Proprietary Trading

1. What is proprietary trading? What are the risks associated with proprietary trading? What is the Volcker rule? How is the Volcker rule reflected in the Dodd-Frank Act?

Proprietary trading and its risks:

Usually the main function of brokers is putting buyers and sellers together and they get commission. Proprietary trading occurs when a bank, broker, or other financial institution trades stocks, bonds, currencies, derivatives or other financial instruments on its own account rather than on behalf of customers. They trade by using their own capital for speculative purpose. Proprietary trading entails some risks. For example, banks have a large inventories of securities and derivatives because they speculate that there will be a high demand in the future and they can make profit if price of those securities increase, but it turn out that nobody want to buy those securities. Thus, banks face loss if they make a wrong bat on market. The risks might be amplified if those securities are actually bad securities or toxic derivatives such as subprime mortgage back securities. Moreover, banks might have high leverage if they borrow money to trade on their own account.

Dodd-Frank Act and Volcker rule:

Dodd-Frank Actis created under president Obama administration in response to the financial crisis of 2008. The act is believed to be the most sweeping overhaul of the financial system since the Great Depression. It will affect how financial institutions operate individually and interact with each other and their customers. At Obama's request, Congress later added the Volcker Rule to this proposal in January 2010. The Volcker rule limits a covered banking entity's investment in proprietary trading to no more than 3% of its Tier one capital and also limits its aggregate investment in any and all hedge funds and private equity funds to no more than 3% of its Tier one capital. The measure's aim is to prevent big banks from trading on risky financial securities and putting their risks on government because of the too big to fail rule, thus they might count on government bailouts. However, the rule has been opposed by many financial institutions who view it prevent them from one of the most profitable activities. Moreover, it is complicate to distinguish proprietary trading from hedging and market-making.

2. What is the shadow banking system? What are the problems of the shadow banking? What are the major lessons we can draw from the Bear Sterns case?

The shadow banking system (or shadow financial system) is a network of financial institutions comprised of non-depository banks -- e.g., investment banks, structured investment vehicles (SIVs), conduits, hedge funds, non-bank financial institutions and money market funds. They generally serve as intermediaries between investors and borrowers, providing credit and