Prop Trading Firms - Note On Threatening Regulatory Developments

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traderob

PROPRIETARY TRADERS
PROPRIETARY TRADERS OVERVIEW
October 1, 2006 News Update, by Robert A. Green, CPA & CEO

The NASD and Securities and Exchange Commission recently declared some smaller proprietary day-trading firms to be in violation of Regulation T margin rules, which determine the borrowing power a trader has at a given moment.

The regulators appear to be selectively forcing targeted firms – on a case-by-case basis rather than through published guidance – to immediately comply. Targeted firms face a stark choice of either quickly restructuring their operations to cure the violation or eliminating their prop trading activity.

The NASD and SEC have substantial legal authority and it is unlikely any court will overturn their jurisdiction. It’s been our opinion for the past several years – while these and other related issues were evident – that the prop trading industry is living on borrowed time from the regulators.

In 1998, there were more than 100 prop trading firm broker/dealers, and now there are only a few left. Most have exited the business for a variety of reasons, including regulator actions, connections with hedge fund investments and more.

Regulators have indicated they are now applying more stringent rules but, again, that’s on a case-by-case basis, during audit or enforcement proceeding.
 
Regulators have indicated they are now applying more stringent rules but, again, that’s on a case-by-case basis, during audit or enforcement proceeding.

We are not ringing an alarm bell yet. We have no indication if wider industry application of these more-stringent rules will happen anytime soon.

Are deposits going to be barred for prop traders?
Previously, traders’ deposits – cash deposited to guarantee performance with the prop trading firm’s guidelines and, in some cases, used to start an account from which the trader’s losses are deducted – were allowed in prop day-trading firms in all three current business models (employment, independent contractor, and LLC K-1).

We understand that regulators want to bar deposits across the board. Deposits will be allowed for retail customer accounts only.

Regulators seem bent on considering deposits in prop trading firms to be disguised customer deposits. If the relationship is customer/broker rather than prop trader, the firm must apply the Reg T margin rules, with much lower margin allowed than in a prop trading firm. The implications for this change are fundamental and striking.

Transaction fees and commissions are a problem, too
Regulators don’t like prop-trading firms charging their prop traders for transaction fees (commissions).
That resembles the broker/customer relationship.

Will prop traders have to share in firm-wide profits?
The predominant prop day-trading firm model is the LLC K-1 model (learn more below).

Fundamental to this model is that prop traders are separate ownership class members in the LLC, and each trader shares only in their own trading profits.

Firms allocate between 60 and 100 percent of each trader’s respective gains and losses to their own sub-trading account within the firm. Law articles on this subject have concluded that payouts over 80 percent are too high and again resemble a broker/customer relationship.

The problem regulators have now is much more fundamental, it seems. Traders do not currently share with other traders in the firm and they also don’t get a share of trading commissions earned by prop trading firms organized as broker/dealers.

Regulators say they want to bar special allocations in this manner and only allow firm-wide sharing of profits and losses.

If this is true, it would probably be a deal killer for the prop trading firm industry. Very few traders would want to share in the losses of a neighbor trader within the same firm and very few firms would want to share commissions with their prop traders.

How might day trading prop trading firms reorganize?
These firms could adopt the proven models used by large Wall Street broker/dealers with significant proprietary trading divisions.

Hire a prop trader as an employee and do not require a deposit. Pay that trader a hefty wage bonus based on their contributions to profits
 
I'm surprised that more traders here are not worried and concerned about these developments. This link was posted on another (since closed) thread, so I'll repost it here:

http://www.greencompany.com/PropTraders/PropTradersIndustryNews.shtml

It appears that these changes could be a huge impact on the prop trading industry. It sounds like the NASD/SEC are insisting on changes to a firm's prop organization during their routine annual audits. The required changes seem to require prop traders to:

1) Must be licensed S7/55
2) Firm may NOT hold a deposit or capital in any form from the trader (i.e. trader is trading 100% firm capital, and risk of loss is the burden of the firm)
3) Trader receives profit sharing on a share (not 100%) of his/her profits.

There is also an indication that the regulators do not like to see profit sharing above 80% of the profits generated, and also frown upon the firm charging commissions to their traders.

If these changes are fully implemented, it would appear that it will have a drastic effect on the industry.

Don: I'm sure you have better information flow than most of us on this issue, what do you hear is coming from the regulators?
 
Everyone I have talked to is not worried about it. Notice that this is not a press release from the SEC but rather from Green Trader Tax service trying to get some new business setting up hedge funds.
 
Quote from Maverick74:

Everyone I have talked to is not worried about it. Notice that this is not a press release from the SEC but rather from Green Trader Tax service trying to get some new business setting up hedge funds.
More...

It's more than just a press release by Green. It basically confirms rumors that I've been hearing for over a month, and also matches the changes that one major firm made for their prop trading operation just last week (that firm was in the midst of their annual NASD audit last week, also confirming what Green had suggested). I have no doubt that this is 'real', but wonder to what extent it will affect the industry. Firms may find new ways to get around the these new areas of focus by the regulators, or it could become a huge problem that unavoidably has a drastic and adverse impact on the industry. This extent is what is in question, IMO.
 
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