Proprietary Trading Desk Setup: A Step by Step Guide

Author: Chainika Thakar

Establishing a proprietary trading desk is a complex yet rewarding endeavour. It offers significant benefits such as generating returns that are not required to be divided. This guide will walk you through the essential steps and considerations for setting up your own proprietary trading desk, ensuring you have a solid foundation for success.

From understanding the educational prerequisites and importance of internships to navigating the regulatory landscape and building a robust technology infrastructure, each step is crucial for the seamless operation of your trading desk.

We will delve into the critical aspects of financial management, strategy development, risk management, and compliance, providing practical tips and insights to help you avoid common pitfalls. By following this comprehensive guide, you will be well-equipped to launch and manage a proprietary trading desk that can capitalise on market opportunities while mitigating risks. Whether you are a seasoned trader or new to the industry, this guide will provide valuable knowledge to help you succeed in the competitive world of proprietary trading.

This blog covers:

• What do you mean by a Proprietary Trading firm?
• What are the benefits of being a Proprietary Trader?
• Prerequisites to setting up a Proprietary Trading Desk
  • Educational requirements
  • Internship
• Steps for setting up a Proprietary Trading Desk
  • Step 1 - Registration
  • Step 2 - Market access
  • Step 3 - Arrange the capital
  • Step 4 - Get the essentials
  • Step 5 - Regulation and compliance
  • Step 6 - Risk management
  • Step 7 - Begin trading
• Common mistakes made while setting up the Proprietary Trading Desk
• Tips while setting up your trading desk
• Frequently asked questions while setting up the Proprietary Trading Desk

What do you mean by a Proprietary Trading firm?

A Proprietary Trading (or prop trading) firm is a financial institution that invests directly in the financial markets with its own capital, rather than on behalf of clients. The main goal of a prop trading firm is to generate profits from its trading activities. Here are some key points about prop trading firms:

1. Returns Generation: The primary objective is to generate returns for the firm. Traders at proprietary trading firms use various strategies, including market making, arbitrage, and statistical analysis, to identify and exploit market opportunities.
2. Risk Management: Since they trade with their own money, prop trading firms have a strong focus on risk management. They employ sophisticated risk models and controls to manage and mitigate potential losses.
3. Technology and Data: Proprietary trading firms often rely heavily on advanced technology and quantitative models. They invest in algorithms, and data analytics to gain a competitive edge in the markets.
4. Compensation: Traders at proprietary trading firms are typically compensated based on their performance. They might receive a base salary along with a significant portion of the returns they generate.
5. Regulatory Environment: Proprietary trading is subject to regulatory scrutiny. Different jurisdictions have different rules and regulations governing the activities of proprietary trading firms.

Examples of well-known proprietary trading firms include Jane Street, Tower Research Capital, and DRW Trading. These firms are known for their rigorous hiring processes, often seeking candidates with strong quantitative and technical skills.

The video below covers the introduction of proprietary trading in less than 1 minute.

Before learning the setting up process of a proprietary trading desk, let us now see the benefits of being a proprietary trader next.

What are the benefits of being a Proprietary Trader?

Most of the investment banks have their own proprietary trading desks and so do many firms, financial institutions, banks, etc. Proprietary trading firms benefit in the following ways:

• 100% returns come to the proprietary trader
• A Proprietary trading firm can stock an inventory of securities for future
• Market making is possible

100% returns come to the proprietary trader

The main advantage of proprietary trading is that proprietary trading allows an institution to realise 100% of the returns earned from an investment, hence in the balance sheet of the company they are represented under investments.

On the other hand, when financial institutions trade on behalf of clients, they earn revenue in the form of fees and commissions, which is generally a small percentage of the total amount invested or the gains generated. These earnings (from trading on clients’ behalf) are shown in the income statements of the company under commissions earned.

A Proprietary trading firm can stock an inventory of securities for future

Stocking the inventory of securities for the future is another huge advantage of proprietary trading. Since the proprietary traders use their own fund’s capital, they can stock the securities for their speculative activities or market-making functions. They might hold securities with the expectation of future price appreciation or to hedge other positions.

Market making is possible

A proprietary trading firm provides liquidity to the market since it buys the securities and sells across the various financial markets at a future date.

For a proprietary trading firm, the returns in market-making come from the bid-ask spread, which is the difference between the price at which they buy (bid) and the price at which they sell (ask). By managing these spreads and holding an inventory of securities, the firm can get returns while also ensuring there is sufficient liquidity in the market. Thus, market-making can be a key strategy for proprietary trading firms.

We have a video below that discusses market-making strategies briefly to widen your knowledge.

As we have now discussed the basics of proprietary trading firms, let us examine the essentials and prerequisites for setting up the proprietary trading desk. These essentials will set you up for a successful journey ahead.

Prerequisites to setting up a Proprietary Trading Desk

The main prerequisites for setting up the proprietary trading desk are educational requirements and an internship to gather experience. Let us see both in detail below.

Educational requirements

To set up a proprietary trading firm, you need the knowledge in:

• Finance/Economics: Since proprietary trading firms are nothing but financial markets’ trading firms and hence, education or sound knowledge in finance/economics is essential.
• Mathematics: The concepts of mathematics help to use statistical tools for historical market data analysis in trading. Historical market data analysis is quite imperative for predicting the market and for deciding the entry and exit positions.
• Business knowledge: The business know-how is also essential for proprietary trading since at the end of the day it is a business of trading in the financial markets.
• Computer Science: Programming knowledge (such as Python) is required for algorithm development for automated trading.
• Physics: Problem-solving skills and quantitative analysis can be learned with the help of Physics-related degrees.

Both undergraduate and advanced degrees in the above-mentioned subjects are beneficial but, having an undergraduate degree can also help you gather the required knowledge for setting up the proprietary trading desk.

Having said that, an advanced degree will surely help with deeper knowledge but don't worry if you don't have one. You can select a course from the range of specialisation courses to get ahead.

Internship

Having knowledge or education in financial trading-related subjects is a great first step towards becoming a successful proprietary trader but that is not enough. Theoretical knowledge does not provide the necessary practical knowledge.

When you step into the financial market and begin trading, you get to know the actual challenges and finding the solutions with the right trading strategy is what makes you better.

Hence, becoming an intern with a trading firm can lead to drastic knowledge enhancement about historical market data analysis, strategy creation, backtesting and live execution of trading strategies.

For both a student and a non-student beginner in the trading domain, learning algorithmic trading is optional. However, the world has almost completely shifted to algorithmic trading including Wall Street. ⁽¹⁾

Going forward, after gaining the prerequisites, you can move to setting up the proprietary trading desk. Next, we will discuss the steps required to set up a proprietary trading desk.

Steps for setting up a Proprietary Trading Desk

Below you can see the steps for setting up the proprietary trading desk.

Step 1 - Registration

Once you are ready to begin setting up your proprietary desk, the first step is to register your firm/entity as a company or Limited Liability Company (LLC), Limited Liability Partnership (LLP), a partnership and even as an individual or proprietor. You will be required to adhere to formalities when registering the firm/entity.

Step 2 - Market access

Market access is nothing but finding your way to the financial markets in order to fetch market data (including historical market data for data analysis) as well as to send orders and execute trades. In simple words, you need market access to enter and exit the market to take favourable positions.

Suggested reads:

1. NYSE Proprietary market data
2. NYSE data products
3. NSE data usage and sharing policy
4. Direct Market Access (DMA)

Step 3 - Arrange the capital

Since proprietary trading implies trading with your own money instead of with the raised money, you need to arrange the required capital for trading. It is as simple and as challenging as that!

Since you can not raise the capital unlike hedge funds, you will have to dig into your own pocket.

Step 4 - Get the essentials

Okay, now that you have the capital arranged, you will need to also invest in getting all the necessary equipment, knowledge (through courses, blogs, etc.), infrastructure etc. for your proprietary trading firm.

In the case of manual trading, you mainly need a monitor for regular monitoring of markets. Whereas, for setting up an algorithmic trading desk, apart from a sound knowledge of algorithmic trading, you will need infrastructure, platform, risk management practice, backtesting etc.

Step 5 - Regulation and compliance

Coming to regulation and compliance, it varies across geographies and trading destinations. Some of the exchanges need the trading system to pass through the conformance process, while some may need every automated strategy to be empanelled or approved. In India, the Securities and Exchange Board of India (SEBI) regulates the securities market, including activities related to proprietary trading by firms. In the U.S.A., it is the Securities and Exchange Commission (SEC).

If your firm is a member of the exchange, you would also need to comply with various statutory guidelines along with various mandatory audits as your respective regulator and/or the exchanges may prescribe.

Step 6 - Risk management

Risk management is the identification, assessment, and mitigation of risks. This will be followed by a coordinated and economical application of resources to minimise the impact of unfortunate events or to maximise the realisation of opportunities. A risk management system (RMS) is installed within an algorithmic trading platform to manage and mitigate the risks of data access, consistency and quality of data, network protocols, and scalability factors.

Step 7 - Begin trading

Yes, now you can begin trading using your very own Proprietary Trading Desk. All the best!

But before ending this blog, let us take a quick look at some common mistakes that are made while setting up the proprietary trading desk.

Common mistakes made while setting up the Proprietary Trading Desk

Below we will discuss the commonly made mistakes to avoid while setting up the proprietary trading desk.

Let us discuss the tips as well that can come in handy while setting up the trading desk ensuring a smooth and successful launch.

Tips while setting up your trading desk

Here are some tips that can help you.

Below we have some frequently asked questions which traders usually look for answers to while setting up the proprietary trading desk.

Frequently asked questions while setting up the Proprietary Trading Desk

Q: What are the essential tools and technologies needed for proprietary trading?

A: Essential tools include a reliable trading platform, real-time and historical market data feeds, risk management systems, and advanced analytical tools. Investing in cybersecurity measures is also crucial.

Q: How can I stay updated with market trends and changes?

A: Stay updated by conducting thorough market research, following financial news, attending industry conferences and workshops, and continuously learning through professional development opportunities.

Q: What are the regulatory and compliance requirements for proprietary trading?

A: Regulatory requirements vary by jurisdiction and trading destination. Ensure compliance with relevant regulations, obtain necessary licenses, and adhere to statutory guidelines and mandatory audits.

Q: How important is risk management in proprietary trading?

A: Risk management is crucial to protect capital and manage potential losses. Implementing robust risk management practices, setting strict risk limits, and regularly reviewing risk management policies are essential for a successful trading desk.

Conclusion

Setting up a proprietary trading desk involves a complex and detailed process that requires careful planning and execution. By following a structured approach, you can ensure a smooth and successful launch of your trading desk. Start with sufficient capital and a clear financial plan to manage expenses and trading losses.

Develop a well-defined and tested trading strategy, and implement robust risk management practices to protect your capital. Invest in reliable technology infrastructure, comply with regulatory requirements, and hire a skilled team to drive your trading operations. Stay updated with market trends, conduct thorough research, and maintain detailed documentation of your trading activities.

Lastly, foster a culture of continuous learning and improvement to adapt to market changes and enhance your trading strategies. By adhering to these tips and avoiding common mistakes, you can set up a successful proprietary trading desk and achieve your trading goals.

Next step

Now you can work towards building your knowledge base by choosing courses that will help you get started with Algorithmic Trading, and then proceed to develop and evolve yourself to gain an edge in your trading.

Note: The original post has been revamped on 2^nd September 2024 for recentness, and accuracy.

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