Should Proprietary Trading Firms Be Regulated?

In what can only be described as an uncertain period for online traders recently, regulators now have proprietary trading, or prop trading, on their radar. Prop trading involves a firm using its own capital to trade in order to strengthen its own balance sheet. 

While formalized prop trading dates back to the 1980s, the market has evolved over the years from brick-and-mortar settings to online opportunities for novice and sophisticated traders alike. Today, it's a multi-billion dollar market with a compound annual growth rate (CAGR) of 4.2% attached for 2018-2021.

Prop traders play an important role in the grand scheme, lending liquidity, efficiency and price stability to markets so that they can run more smoothly than they otherwise would. Whether or not they're seen, prop traders pave the way for other traders to execute trades more seamlessly. 

The regulation around prop trading is somewhat murky. The important thing to note is that prop traders aren't trading their clients' capital. Instead, they're trading the capital of the institution that's funding or employing them with the goal of making money for the firm, whether it's a hedge fund, investment bank or some other financial institution. 

Prop traders have a history of making risky bets with high amounts of leverage using the firm's money. However, after the 2008 financial crisis, U.S. regulators took notice, introducing policies like the Dodd-Frank Act and the Volcker Rule, which took aim at banks, including their prop trading activities. The rise of independent prop trading firms began, as these weren't subject to the same narrow guardrails as their larger institutional peers.  

Most recently, regulators are reportedly taking a deeper interest in the prop trading industry as trader-funded firms grow in popularity, capital and influence. The industry was also thrust into the spotlight in 2023 after the Commodity Futures Trading Commission (CFTC) and Canadian regulators charged My Forex Funds with fraud. 

According to Finance Magnates, the European Securities and Markets Authority (ESMA) – a pan-European supranational regulator – has now taken the baton, examining prop trading firms and speaking with stakeholders to ascertain what greater oversight of this industry might resemble. These conversations are reportedly occurring both in Europe and in the United States. Not surprisingly, industry participants are abuzz, envisioning a future with more rules. 

Prop trading regulation varies depending on the jurisdiction, but for the most part, companies are required to abide by consumer and data protection laws, as well as other financial and trading regulations. 

For example, funded traders act with the prop trading firm's capital, not their own, and consequently, they fall under the bucket of remote workers. Therefore, the prop trading firm must assign them accordingly, whether it's as an independent contractor or employee. Plus, prop-trading firms must comply with any anti-money laundering (AML) requirements in their respective jurisdictions, considering trader payouts involve third-party providers. Additionally, prop trading firms may also be required to adhere to know-your-customer (KYC) regulations to ensure a trader is who they say they are. 

In Singapore, the activity does not fall under the Singapore Securities and Futures Act 2001. However, independent trader-funded firms like PipFarm willingly follow various regulations designed to protect consumers, such as the Singapore Consumer Protection (Fair Trading) Act 2003. 

Prop Trading Regulation Pros 

In any industry, nefarious actors have a way of ruining the bunch. This is prolific in financial markets, and prop trading is no exception. In this sense, the introduction of tighter regulation would be a welcome development, as it would help to remove bad or unfit actors who give the industry a bad rap. 

Narrower regulatory guardrails could also provide a more accelerated path to dispute resolution between traders and platforms, offering both sides clear and fair steps to avoid further escalation, including arbitrarily disqualifying traders amid the tacking on of additional fees.

If prop-trading firms are required to obtain certain licensing to support prop trading, it would introduce greater transparency for stakeholders, including traders. 

Also, it could trigger changes in the treatment of capital. For example, regulation could enable investors to direct capital into prop trading firms, a paradigm shift from the current model in which firms are generally self-funded. Additionally, rules might limit the ways in which prop firms are allowed to use available capital in an attempt to quash any unscrupulous behavior by firms. 

For example, capital requirements might dictate that prop firms earmark a certain amount of outside investment capital to pay traders, including a fee model in which a specific percentage of revenue or dollar amount is directed toward each trader or something along those lines. 

Prop Trading Regulation Cons

When regulators don't understand complex sectors like prop trading, they sometimes run the risk of swinging too far and doing more harm than good. Additionally, many prop trading firms are independent in nature and, therefore, don't have the backing of a bank's balance sheet to support them. Any severe regulatory requirements could cause undue harm to these firms by placing unrealistic expectations on them surrounding the implementation of risk management measures. 

There could be varying degrees of fallout, not least resulting in less available capital for trader-funded firms to share with traders. Additionally, high licensing and registration fees could trigger a chain reaction, causing a bottleneck in capital as well as diminished control over capital. 

In a worst-case scenario, excessive oversight would create a financial strain that could cause some law-abiding employers to shutter their operations. Or, one potential unintended consequence could be the prop trading firms would relocate offshore where they wouldn't be subject to the same harsh regulation. It's not as though there isn't a precedent for it, most notably in the contracts for difference (CFD) trading industry.  

In recent years, EU, UK and Australian regulators attached onerous leverage caps on CFDs. Rather than sacrifice profits, industry brokers responded by relocating their businesses offshore or setting up shop in more regulatory friendly jurisdictions. 

PipFarm Offers Traders A More Secure Way To Trade

PipFarm has a platform that seeks to usher in the next generation of forex traders with its battle-tested cTrader platform, known for its stability and user friendliness for traders at all levels. 

Not only does PipFarm offer qualifying traders an opportunity for funded trader programs, but it does so in a way that makes traders feel secure. By taking a proactive approach to risk management and sustainability, PipFarm is clearly in this market for the long haul. Traders who are interested in aligning themselves with a firm that prioritizes the trader experience might want to consider making their trading ambitions a reality with PipFarm. 

Featured photo by herbinisaac on Pixabay. 

This post contains sponsored content. This content is for informational purposes only and is not intended to be investing advice.