Should brokers launch a proprietary trading wing?

Proprietary trading has ignited a considerable debate among brokerage firms, particularly as some consider launching their own prop trading wings. This move, often characterized by attracting traders through funded programs could represent a significant shift in strategy for traditional brokerage firms.

The debate hinges on the balance between seizing new opportunities for growth and navigating the potential risks associated with compliance, reputation, and risk management.

Opportunities for brokers

Prop trading offers brokers a chance to tap into a new demographic of traders — younger, motivated individuals looking at trading as a career rather than just an investment opportunity. Anton Sokolov from Brokeree Solutions emphasizes that prop trading or trader funding firms (TFFs) present a product better suited for those without significant capital to invest upfront, suggesting a clear, interactive path into trading. This aligns with the evolving demographic interests and the global economic context that favors lower average deposit values.

Furthermore, the prop trading model can help brokers expand their client base and diversify their revenue streams. Evgeny Sorokin from Devexperts points out that prop trading opens up new audiences previously unreachable, thanks to the lack of regulation around aggressive marketing for contests and simulated trading. This opportunity for growth comes with the added benefit of potentially increasing the overall size of the market for the industry.

A recent report by Acuiti found that 2024 is set to witness a significant uptick in investment budgets in prop trading, with 63% of the surveyed prop firms planning higher-than-average investments and a substantial increase in exposure, especially in FX and equity options.

Risks and challenges

The move towards prop trading is not without its challenges. Compliance issues loom large, with regulators potentially viewing prop trading unfavorably under new frameworks, as highlighted by Sorokin. The risk of regulatory crackdowns could lead to significant operational and financial losses for brokers venturing into this space.

Reputational risks are also a concern. Andrew Saks from TraderEvolution Global warns of the “death by association” risk, where the actions of a few bad actors in the prop trading space could tarnish the broader industry’s reputation. This concern is echoed by Sorokin, who notes the potential for negative stigma stemming from disillusioned traders and the history of bad actors in similar markets.

Risk management poses another critical challenge. Elina Pedersen from Your Bourse and Natalia Zakharova from FXOpen both emphasize the need for robust risk management practices and the development of proprietary trading strategies and infrastructure. This is essential to navigate the complex market dynamics and avoid significant financial losses.

The invaluable insights shared by the thought leaders mentioned above provide a deep dive into the dynamics of brokerage firms considering the launch of proprietary trading wings. Given the depth and breadth of their expertise, spanning regulatory considerations, market opportunities, risk management strategies, and the evolving landscape of trader demographics, their full perspectives deserve thorough attention.

Here, we present their complete insights. Each expert brings a unique viewpoint, grounded in extensive experience and strategic foresight, making their contributions essential reading for anyone interested in the future of brokerage and prop trading.

Evgeny Sorokin, Devexperts

“An attractive window of opportunity has opened up in the prop trading space — particularly for retail brokers.

The lack of regulation around aggressive marketing for contests and simulated trading means brokers can tap into new audiences that weren’t reachable before. Trading competitions flatter the intellectual gamblers, those who consider themselves to be the elites of the trading world. These individuals pride themselves on their extensive market knowledge, viewing themselves as the experts.

In many ways, traders who participate in evaluations and contests are similar to the traders who are engaged with retail forex. Brokers are very much accustomed to serving this clientele.

Funded programmes grow the overall size of the pie for the industry. Some of the contestants will stay in trading even if the prop saga ends.

The firms that are used to adapting to maintain a competitive edge will be able to take advantage easily by offering a slightly different product. Only a gentle adjustment rather than a loud change would be required.

The perfect scenario for brokers, right?

However, firms will need to tread carefully and weigh up several risks.

Let’s start with the obvious: compliance. If the regulator deems props unfit under the new framework, the firms could be outlawed overnight. Brokers looking to invest in the creation of a prop trading wing will need to consider how they feel about this Sword of Damocles.

On the other hand, if the broker is experienced, they have a mature operational structure with reliable marketing, sales, compliance, dealing, and other functions. They have mastered trading platforms, CRMs, MIS, BI, and back-office software. They have a web of PSPs, LPs, etc.

In this case, launching a retail prop is an exercise with a working weight. So shutting it down shouldn’t hurt too much, as the firm is back to their core brokerage business.

The investment in this product would still be written off though, and the loss could be significant.

On the other hand, prop trading firms come in so many shapes and sizes: market signals, competitions, etc. As long as trading on demo accounts is permitted, it’s really hard to define what the prop trading business is, and therefore, hard to ban it.

Regulatory bodies will be implementing new controls, and props will be encumbered with processes and reports. This will inevitably lead to breaches, with corresponding penalties. Brokers need to decide if they want to open themselves up to this scrutiny.

Prop trading is currently shrouded in marketing that sometimes pushes alluring golden ticket-style campaigns, attracting a certain type of customer, and thus creating a certain type of stigma.

In the same way that a gambler with poor strategies or irrational expectations tends to be vocal towards the house when they lose, calling ‘‘scam’’ from the rooftops; inexperienced traders who are disenchanted with prop firms because they were banking on fast returns, create a cloud of negativity over the industry.

Then there are bad actors. We saw this dynamic play out with ICOs and binaries, and again with retail traders during the rise of forex and crypto trading.

The broker’s reputation will need to hold up and be ready to withstand fires of this nature.

One could argue that props could be launched under a different brand — a kind of damage control. We see that many retail brokers conduct their funded trading programmes under a separate entity and a brand.

Finally, there are risk management challenges.

Risk management is often overlooked in the unregulated and synthetic environment.

Mistakes in the platform configuration, loopholes in the trading terms & conditions, or lack of risk management policies, may bite you, especially when the market suddenly moves. The firm may suffer from unexpected payouts or losses that they never projected or accounted for.

Additionally, many systems that are currently in use are tailored for regular trading, and while there is a big intersection with props setup, risk management is one field where nuances matter the most.

While the prop trading playing field has undeniably evolved into a favorable environment for brokers, firms will need to consider their threshold for withstanding the fallout associated with the risks laid out here.”

Anton Sokolov, Brokeree Solutions

“Prop trading services attract a different audience to that of retail brokers – younger, motivated, and committed to stable performance over a longer period. From the looks of it prop trading or trader funding firms (TFFs) have a better-suited product for those who are eyeing trading as a “career” path rather than an investment opportunity. We might argue that retail brokers are also interested in such clients, the key difference is that the current onboarding process seems a bit detached from the actual needs of traders. Whereas an offering of prop firms paves a clear interactive and guided path, especially for those who do not have thousands of dollars to invest right away.

Retail brokers will surely benefit from similar services as long as they specify their target audience. Some brands may want to establish actual proprietary trading operations, others might lean towards building a network of talented traders who then will be servicing brokers’ existing clientele via social trading or portfolio management services. What I know for sure is that prop trading firms showed us what the upcoming demographic is interested in and we also know that the global economic situation does not contribute to an average deposit value especially for said younger demographic. If retail brokers want to stay relevant and approachable for such traders, they have to pay attention to the trends set by TFF.

As for the challenges, I actually see less of them for established brands as the majority of the latest controversial cases come down to either breaching licensing terms, servicing US clients without proper authorization, or general malpractice and fiddling with trading data. Established retail brokers already have strong compliance teams and well-polished processes. As long as retail brokers place transparency in client communication above all else, they should not face the majority of issues random startups face.”

Natalia Zakharova, FXOpen

“One key consideration for brokers venturing into prop trading is the choice between relying on third-party software solutions or investing in building in-house trading infrastructure. While third-party software may offer convenience and initial cost savings, building in-house solutions provides greater control, customization, and agility in adapting to evolving market conditions. By developing proprietary trading platforms and analytical tools, brokers can enhance their competitive advantage and optimize trading performance.

Moreover, it’s imperative for brokers engaged in prop trading to approach the activity with a clear understanding of the risks involved. Just as with retail clients, brokers must exercise diligence and caution, acknowledging the potential for significant financial losses. Adhering to stringent risk management protocols, conducting thorough due diligence on investment opportunities, and implementing robust compliance measures are essential to mitigate risks and safeguard the firm’s capital.

Ultimately, prop trading can offer brokers a range of benefits, including the potential for enhanced profitability, diversification of revenue streams, and greater flexibility in managing market exposures. However, success in prop trading hinges on a disciplined approach, a deep understanding of market dynamics, and a commitment to prudent risk management practices.

Proprietary trading, as long as it’s executed using the broker’s own capital and doesn’t compromise the quality of service for clients, can be considered acceptable and even encouraged within the financial realm. However, it’s crucial for brokers to maintain transparency and uphold client interests, adhering to regulatory guidelines and ethical principles.”

Andrew Saks, TraderEvolution Global

“Proprietary trading is currently going through a similar developmental period to that experienced by the retail electronic trading sector around 20 years ago, in that the established few brokerages which had been in existence since the 1970s and 1980s with their own trading infrastructure and management led by financial markets experts were suddenly joined by a flood of near-identical new entities using an off-the-shelf platform, some of which were unregulated and employed questionable practices.

This led to entire regulatory frameworks being set out such as MiFID II in Europe and in some cases advertising bans of CFD products on display media channels, meaning that the established, well-operated companies that had invested correctly into building their own trading environment and had loyal customers were also subject to some ‘anti-CFD’ sentiment by association.

Proprietary trading firms were for many years corporate environments with professional traders, and now suddenly those firms are being overshadowed by the triumph of marketing over substance which we are seeing now with these latest entrants offering challenges and using unregulated retail platforms. We can look back at what happened with binary options; the entire industry was banned. Regulators and ad networks could come down harder on retail trading firms that have similar product lines to those offering prop trading and are using similar off-the-shelf systems. This is ‘death by association’ and should be a concern.

Whilst recent reports including news of a prop firm looking to purchase a broker are only beginning to emerge it is possible that more mature prop firms could do this, thus becoming regulated entities, but it could take time, just as it did for the unregulated FX brokers to be weeded out 20 years ago. It is imperative to build your own brand and be able to create loyalty among good quality traders with a good quality range of products, rather than to allow this sudden wave, which already has some bad press and is aimed at a lower quality audience, to impede your brokerage’s ability to attract and retain high-quality traders across all global markets and asset classes.”

Elina Pedersen, Your Bourse

“The emergence of “prop trading” firms shows us once more that the retail trading industry will keep flourishing no matter the regulations (leverage, etc.), no matter the restrictions sometimes imposed by technology or liquidity providers, and even governments. Human nature will always prevail, and prop trading is just a new way for newcomers to experience the thrill of trading.

If we look at statistics we will find that on average the CLV (customer lifetime value) and the ACL (average customer lifespan) are similar to what they used to be before the cut in leverage (with leverage under 1:50 it is significantly increased, but the CLV is still the same), while the entrance barrier for the next clients is just much lower.

Call it evolution if you like. It goes without saying that the “grey field” industries very closely related to strictly regulated activities have a higher risk associated with running the business. But the risk = higher margin. At Your Bourse, we follow the client (within reason). The management team has extensive brokerage experience; after all, we ran brokers in the past, both regulated and offshore. Hence, we understand the complexity of the systems and risk management needed and are able to supply it as a technological suit.”