rigid to enormous losses in the event of a decline in value, also due to losses when investing in such stocks.
  • Speculative business : Big banks take huge positions, either through derivative instruments or by buying direct stocks, bonds, etc. based on the analysis (fundamental and technical) and the superior information available to them.

Let's understand a few examples:

ABC Bank has its own sales counter, which carries out proprietary trading on behalf of the bank. The trading desk, based on thorough research and market intelligence, decided to buy a large amount, e.g. B. Rs 100 million from Insync International, an automotive company. In such a case, ABC Bank will invest a large sum of 1 billion rupees and if Insync International Scrip rises, it will generate a higher return. However, the loss amount will also be very high in the event that the price of Scrip drops in the event of a deterioration in the company's fundamentals or adverse policies for the company. By doing proprietary trading to make big profits, ABC Bank also increases the bank's risk.

Let's understand proprietary trading as a market maker using another example:

Chrome International is a proprietary trading firm that, acting as a market maker for various companies, plans to outsource a large amount of their companies' stocks. As one of the companies, L International appoints Chrome International as Market Makers who will assist them in outsourcing a large number of market shares. In this case, Chrome International takes over the other side (buy side) and buys all of the stocks unloaded from L International without any significant change in L International's scrap price. Chrome International later sells the purchased shares to other investors in small quantities at higher prices, thereby making a profit for Chrome International. As a market maker, Chrome International remains at risk of big losses if prices go unfavorably.

So we can see that prop trading is a high risk business run by big banks that use their own capital for big profits. However, such trading also carries risks for banks and leads to instabilities in the financial system. Since the banks basically use the money deposited by the public, the public money is at risk. Various countries around the world have restricted proprietary trading by banks. Of particular note is the Volcker Rule, which is part of the Dodd-Frank-Wall Street reform introduced after the 2007-2010 financial crisis. The regulation prohibits banks and affiliated companies from short-term proprietary trading in securities as well as the derivative strategy for these securities for their own account and restricts banks' participation in hedge funds and private equity up to a certain percentage.

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