October 1, 2006 News Update, by Robert A. Green, CPA & CEO
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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.
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 in the firm.
If that employee trader becomes highly successful for the firm, offer them
ownership in the firm. It’s that simple!
Or, firms might revert to handling retail customer accounts and charge for a
long list of services offered to their traders. They could charge for office
space, community, training, risk management systems and, of course,
commissions.
But can retail traders make a good living?
Some firms argue that retail traders cannot make a significant income with the
current margin rules (4-to-1 for pattern day traders).
We have hundreds of retail traders who do make a good living. We do agree that
leverage can be helpful in making more money on a smaller capital size. But
leverage comes with risks, too. There are other changes brewing in the margin
rules that can help retail traders (hedging margin and more).
The history
The proprietary day-trading firm industry involves very active trading in
equities and, sometimes, equity derivatives and futures using the firm’s
capital.
Requiring deposits from traders is what sets prop firms apart from major
brokerage firms on Wall Street, who have large profit-centers from prop trading
activities, too.
Major brokerage firms pay their prop traders as employees with annual W-2s
(wage reporting statements), and the firms rarely require employees to make
good faith deposits. Come bonus time, the firms look to each trader’s
individual trading results, or more commonly as part of an employee trading
pool, and wage bonuses are a significant part of a prop trader employee’s annual
compensation.
This is in stark contrast to most prop day-trading prop firms that require
deposits from traders before they allow them to join a firm to trade – usually
as an LLC member, and in some smaller firms as independent contractors or
employees.
Another key difference is Wall Street firms pay traders from a bonus pool,
whereas prop day-trading firms pay traders a high percentage of what a prop
trader makes in a separate sub-trading account. Plus, prop day-trading trading
firms charge their traders for their losses, by applying losses against their
deposit accounts and requiring prop traders to replenish their deposits with
the firm.
Another problem that occurred in prior years – and it’s mostly been corrected
by regulators – is that some prop day-trading firms counted these deposits in
their net capital computations, and that was not proper.
Connect the dots between trading gains and losses and deposits and you can
understand why regulators have concluded that in some cases, firms are
disguising retail/customer accounts and violating the Reg T margin rules in the
process.
Regulators may act selectively but forcefully
Regulators may force selected firms on a case-by-case basis (either during an
audit or enforcement process) to change how they do business or cease doing
business in their current manner.
Unfortunately, once regulators act, it’s often immediate and dramatic. Prop
traders and firms will need more time to restructure. This may be why
regulators are rolling out these changes (apparently) on a selected basis. That
begs the question – is this arbitrary and selective enforcement, and is that
proper?
Ask your firm what’s going on
It’s wise to consider asking your firm’s management about these matters. You
may find it advisable to reduce your deposit size or even do away with it.
Also, it may be wise to draw as many of your trading gains as possible out of
the firm.
Can you consider retail trading if need be? Forming a hedge fund is another way
to trade other people’s money. Learn the differences below between prop
trading, retail and hedge funds.
You don’t want to have your capital and trading access frozen by regulators
before you can do anything about it. Once the regulators act, you may not hear
about it until it’s too late. Most firm managements do not disclose these
matters to their prop traders, even though they may be LLC owners. Lower
classes of ownership do not have a seat at the table.
Most firms don’t allow overnight positions and, presumably, their deposits are
kept separate from net capital. They should be able to comply with any strict
regulatory action without putting your deposit at risk. But your trading access
could be denied nonetheless.
Remember Refco and Worldco
Read the stories about the demise of Worldco (a large prop day-trading firm)
and Refco (who also had some prop traders) and learn those lessons.
Some of Refco’s prop traders sought government insurance from SIPC for lost deposits,
claiming they were disguised retail customer accounts. Prop traders don’t get
SIPC insurance, but retail customers do. The Refco demise may have been a
rallying cry for the regulators to take more concerted action per above.
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 “jobs” (with W-2s) to
traders. In the past, we pointed out that some job ads were really “come-ons”
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 “special allocations” 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 doesn’t 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 don’t 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 regulators’ 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
“quote rates” – 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 “sub-LLC” to
recruit smaller non-broker traders with lower deposit amounts. That broker may
quote rates and it can be troublesome.
What one large firm says about this story now?
We spoke with one large prop day-trading firm and they say the regulators are
not pressing these issues with them at this time.
Perhaps this is the reason the regulators are dealing with this issue on a
case-by-case basis – so they don’t cause havoc overnight in the industry.
That’s the name of the regulatory game over the past decade – be careful not to
upset markets and keep the lid on changes (George Soros’s concept of
"Reflexivity").
Paperwork is not always reality
In all the above models, the prop traders sign lengthy detailed agreements
provided by the prop day-trading firms in which the trader agrees that he or
she is not a “customer” of the trading firm (but, rather, an employee,
independent contractor, or member, depending upon the structure used).
Just because a trader and a firm call a deposit what they like doesn’t mean the
regulators cannot call it what it appears to be in their view – a disguised
customer deposit. However, for the regulators to succeed on this view in court,
they might have to show that the traders are “disavowing” (i.e., reneging) on
agreements they entered into as consenting adults.
Older writing from before the news above
In certain cases, the trader must place funds in a type of surety account, in
effect, to ensure that when they trade the firm’s capital they do not act
recklessly, because their account can be depleted. In some cases, the trader
agrees to be liable for trading losses incurred by the firm arising from the
trader’s activities, above the amount placed in the surety-type account.
For some time now, we have been advised that the NASD is investigating
proprietary trading firms, on a case-by-case basis, regarding the proper
characterization of traders as traders or “customers.”
We recently learned that the NASD, acting in conjunction with the SEC, acted to
force one or more prop day-trading firms to revise their model as laid out in
general above – to either treat their traders as retail customers or conform to
the limited ways of carrying on a prop day-trading firm activity.
The NASD reviews were sparked by the actions of some former proprietary traders
of Refco Inc. These traders argued that they were customers of Refco, not
traders, because when Refco entered bankruptcy, they would have a better
position in the bankruptcy court. In addition, as customers they could claim
SIPC insurance for brokerage accounts. While we wait for the wheels of justice
to grind on further, proprietary trading firms and traders would be
well-advised to review very carefully the structure of the firm, the rights and
liabilities of members, and regulatory developments. Our recent news stated
above is a call for immediate action.
It is a fact of life in this industry that proprietary trading is viewed with disfavor,
even downright suspicion, in some quarters. Monitoring developments, therefore,
is a must for all concerned.
Even before the Refco Inc. bankruptcy, we alerted the prop trading industry to
this same concern. Click
here to follow our prop trading industry news.
Proprietary Trading compared with Retail Trading and Hedge Funds
You can trade actively in a number of different ways: retail, proprietary
trading, or in a hedge fund.
• Retail trading: The majority of business traders open their
own "customer accounts" with a direct-access and/or online brokerage
firm. They are known as "retail traders." Active retail trading often
triggers the "pattern
day-trader (margin) rules," which sets minimum account sizes of
$25,000.
We cover all the tax and accounting issues for retail business
traders on our site and in our guides. Retail
business traders also need to do their own accounting using our recommended GTT TradeLog and
general ledger programs, such as Quicken, for their expenses. Retail traders
are entrepreneurs who are entirely on their own.
• Proprietary trading: This phrase was originally created when
larger full service Wall Street brokerage firms and other financial
institutions employed traders to trade their capital. However, don't
confuse this “true” type of employee prop trading with the general proprietary
trading industry, which evolved from the day-trading firms of the 1990s.
Most prop traders that are members of, or work in, a "proprietary trading
firm" are asked to risk their own capital in front of the firm's capital.
They are not employees with a job on Wall Street!
These proprietary traders are very much like retail traders because, in
reality, they are risking their own money. The big difference is that these
prop traders have access to far greater leverage than retail traders, who have
4-to-1 leverage or margin under the pattern day-trader rules and 2-to-1
otherwise. Proprietary traders often get 10-to-1 or 20-to-1 leverage because a
proprietary trading firm may allocate money to traders within a firm however it
likes. Broker/dealer prop trading firms are limited to 6-to-1 leverage overall.
• Hedge fund trading: There is a third way to trade: in
your own hedge fund. This is truly trading "other people’s money."
GreenTrader helps start up
hedge funds. Hedge-fund manager/traders usually earn a 20-percent profit
allocation or incentive fee on new high net profits, plus a 2-percent
management fee, based on funds under management.
New traders need to build an excellent performance record in the business
before they can be successful in a hedge-fund business. The GreenTrader
Incubator Fund strategy is a great way to start building your historical
performance record at very low cost.
Although a proprietary trading firm's sales pitch may imply otherwise, these
types of proprietary traders are not really trading "other people's
money" but rather risking their own money to cover their own trading
losses (generated in sub-accounts of the firm) and paying for their own expenses
incurred within the firm (such as margin interest, training, office usage, and
more). In the majority of cases, the firm does not ultimately pay for any of
the traders’ losses and expenses.
This is the opposite of proprietary trading on Wall Street where the firm pays
for all losses, expenses, and salaries to the trader. Proprietary trading firms
do not pay salaries, and the traders lose their own money. So, using the term
"proprietary trading" is deceiving.
"Entrepreneur proprietary traders" risk their own money in the same
manner a "retail business trader" does. The big difference is that
entrepreneur proprietary traders have access to more leverage than retail
traders do. A better phrase would be to say a proprietary trader is
"trading other people's leverage."
Proprietary trading firms’ sales pitches can sound very attractive to business
traders who believe they do not independently have sufficient risk capital and
leverage to make a living. Joining a firm to get access to "other people’s
leverage" is the main attraction here.
Caution: Leverage can be expensive and dangerous. Leverage is not free; you
must pay market interest rates for using the firm's capital. Trading with too
much leverage can burn you out of positions faster and with bigger losses.
A key point to understand upfront is that proprietary trading firms will
strictly police how you use their leverage. These firms know they are
attracting many unsophisticated (and new) traders and they strictly restrict
your trading privileges. Almost all firms disallow overnight positions. They
limit the securities you can trade, and they will force you out of positions
when they like.
Some prop traders flourish under these restricted conditions, and they
appreciate the firm's oversight and discipline. They do well with leverage, but
many others burn out faster with leverage and lose their initial deposits and
much more. Before you join a proprietary trading firm, carefully read the fine
print and understand what you are getting into.
It also is important to learn about how tax issues differ between proprietary
and retail traders. Like retail business traders, entrepreneur proprietary
traders can deduct their business expenses (outside of the firm) with
"unreimbursed partnership expenses" (UPE) deducted on Schedule E (if
they are LLC members of the firm), or as business deductions on Schedule C (if
they are independent contractors of the firm).
Proprietary traders must maintain deposits of $25,000 or more if the firm is a
registered broker/dealer. These firms require their proprietary traders to have
a current brokerage license. Most firms require that a proprietary trader join
as an LLC member. Some still allow independent contractors and/or employees.
Smaller boutique prop trading firms are not organized as broker/dealers and are
not members of an exchange. These firms allow lower minimum deposits, and they
do not require brokerage licenses.
Retail and prop traders' share many tax benefits in common, but there also are
many important differences. Learn the special rules for prop traders in the
proprietary traders section.
Remember, your interests are not fully in line with the firm's interests. The
firm earns significant commission income on your forced hyperactive day trading
and you only make money when you generate consistent trading gains. You are not
taking a job with a salary.
Compare having your own hedge fund with proprietary trading. In a proprietary
trading firm you can receive between 60 percent and 99 percent of your trading
profits, which is considerably higher than the 20-percent profit allocation in
a hedge fund. But with a proprietary trading firm you have much greater risk.
You are responsible for 100 percent of your losses in a proprietary trading
firm whereas in a hedge fund you are not responsible for any losses. Again, the
proprietary trading firm has many restrictions on your trading, whereas you
write your own trading program in your own hedge fund. Moreover, with a hedge
fund, you can hold positions overnight, which is the norm for hedge funds;
plus, an entrepreneur can gain more value over the long term by building a
hedge-fund brand.
The bottom line is that there are many ways to trade, and you should choose
which informed way is best for you. Note that proprietary trading tax and
business issues are complex and highly nuanced. Few professionals understand
all the issues, but our professionals have many of the answers you need.
Whether you are joining a prop trading firm, or operating a firm, we can help
you.
Use this section on proprietary trading to learn the ins and outs. When you
are ready for our help, go back to our business
traders section to learn more and sign up for consultations, preparation,
entity formations, retirement plans, IRS exam representation, and more.
There also is an entire chapter on proprietary trading in Robert Green's
book, The Tax Guide
for Traders, published by McGraw-Hill. Click here to learn
more and buy the book online.
Some of our leading tax attorneys provide legal services to prop traders and
prop trading firms through their independent law firm.
We cover the proprietary trading industry looking for stories that can
impact our clients. Click
here to read some of the stories we are working on.
Please also email us any comments you have about the industry and the new
developments above.
If you have any questions or comments about propriety trading, feel free to contact us. We
look forward to working with you soon.
Robert A. Green, CPA & CEO
