What is Prop Trading?

Proprietary trading (“prop trading”) is where a company trades financial instruments on its own account and at its own risk rather than for clients. New forms of prop trading models are increasingly popping up, such as via online platforms as “trading challenges”, training and education programmes or profit-sharing schemes for external traders. In such prop trading models, companies often benefit from the fact that a large number of traders make trading decisions thereby generating trading data.  Often in so doing trading with real capital often doesn’t occur, or there is no actual proprietary trading.

What do you need to be aware of under supervisory law as an external trader?

Depending on the specific design of the business model, the follow investment services under the Securities Supervision Act 2018 (WAG 2018; Wertpapiersaufsichtsgesetz 2018) may come into consideration based on the specific design of the business model:

  • Investment advice
  • Individual portfolio management
  • Proprietary trading

Where trading is conducted solely using fictitious capital, the main consideration is whether the activities constitutes investment advice that requires a licence.

When may prop trading be considered as investment advice requiring a licence?

Investment advice is providing a personal recommendation to a client regarding transactions involving financial instruments. Prop trading is not a classical example of investment advice, but may constitute one in certain forms. In such cases, a personalised recommendation for buying or selling a financial instrument may be made where an (external) trader includes a notional representation of a financial instrument e.g. A derivative, in a notional portfolio within a simulated environment. In substantive terms, this may amount to a recommendation to buy or sell. In this case, it is not decisive that the notional financial instrument itself does not have a direct monetary value.

Investment advice requires a licence where it takes place with the intention of generating income and relates to financial instruments. Financial instruments consist in particular transferable securities, above all shares and bonds, money-market instruments, fund units, as well as different types of derivatives and emission allowance certificates.

Whether an activity that requires a licence actually occurs, depends on the specific circumstances of the respective business model. The key factors are:

  • whether trading takes place exclusively in a simulated environment,
  • whether trading decisions relate to financial instruments,
  • whether such decisions are used for commercial purposes,
  • whether a personal recommendation is made, and
  • whether the activity takes place with the intention of generation income.

Profit-sharing arrangements, covering of losses or repayment commitments may also be relevant under supervisory law for other licence obligations. It is therefore not possible to make a blanket assessment.

What risks exist for potential external traders?

Traders are frequently required to make payments themselves before they are able to receive payments form the prop trading company. Fees are charged for training, a verification phase or challenges. Participations should therefore check their opportunities and risks, their potential benefits as well as their legal protection, e.g. as a consumer.

A situation may in particular arise in the case of paid challenges, that is similar to the relationship between gamblers and a gaming house: One side frequently wins at the expense of the other side. The company exclusively sets the rules, and they are not necessarily balanced. In this context, it is possible to speak of there being a structural advantage for the company. The decisive factor is whether traders pay more in fees or stakes than they may realistically expect to get back from potentially profits from trading. As the company defines the rules of the game, it at least has the possibility to steer this relationship.

The enquiries received by the FMA show an increased risk to exist that market participants do not have a full understanding of the economic and legal consequences of their participation in such prop trading models:

  • The offering on the same platform is often interpreted in differently. This may be due to a misleading presentation of the offering, a lack of transparency regarding the issue of whether real trading activities are conducted or only a simulation, as well as contractual conditions being complex or difficult to understand. Traders who sustained losses, report of exaggerated spreads compared with real brokers. Such spreads may lead to a position starting significantly in negative territory and with trading deviating strongly from realistic market conditions.

Example:

  • Market spread: 0.8 pips
  • Prop firm’s spread: 2.5 pips

If a position opens at 1.0000 it may only be sold immediately at 0.9975. This means that the position starts with a loss even though there has not been any movement in the market. It is often not clear for traders where the platform obtains its prices and spreads, and whether they are represented correctly.

  • Many prop trading platforms advertising offering eye-catching discounts, sometimes discounted by up to 90 per cent. This is intended to lure traders with a professional and check trading environment, without requiring them to stake their own capital. In practice, however, many platforms focus on pressure to perform, gamification and the prospect of being able to become a real trader for the company in the future. This motivates traders to repeatedly take part in challenges, and to pay fees for the privilege of doing so.
  • The business model often primarily is sustained by the fees that many traders pay for challenges, and not from realistic trading. Even if they advertise that traders do not bear any trading risk, many of these platforms can be a money pit.

Most prop trading platforms are currently not subject to any official supervision, and are therefore not required to meet the strict requirements that apply for regulated financial services providers.

Summary:

Whether an FMA licence is required for a prop trading business model depends on the model’s specific design.

Even in the case of trading taking place exclusively in a simulated environment and with fictitious capital, investment advice requiring a licence may still exist.

Both the providers and participants in such business models should therefore not only carefully weigh up the economic risks, but also their classification under supervisory law.