Prop firms trading has recently surged as retail forex brokers face tightening regulations and leverage restrictions worldwide. In response to these constraints, many traders and companies shifted their focus toward proprietary trading firms, which offer traders funded accounts through trading challenges. This evolving industry presents unique opportunities, allowing individuals to trade with firm capital while sidestepping traditional brokerage hurdles. However, understanding the distinctions between prop firms and conventional forex brokers is crucial to navigating risks and rewards effectively.
Have Strict Regulations Pushed Retail Forex Traders Toward Prop Firms?
Over the past decade, the retail forex market has experienced significant global changes. Governments worldwide have implemented increasingly stringent regulations to enhance industry integrity and protect retail investors. A notable measure has been the limitation of leverage that retail forex brokers can offer their clients. For instance, in the United States, the Commodity Futures Trading Commission (CFTC) limited leverage to 50:1 on major currency pairs and 20:1 for others. Similarly, the European Securities and Markets Authority (ESMA) imposed leverage caps ranging from 30:1 for major currency pairs to 2:1 for cryptocurrencies.
These regulations aimed to protect retail investors from excessive risk and to address unethical practices within the industry. However, they also introduced challenges to companies offering brokerage services. Compliance with new regulations has increased administrative burdens and operational costs for companies. The standardization resulting from these regulations has made it harder for brokers to differentiate their services and to truly stand out. This led some smaller firms to exit the market due to the heightened compliance requirements.
Naturally, this forced FX brokers and other interested parties to look for ways to circumvent all these limitations and to look for other sources of revenue. Resultingly, some of them moved to offshore jurisdictions. Most of these places have lax regulations and it is relatively cheap to establish branches of their existing brands there. Others started offering entirely different products to retail traders; that’s how prop firms with their challenges and funded accounts came to the fore.
What is Proprietary Trading, and How Did It Evolve Over Time?
Proprietary trading, often called “prop trading,” means trading with a firm’s own money rather than focusing on trades funded at the customer’s expense. This practice has been around for decades. Back in the day, large banks and institutions sought to profit from market inefficiencies before the trading world became as complex and technology-driven as it is today. Over time, especially in the 1980s, deregulation opened the door for banks in the U.S. to pursue more aggressive strategies. This led to the rise of in-house trading desks dedicated to capitalizing on market movements.
By the 1990s, technological advancements, like electronic trading platforms and algorithmic systems, supercharged the industry. They paved the way for high-frequency trading and more sophisticated approaches. However, after the 2008 financial crisis, regulations such as the Volcker Rule put a damper on banks’ ability to engage in certain speculative trades. As a result, many talented traders found themselves out of work and decided to branch out and establish independent proprietary trading firms.
Bank-affiliated desks, restricted by newer rules, cannot operate with the same freedom they once did. Today, institutional prop trading takes several forms. For example, independent firms focus solely on trading their own capital. Meanwhile, some hedge funds employ prop trading strategies by setting aside a portion of their capital for speculative trades outside their usual client-focused portfolios.
A handful of major names stand out in the institutional prop trading world. To name a few: Hudson River Trading (founded in 2002), Jane Street, Citadel Securities, and Jump Trading. Each of them is renowned for embracing cutting-edge technology and sophisticated strategies to stay ahead in highly competitive markets.
What Does It All Have to Do With Retail Traders?
What essentially happened is that a new type of market participant emerged and highjacked the term of proprietary trading. So, there are two types of Prop firm. This new type allows retail customers to participate in challenges (more on this later) and the other traditional proprietary firm is how we described above. They might use the same term to describe themselves, but they’re built on very different foundations. As we mentioned earlier, in response to the introduction of more stringent regulations governing forex trading services for retail clients, many firms have sought alternative methods to maintain their business models while adhering to the new rules. One such approach has been the adaptation of the “proprietary trading” model to offer funded accounts to retail traders after they complete a trading challenge. From a business perspective, it works for both parties, compared to running a full-fledged forex brokerage. But how so?
Prop Firms vs Classical Forex Brokers
With a conventional forex broker, you typically deposit your own money—after completing a standard KYC (Know Your Customer) procedure. Brokers must hold licenses from regulatory authorities in the regions where they operate. It is a requirement that comes with high costs and strict rules.
How Do Prop Firms Work?
In contrast, many “prop firms” offering “funded accounts” to retail traders position themselves as proprietary trading and/or educational platforms rather than direct financial service providers. The premise is that, if you succeed in their challenge or evaluation, they will eventually fund you. As a result, they often avoid the same regulatory scrutiny that brokers face. Instead of depositing funds into a trading account, you’re essentially paying for a service or a digital product. You are paying for the chance to prove your trading skills and, potentially, qualify to trade with their capital. This challenge fee can be a robust revenue stream for the firm. The primary reason for that is they take on minimal risk. Especially since most retail traders do not succeed in the long run.
The Firm’s Perspective: Risks vs. Rewards
Think about it from the owner’s perspective. Given the statistics, why risk real capital on someone who’s still figuring out the basics? There are hundreds of posts on Reddit where people ask questions about pip values or discuss a hidden “algorithm” that drives the entire market. It’s easy to see why, for the firm, collecting fees from unsuccessful challenges can be a safer bet than actually supplying large amounts of capital to newcomers. By the way, many such firms don’t offer a simulated trading environment, also known as demo trading.
FUN FACT: A study analyzing 300,000 prop trading accounts revealed that approximately 14% of traders passed the initial evaluation to obtain a funded account. Among these funded traders, about 45% received a payout, equating to roughly 7% of all traders. The average payout was around 4% of the funded account size. Let us not forget that these payouts may have been a one-off thing. This means a trader who achieved this result once may not be able to achieve this result again.
By comparison, a traditional forex broker might run an A-book or B-book model. If it’s the latter, the broker may choose to internalize trades deemed likely to lose. In simple terms, if you lose, they gain; if you win, they pay out of pocket. While this can be concerning, reputable brokers will disclose these practices. And it’s worth noting that a large number of retail clients end up losing money, anyway.
In the end, it’s crucial to understand these nuances. Whether you choose a prop firm or regulated broker, be sure you fully grasp their fees, regulation, and trading methodology. That extra bit of homework can save you major headaches—and money—down the line.
Metaquotes Restricts Prop Firms: Understanding the Reasons and Implication
MetaQuotes, the creator of the widely popular MetaTrader platforms (MT4 and MT5), has recently imposed restrictions preventing proprietary trading firms from using their software. One major driving force behind this move is the elevated regulatory and legal risk that prop firms often carry. This is especially true for countries like the United States, the UK and the EU, where strict financial laws exist. Many prop firms lack formal licenses or oversight. This could expose MetaQuotes to liability issues, prompting the software developer to step in and protect its own interests.
Another contributing factor centers on operational concerns. In what’s sometimes called “grey labeling,” certain prop firms use the MetaTrader platform under their own branding while a separate entity provides the actual trading infrastructure. This arrangement means MetaQuotes can’t always monitor or regulate how and by whom its software is deployed. This creates a potential minefield of misuse and reputational risks.
On the revenue side, MetaQuotes charges fees for live accounts but typically not for demo accounts. Some prop firms leverage mostly demo environments to sidestep these fees, effectively cutting into MetaQuotes’ income stream. By disallowing these firms from using their software, MetaQuotes aims to preserve the financial model that underpins its business.
Lastly, by taking this stance, MetaQuotes aligns itself with broader industry standards of market integrity and client protection. Banning many prop firms from the MetaTrader platforms helps reduce the likelihood of abusive practices and safeguards traders.
IMPORTANT: MetaQuotes recently allowed one of the prop firms to resume using their MT5 trading platform. This means that they found a way to resolve or mitigate the issues we outlined above.
Summary
Despite operating in a largely unregulated environment, proprietary trading firms (prop firms) have established business models that are both profitable and less risky compared to traditional brokerages. This resilience suggests their continued presence in the financial landscape. Factors such as the lack of regulation, recent actions by MetaQuotes, or the high failure rate among retail clients are unlikely to deter individuals from engaging with these firms.
Despite statistics indicating that a majority of retail traders incur losses, interest in trading challenges and funded accounts offered by prop firms remains high. The allure of accessing significant capital and the potential for substantial profits continue to attract retail clients. This suggests that the high failure rate among retail traders is unlikely to deter new participants from engaging with prop firms.
The combination of a profitable and lower-risk business model, adaptability to platform restrictions, and sustained interest from retail clients suggests that prop firms will continue to operate and attract traders. While challenges such as regulatory scrutiny and platform limitations exist, the fundamental appeal of prop trading remains strong. This ensures its persistence in the financial industry.
