CFTC rules appear silent on non-bank prop firm challenges.

In its attempt to provide a political solution to the Great Financial Crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Congress had the banking industry in its regulatory sights, in particular the banking industry’s proprietary trading activity which many in Congress believed was near the root cause of the melt down in the financial markets.

As a result of the additional scrutiny, banks decided to either reduce proprietary trading activities to those allowed under Dodd-Frank or simply get out of the proprietary trading business. 

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The old prop firm model, where traders, like a barber, rented a seat with a registered member of an exchange and traded for them has been replaced by a remote model where a non-bank prop firm provides a new or experienced trader the opportunity to trade for the firm after passing an evaluation.

The old prop firm model required a trader, in addition to renting her seat, to bring capital of their own to mitigate any potential risks to the firm due to her trading.  Today’s prop firm appears to mitigate some of this risk by evaluating the new trader and collecting a fee from the trader during this evaluation phase.

It makes sense that an applicant to a prop firm would be wary of the evaluation process, the evaluation fees, and the level of restrictions that could be placed on a trader’s strategy during the evaluation phase.

The prop firms who are concerned about recruiting and keeping the best traders so that their firms become and stay profitable will be diligent about abiding by contractual terms and conditions while keeping their eyes open for potential regulatory scrutiny.

So far, Commodity Futures Trading Commission rules on proprietary trading, 17 CFR 75.3, do not explicitly address the evaluation process prop firms employ for recruiting traders. 

Also, prop firms should consider whether a trader evaluation or challenge could be described as an unfair, abusive, deceptive act or practice where the trader claims abusive or deceptive restrictions on their ability to say implement a trade strategy or trade on a weekend. 

At a minimum, a reputable prop firm will want to follow a few Federal Trade Commission consumer protection guidelines to ensure that its evaluation practices do not mislead or are likely to mislead a trader; that the prop firm creates an environment or relationship such that the trader’s interpretation of deception, misrepresentation, or omission is unreasonable; and that any misrepresentation or omission, given the environment the prop firm creates is not material.

The current proprietary trading firm model, when not abused, creates a balance between a prop firm and prospective trader.  A reputable prop firm creates an environment where both it and the trader can profit.

Alton Drew

29 July 2022

Disclaimer: This blog post should not be construed as legal advice or an agreement to provide legal or political analysis.  To set up a consultation, contact us at altondrew@altondrew.com.

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