Legal And Regulatory Considerations For Proprietary Trading
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The main regulatory and legal considerations for prop trading firms:
For financial institutions, there are so many regulatory and legal considerations that understanding how to operate within the law can be incredibly complicated. Particularly, the regulations surrounding prop trading firms can be complex depending on how they are engaging with financial markets. In this article, we’ll take a surface-level look at the regulations that prop trading firms are required to adhere to and examine how the different policies and laws set by regulatory bodies apply to prop trading firms.
Legal and regulatory considerations for prop trading
Proprietary trading is defined as the trading conducted by financial institutions or commercial banks for direct profit, rather than to generate profit for investor clients. The organizations who engage in prop trading are called prop trading firms, and they employ dedicated traders, called prop traders, to manage assets, buying and selling them with the aim of producing consistently positive returns. Prop traders and prop trading firms are required to comply with financial laws and regulations in order to maintain the integrity of their trading practices. The most prominent of those legal and regulatory considerations are:
Registration;
Minimum capital requirements;
Risk management;
AML and KYC requirements;
Trade reporting.
Let’s look at each of these in more detail.
Registration
Proprietary trading firms need to register with relevant regulatory authorities. The registration process typically involves submitting detailed information about the firm's structure, business activities, and employed traders.
The need for registration or licensing depends on the regulatory jurisdiction under which the prop trading firm operates. Different countries and regions have differing requirements, and it's crucial to understand and comply with the specific rules of each jurisdiction. For example, prop trading firms in the UK do not need to be regulated. In the USA however, prop trading firms that trade securities must register with FINRA and comply with its rules and regulations. Many prop trading firms manage to skirt this regulation through legal loopholes however (more on this later). As a trader, you must make sure that your prop firm is registered with the respective authorities to avoid any liabilities.
Within many jurisdictions, individual traders involved in proprietary trading may also need to obtain specific licenses. These licenses often require passing qualifying exams and demonstrating a sufficient understanding of financial markets and regulations.
Minimum capital requirements
Prop trading firms are often required to maintain sufficient net capital — the difference between assets and liabilities — to ensure financial stability and protect market participants. These requirements act as a safety buffer to absorb potential losses during trading activities.
However, most prop trading firms trade exclusively with their own funds and do not manage client assets, exempting them from these regulations. Consequently, individuals with adequate capital can establish their own prop trading firms without regulatory hurdles.
Risk management
Prop trading firms implement risk management procedures to follow regulatory rules and ensure safe trading practices. For example, a firm may set limits on the amount of money a trader can invest in a single trade to control potential losses. They may also employ automated systems that monitor trades in real-time, triggering alerts or halting activities if predetermined risk thresholds are breached. Additionally, these firms regularly assess the overall risk exposure of their portfolios, using various tools to analyze market trends and potential impacts on their financial health.
Anti-money laundering (AML) and know-your-customer (KYC) requirements
AML laws aim to prevent criminals from disguising illegally obtained funds as legitimate income, while KYC processes verify client identities to avoid fraudulent activity. Prop trading firms, despite not managing client funds, must adhere to these regulations to ensure their operations maintain financial system integrity. This includes:
Implementing measures to prevent misuse of the firm for money laundering.
Conducting due diligence during interactions with counterparties.
Reporting suspicious activities as required by regulatory authorities.
Trade reporting
Trade reporting ensures transparency by requiring firms to disclose transaction details to regulators promptly. The types of reports include:
Transaction reports. Outline individual trades.
Counterparty reports. Identify trading partners.
Position reports. Detail current holdings.
Risk exposure reports. Assess overall risk levels.
These reports help regulators monitor market activities and prevent abuse. Some prop trading firms circumvent reporting obligations by exploiting regulatory loopholes, but recent efforts by the SEC aim to close these gaps.
We have prepared a list of the top compliant prop trading firms out there. You can compare their features and compare to the one you’re using currently in terms of regulatory and legal compliance:
| Funding Up To, $ | Profit split up to, % | Min Trade Days | Trading period | Max. Leverage | No-Evaluation | Free Evaluation | Open an account | |
|---|---|---|---|---|---|---|---|---|
| 4 000 000 | 95 | 2 | Unlimited | 1:100 | Yes | No | Open an account Your capital is at risk.
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| 200 000 | 90 | No time limits | Unlimited | 1:30 | No | No | Open an account Your capital is at risk.
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| 2 500 000 | 90 | 3 | Unlimited | 1:100 | Yes | No | Open an account Your capital is at risk.
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| 2 000 000 | 95 | 3 | Unlimited | 1:100 | Yes | No | Open an account Your capital is at risk.
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| 400 000 | 80 | 10 | Unlimited | 1:30 | No | No | Open an account Your capital is at risk. |
Additional legal and regulatory considerations for prop trading
There are further legal and regulatory considerations that proprietary trading firms must take into account:
Conflicts of interest. Prop trading firms may engage in proprietary trading alongside other financial activities. Conflicts of interest can arise when the firm's trading activities conflict with the best interests of their clients in their other activities. For example, if a prop trader invested in a security for the firm, before investing in the same security on behalf of a client, this would constitute a conflict of interest. Prop trading firms must establish robust internal controls and disclosure mechanisms to identify, manage, and mitigate conflicts of interest.
Market manipulation. Market manipulation refers to the intentional attempt to interfere with the supply or demand of a security, affecting its price and misleading other market participants. Prop trading firms are obligated to refrain from engaging in any form of market manipulation. Implementing surveillance systems and adopting ethical trading practices helps to prevent manipulation. In 2022, Nova Scotia based trading firm Maritra Trading Services Inc was required to hire a new regulatory consultant after its traders were caught engaging in manipulative trading. Collaborating with regulatory authorities to report and address suspicious activities is essential.
Insider trading. Insider trading is an illegal practice that involves trading based on access to material, non-public information. Prop trading firms often have access to sensitive market information and so must prevent any misuse of such information for personal gain. To do this, they can enforce strict policies and procedures against insider trading, such as maintaining information barriers within the firm, educating employees, and monitoring trading activities to detect potential breaches.
International regulatory frameworks
Prop trading firms operating across multiple jurisdictions must tackle a complex web of international regulations. For example:
European Union (EU): The Markets in Financial Instruments Directive II (MiFID II) mandates that firms engaging in proprietary trading obtain specific authorizations, particularly for “Dealing on Own Account” activities.
United States: The Volcker Rule restricts proprietary trading by banking entities, aiming to reduce systemic risk.
Technological infrastructure and compliance
The rise of high-frequency trading (HFT) and algorithmic strategies has introduced new compliance challenges for prop trading firms. Key considerations include:
Ensuring trading algorithms do not engage in manipulative practices.
Implementing regular audits and updates to trading systems.
Adhering to specific provisions for high-frequency trading, such as those under MiFID II.
Record-keeping and communication compliance
Regulatory bodies emphasize the importance of comprehensive record-keeping and approved communication practices. Recent enforcement actions highlight key requirements:
Maintaining records of all business communications, including electronic messaging.
Using approved communication channels to prevent compliance breaches.
For example, in 2024, firms were fined millions for record-keeping failures.
Evolving regulatory landscape and future considerations
Regulations for prop trading firms are constantly evolving. Recent developments include:
Expanded SEC rules covering previously exempt firms.
Stricter transparency requirements in global markets.
Firms and traders should both stay cautious
For firms hiring traders from different countries, taxes on profits can get tricky. Some countries might expect you to withhold part of the trader’s earnings for tax, and ignoring this can cause legal trouble. To avoid this, work with a tax expert to set up the right systems for each country. It’s also a good idea to train traders on the rules they need to follow, like laws about insider trading or restrictions on certain assets. This keeps everyone on the same page and helps the firm stay out of legal trouble while showing traders you care about doing things right.
And for traders, the fact is that many new traders don’t pay enough attention to the legal side of working with a prop trading firm. Before signing up, carefully read the fine print on profit sharing and any terms about paying back losses (known as “clawbacks”). If it’s unclear, ask the firm to explain or adjust it. These clauses can eat into your earnings. Also, check if the firm is officially registered with financial regulators. Unregistered firms might lead to problems like frozen accounts or even legal trouble. Asking these questions upfront can help you avoid big headaches later.
Conclusion
Prop trading firms face varied regulatory requirements depending on their jurisdiction, activities, and operational structures. While firms using their own capital often fall outside stringent regulations, those acting as broker-dealers must comply with specific registration and reporting rules. Key considerations include maintaining capital adequacy, adhering to AML/KYC protocols, and fulfilling trade reporting obligations to ensure transparency and market integrity. Recent regulatory updates, such as expanded SEC rules, aim to close existing loopholes and enhance oversight. Staying informed and proactive in compliance measures is essential for the long-term success and legal operation of prop trading firms.
FAQs
How are prop trading firms regulated?
This depends on the type of prop trading firm. If they employ traders directly or act as broker-dealers, they may be subject to regulation by FINRA and the SEC. However, if they are allocating funded or demo accounts to independent traders, they are able to circumvent most financial regulations.
Is trading with a prop firm legal?
Yes, prop trading firms operate within the law, though many are not subject to the same stringent regulations as other financial bodies, making them higher risk.
Do prop traders need a license?
Prop traders working directly for prop trading firms generally require a license. Traders using funded trading accounts do not usually need a license however.
Are prop trading firms a scam?
No, prop trading is a legitimate form of trading, though there are more legitimate firms and some more fraudulent ones.
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Team that worked on the article
Mikhail Vnuchkov joined Traders Union as an author in 2020. He began his professional career as a journalist-observer at a small online financial publication, where he covered global economic events and discussed their impact on the segment of financial investment, including investor income. With five years of experience in finance, Mikhail joined Traders Union team, where he is in charge of forming the pool of latest news for traders, who trade stocks, cryptocurrencies, Forex instruments and fixed income.
Chinmay Soni is a financial analyst with more than 5 years of experience in working with stocks, Forex, derivatives, and other assets. As a founder of a boutique research firm and an active researcher, he covers various industries and fields, providing insights backed by statistical data. He is also an educator in the field of finance and technology.
As an author for Traders Union, he contributes his deep analytical insights on various topics, taking into account various aspects.
Mirjan Hipolito is a journalist and news editor at Traders Union. She is an expert crypto writer with five years of experience in the financial markets. Her specialties are daily market news, price predictions, and Initial Coin Offerings (ICO).
Proprietary trading (prop trading) is a financial trading strategy where a financial firm or institution uses its own capital to trade in various financial markets, such as stocks, bonds, commodities, or derivatives, with the aim of generating profits for the company itself. Prop traders typically do not trade on behalf of clients but instead trade with the firm's money, taking on the associated risks and rewards.
Risk management is a risk management model that involves controlling potential losses while maximizing profits. The main risk management tools are stop loss, take profit, calculation of position volume taking into account leverage and pip value.
Forex leverage is a tool enabling traders to control larger positions with a relatively small amount of capital, amplifying potential profits and losses based on the chosen leverage ratio.
Swing trading is a trading strategy that involves holding positions in financial assets, such as stocks or forex, for several days to weeks, aiming to profit from short- to medium-term price swings or "swings" in the market. Swing traders typically use technical and fundamental analysis to identify potential entry and exit points.
An investor is an individual, who invests money in an asset with the expectation that its value would appreciate in the future. The asset can be anything, including a bond, debenture, mutual fund, equity, gold, silver, exchange-traded funds (ETFs), and real-estate property.
