How to Acquire and Manage Liquidity in Prop Trading

The trading field has experienced numerous changes and modifications with the invention of digital platforms and other tech solutions. However, some things remain the same in this active and constantly evolving landscape. Obtaining appropriate levels of liquidity for core operations was relevant a century ago, and it is more than relevant in today’s climate. 

Market liquidity dictates virtually every aspect of trading, whether forex, crypto, or other financial markets are involved. This article will explore the importance of liquidity and its practical applications for proprietary (prop) trading firms.

Before discussing the role of liquidity, let’s get a quick refresher on the definition of proprietary trader firms, or prop firms for short. The financial industry comprises numerous companies that trade on behalf of their clients. Investment banks, prime brokerage firms, hedge funds and other financial institutions engage in trading activities to meet the KPIs and projected returns for their customer base. This model has worked tremendously well for global macro trading, benefitting all parties involved. 

However, some trading organisations devised an idea to reverse this system and allow traders to drive investment decisions empowered by trading companies. In this case, the trading companies provide access to capital, technologies and other crucial resources, allowing traders to acquire everything they need to execute investment strategies. 

There are two distinct variations on the prop firm model. The first model is relatively straightforward, with traders signing up with prop firms and obtaining access to trade resources. Any returns generated from individual traders will be split between the prop firm and its respective traders. 

The allocation percentage depends on many variables, including the general commissions, deal size, and asset classes traded. Traders must also place initial collateral before entering a partnership deal, allowing prop firms to minimise their losses in case of unsuccessful trading outcomes.

The second subset of prop trading is safer and more dangerous at the same time. Prop firms give demo accounts to their traders, giving them access to a simulated trading environment. Prop firms then gather data on potentially successful traders in their roster and execute strategies based on data analytics. Traders who manage to execute simulated strategies successfully are rewarded with a share of income. 

Simulated prop firms require significantly less initial investment from traders but have a sketchier track record. Many retail traders have disclosed that prop firms didn’t pay them promised funds. Since simulated prop firms are not strictly regulated, they have no formal obligation to comply with such demands. So, the second subtype of prop trading should be approached cautiously. 

As discussed above, the entire purpose of prop trading is to uplift retail traders with extensive resources and capabilities to execute large investment strategies with various financial instruments. This model reverses the hedge fund approach, where companies act as client representatives on the market.

While the hedge fund model emphasises the reliability and experience of professional traders, the prop firm methodology is all about exploring new and undefined strategies in the financial market. The source of new ideas and experiments comes from individual investors who might have excellent ideas up their sleeves. 

Naturally, prop firms will experience a much larger portion of unsuccessful or modestly profitable traders, but finding even a few prodigies is worth the investment in this case.

Prop traders give retail traders access to their extensive trading ecosystems, as discussed. However, the biggest challenge of developing such an environment lies in liquidity sourcing. Liquidity is by far the biggest separator of powers in the trading field, having tremendous effects on any trading sector globally.

Any business in this model must acquire sufficient and reliable liquidity from crypto prop trading firms to forex prop firms. After all, accommodating a large pool of traders with increased margins is not a small undertaking, and it requires ample liquidity sources. If prop firms are unable to satisfy liquidity needs, their trader pool will experience numerous problems, starting with decreased investment activity and ending in unfavourable trade margins. 

Liquidity determines how accessible the trade markets are for investors involved in prop firms. This fund accessibility also dictates how easy it is to execute specific strategies and whether there will be delays in the order matching systems. In simple terms, without ample liquidity, the prop firm process slows down to a crawl, resulting in eventual portfolio losses for the company. 

Conversely, if the prop firms have access to extensive liquidity sources, their traders can act immediately and confidently, executing trades and enjoying narrow spread margins on asset classes. 

Perhaps the most critical part of acquiring liquidity is the reduced risks of conducting the proprietary trading practice. While the top prop trading firms might have their own money to create liquidity reserves, most of the market relies on liquidity sources to run the business every month. 

If liquidity reserves shrink, prop trading firms might struggle to generate revenue, decreasing their cash flow. Less cash can sometimes lead to being unable to pay liquidity interest rates. As a result, companies enter a vicious cycle of diminishing profits and operational reserves. Finally, this cycle ends in bankruptcy or a similarly dire scenario for prop firms. 

To escape this downward spiral, companies must establish strong and long-standing liquidity relationships and ensure their liquidity reserves will be sufficient in the long run. 

The biggest challenges of jumpstarting a prop trading company are acquiring liquidity and setting up an optimal system for individual traders. Creating or acquiring a platform that will thoroughly accommodate your retail trading partners is crucial. From live data feeds and data analytics tools to accessible liquidity mechanisms and understandable margin trading options, the prop firm platforms serve as a bridge between the two parties. 

So, it is essential to construct an environment where you give your traders the maximum chance for success. Moreover, prop firms can also provide learning materials and other helpful resources to educate their newcomer traders. After all, many successful traders started as inexperienced novices. Inviting fresh faces to your prop trading environment and allowing them to study the ways of forex, crypto, or other market trading practices could lead to spectacular results. 

However, building such a powerful platform from scratch can prove costly and time-consuming. For that reason, it is advisable to acquire a white-label platform explicitly designed for prop trading. This approach will save you time and money, allowing your startup to decrease the time-to-market period and start generating profits early. 

While other aspects are essential, the most pressing challenge in creating the prop trading firm is obtaining abundant liquidity sources. Acquiring the liquidity reserves varies from industry to industry, with FX prop trading firms having an easier time while crypto prop traders could struggle considerably when scouring the market.

Obtaining liquidity can be achieved through various channels. Some companies like to negotiate investment deals with various funds, increasing the firm’s capital to satisfy monthly liquidity demands. Others might partner with liquidity providers in tier-1 or tier-2 niches. Opening a liquidity credit line with commercial or investment banks is also possible, but the eligibility criteria are quite high in such cases.

Choosing between these options depends on your current capabilities, aspirations and operating budgets. Tier-1 liquidity providers or investment banks might be the best choice for larger companies, while smaller companies can seek liquidity with tier-2 LPs. 

Operating a prop firm is all about managing monthly operational expenses cleverly and finding optimal trading strategies in the process. To achieve that, you must decide which liquidity provider will serve your needs consistently and without unpleasant surprises. 

Prop trading has gained a lot of momentum in recent years, introducing a trading model that rewards experimentation and creativity without skyrocketing the corresponding risks. However, to achieve success in prop trading, your primary concern should be obtaining a reliable and consistent liquidity source. 

If successful, your operations will be in good hands, and your business model will drive growth instead of deepening your debt hole. So, if you are considering opening a prop trading firm, carefully analyse the liquidity channels, providers, and their respective terms, as they could make or break your startup.