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Proprietary trading

August 22, 2012

By Robert A. Green, CPA

Note: This is an excerpt from "Proprietary trading basics" which appears in the October issue of Active Trader magazine, on newsstands at the beginning of September. The material also appears in Green’s 2012 Trader Tax Guide. The full article has all the tax information a proprietary trader needs as well.

Proprietary traders are significantly different from retail traders and have special legal, regulatory, business, and tax compliance needs.

Proprietary traders don’t trade their own capital. They trade the firm’s capital, usually accessed from a sub-trading account within the firm. A prop trader becomes associated with a prop trading firm either as an LLC member (Schedule K-1) — the preferred method by regulators — an independent contractor (1099-Misc), or an employee (W-2).

If you fall in the prop trader category, here’s what you need to know.

Behind prop trading
The Dodd-Frank Financial Regulation law enacted in July 2010 includes the controversial Volcker Rule, which went into effect in July 2012. The Volcker Rule forces commercial banks to close their prop trading desks and exit almost all of their internal alternative hedge fund investments by July 2014, as many of the rules are not yet written.

But working for a big bank as a trader is very different than working at a prop trading firm. These businesses are formed by entrepreneurs to recruit armies of traders. The recruits pay the entrepreneurs for education, software, desk charges, and other services. (In some cases, brokerages pay prop firms a rebate on their traders’ commissions, which sometimes isn’t appropriately disclosed.)

The entrepreneurs hold out the carrot of access to a large stockpile of their own cash to trade, yet many also demand prop traders maintain material deposits of their own money within the firm, which is tapped to cover the traders’ losses. In effect, these traders are trading their own risk capital and they have leverage of 10:1 or more than 100:1 rather than being pinned down by the strict Regulation T (2:1) margin rules for retail traders.

There is a lingering charge by some in the industry over the past decade that prop trading firms are really disguised customer (retail) accounts offering illegal leverage from unregistered broker-dealers. FINRA’s Regulatory Notice 10-18 implies that some prop trading firms have this problem and the regulators are trying to force brokerage firms to stop this practice for their prop trading firm clients. The notice tells clearing firms how to spot this type of inappropriate behavior: Look for prop trading firms with sub-trading accounts for traders where the firm pays the trader more than 80 percent of trading gains. Some prop trading firms pay close to 100 percent and it’s clearly an issue. Other telltale signs are trader deposits and commission rebates.

This story has lingered for some time, but the regulators have not yet pounced on it in the way many assumed they might. Dodd-Frank reins in prop trading in banks, but FINRA allows this type of activity to continue without much restriction.

Ironically, pattern day trader (PDT) rules are having a perverse effect. Retail securities traders can day trade only if they have $25,000 on deposit with their broker, and they’re limited to 4:1 intraday leverage. As mentioned, the leverage offered in a prop trading firm is far higher. Retail securities traders with less than $25,000 on deposit can’t day trade at all under these PDT rules, plus their leverage is limited to 2:1. When regulators reined in securities day traders with these rules, they buttressed the growth of the prop trading firm industry: Undercapitalized traders who want to stick with securities are attracted by the leverage in prop trading firms. Many allow new recruits to put up deposits of $2,000 or $5,000.

Proceed with caution
Many smaller prop trading firms aren’t always complying with regulation. The firms that are more compliant are set up as non-customer account broker-dealers, some on the Chicago Stock Exchange (CSX). As broker-dealers, they’re subject to regulatory oversight. CSX broker-dealers don’t require prop traders to have a brokerage license, but customer-account broker-dealers do.

Some broker-dealer prop-trading firms want a deposit of $25,000 or more to be in line with the pattern day trading rules. CSX firms argue they can take a lower deposit, or none at all.

Many prop trading firms are not broker-dealers, but they associate with broker-dealers. Regulators refer to these firms as “sub-LLCs.” These firms may skirt regulation. But FINRA published Notice 10-18 precisely to flush out these sub-LLCs. If you trade with one such firm, be very careful with your money. Keep taking profit distributions and don’t risk too much ­— or consider other options. Why trade with a sub-LLC that uses a business model that may not pass muster with regulators?

For more information, see our Proprietary Traders Website section.

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