Here are the current business models and how they may be changed by regulators
Note that regulators have been forcing other changes on this industry for many years, but these new changes appear to be much more fundamental with potentially drastic consequences.
Employment model: All or some of the prop traders can be employees of the firm and receive IRS Form W-2 (wages).
The employee model appears to continue to pass muster with the regulators, but deposits from prop traders may no longer be allowed (again, on a case-by-case basis during regulatory audit or enforcement proceedings).
Now we will see how many firms are truly offering âjobsâ (with W-2s) to traders. In the past, we pointed out that some job ads were really âcome-onsâ to attract deposits and earn commissions and other fees for the firms.
LLC K-1 model: All or some of the prop day traders are LLC members of the LLC prop day-trading firm and receive a Schedule K-1 (share of partnership income) based on âspecial allocationsâ of their specific trading profits in the firm.
Management of the firm (the true owners) own Class A shares, and prop traders own a lower class, like B, C or D. Only Class-A members share in firm-wide profits.
Regulators may only allow this LLC K-1 model going forward if the firm allocates profits to members on a firm-wide basis and doesnât bar the prop trader classes from sharing in these profits.
This apparent new requirement could render this LLC K-1 model unattractive to both firms and trader alike. Firms may not want to share commissions and other profits with prop trader LLC members, and the prop traders may not want to risk sharing in losses caused by other traders in the firm.
This LLC K-1 model has been the most prevalent for larger prop day-trading firms, so we are concerned about how regulatory enforcement actions might upset the industry in this regard.
Independent contractor model: All or some of the traders are independent contractors and receive IRS Form 1099-Misc. (with Non-Employee compensation or Other Income boxes checked).
Regulators apparently donât want these relationships at all going forward. Most broker/dealers went away from this model, but smaller boutique non-broker/dealer LLCs use it. Again, no deposits will be allowed.
Non-broker/dealer prop trading firms
The industry has also grown a branch of smaller boutique prop trading firms that are not broker/dealers. These smaller LLCs recruit prop traders who are not licensed brokers and allow lower deposit requirements; usually $3,000 to $10,000.
These smaller firms fly below the regulatorsâ radar screens since they do not file reports required from broker/dealers (FOCUS reports and more). One particular problem for these smaller non-BD firms is that their managers may âquote ratesâ â commissions and transaction costs. Only brokers can quote rates, so this is an illegal activity and the regulators are concerned with it.
Some larger prop day-trading firm broker/dealers utilize many smaller boutique non-broker/dealer LLCs to recruit more trading and business. An entrepreneur prop trading broker in the broker/dealer firm spins off his own âsub-LLCâ to recruit smaller non-broker traders with lower deposit amounts. That broker may quote rates and it can be troublesome.
