17 December
Capital Markets Law

Proprietary Trading in Turkey

by Dr. Ceylan Necipoglu, LLM, Selin Orkun and Yasemin Kocasakal 0 Comments

Proprietary Trading in Turkey

Proprietary trading (“prop trading”) is where a firm invests its own funds for profit rather than using a client’s money. The primary aim of prop trading is profit rather than earning commission from processing trades.

Although this is a general definition for prop trading, the term is also used to refer to “virtual” trading. In the platforms offering prop trading, traders access virtual capital and trade it in real market conditions, instead of using their own financial resources.

The underlying reason for engaging in virtual trading is to allow the traders prove themselves. Prop trading firms allow retail traders to trade with the prop trading firms’ funds and share a portion of the profits with them. However, traders need to prove their skills by taking on trading challenges, and most activities, even trading in funded accounts, happen in a simulated environment (1).

In a standard trading setup, a firm would derive its income on a commission or percentage basis by acting as a broker on behalf of its clients. In the case of prop trading, the firm is using its own funds, so it earns 100% of any profits or losses that it makes. The trader earns money based on an agreed share of any profits that s/he makes (2). In demo accounts, there is a fee to start a trading challenge, and the fee may change depending on the virtual account balance that the trader wishes to start with. The challenges have specific requirements in order for the trader to continue with the demo, such as the profit targets and maximum drawdowns. If the trader fails any challenge, s/he gets disqualified. However, if the traders complete the demo successfully, s/he is allowed to manage a real portfolio and share the profit.

Countries that Benefit from Prop Trading the Most

While prop trading has an important presence all over the world, it is more significant within some financial hubs.

The United States is one of these hubs, especially around the cities of New York and Chicago, hosting numerous prop trading firms and traders. There is a complex regulatory framework in the USA regarding the activity of prop trading firms, which allowed independent firms, prospering to offer funded accounts post-challenge success.

London, on the other hand, is another global financial center. The regulatory framework in the United Kingdom is not as strict, making it an attractive environment for prop trading firms.

Countries in the Asia-Pacific region, especially Singapore and Hong Kong are also important prop trading centers. They have favorable regulations and they allow access to fast-growing markets, together with their strategic geographical location and are pivotal regions for prop trading firms.

Australia and Canada are known for their commodities and natural resources markets. Prop trading firms in Canada offer unique opportunities for traders who are qualified to pass their challenges (3).

It is also important to mention the rise of prop trading in the Middle East. The Middle East, particularly the UAE, has become a center of finance around the globe. The favorable tax advantages, strategic location, and business-friendly environment make the region appealing. Due to their favorable regulations, cities like Abu Dhabi and Dubai have become popular for CFD (known as contract for difference) and cryptocurrency firms. Those locations are currently increasingly drawing in prop trading businesses as well.

The Middle East region gained significant attention recently in 2024 when regulatory issues began to rise in the US prop market. MetaQuotes, a provider of popular trading platforms like MetaTrader, withdrew licenses and services from many local firms, blocking access to clients from this part of the world. As a result, traders migrated to Middle Eastern entities and many firms began relocating to the UAE or neighboring countries. Currently, the UAE ranks as the third most popular jurisdiction among trader-funded firms, accounting for nearly 8% of them, right behind the United States and the United Kingdom (4). Middle East offers traders and firms access to highly-leveraged and a diverse range of trading instruments, making it an increasingly appealing destination (5).

Regulations in the EU

The main regulation for the financial markets in Europe is the Markets in Financial Instruments Directive (MiFID). MiFID II is the revision of the MiFID, originally promulgated in 2004. It is the foundation of the financial legislation for the European Union, which was designed to assist traders, investors, and other participants in the financial sector (6).

Entities engaged in prop trading or dealings on their own account are subject to complex regulations. The expanded scope of licensing requirements necessitates compliance with MiFID II regulations. Also, firms must ensure that their trading activities comply with the specific provisions set forth under MiFID II and applicable national laws.

Engaging in proprietary trading or dealing on one’s own account requires obtaining a license from the relevant national supervisory authority. This requirement applies to entities conducting such activities on a commercial scale or to a degree that demands a commercially organized business operation, irrespective of the legal form of the company. The criterion “dealing on own account” draws a difference between proprietary trading and commission business. In prop trading, the service provider bears the full risk of price and settlement, as opposed to acting on behalf of a client (7).

In 2023, Acuiti Proprietary Trading Management Insight Report which is based upon a quarterly survey of the Acuiti Proprietary Trading Expert Network, indicated that more than a quarter of firms were considering giving up their MiFID II license due to the Investment Firm Prudential Regime (IFR/D), effectively causing their operations to cease in European markets. In addition, around half of firms were considering moving their European trading activities outside the EU or UK in order to avoid the burden of regulation.

The IFR/D, which took effect in 2021, was intended to establish a more relaxed capital and governance framework for MiFID II investment firms that would have otherwise fallen under more strict banking regulations. However, for prop trading firms, it has led to excessively high capital requirements and considerable governance challenges.

According to the survey, while almost three quarters of the firms stated that their capital requirements had increased, just 12% of respondents said that they believed the new rules properly reflected the financial risks their company created for the market. 92% of the participant firms said that their reporting requirements had become more of a burden (8).

Depending on the size of the firm and the instruments traded, IFR/D presented different challenges. In May 2023, no prop trading firm met the criteria for the Class 3 classification, which was intended to offer a lighter capital and governance framework. Smaller prop trading firms, categorized as Class 2, have reported facing capital requirements that are significantly higher than the margin they are required to maintain, in addition to complying with strict governance rules related to clawbacks, non-cash bonuses, and the creation of independent pay review bodies. For larger firms, the risk is that they may be classified as Class 1 firms if their assets surpass a certain threshold (8). Class 1 firms are supervised under the Single Supervisory Mechanism (“SSM”) if they are in the Eurozone, and under the SSM, the European Central Bank is the central prudential supervisor of financial institutions. They are also regulated under the Regulation (EU) No 575/2013 (“CRR”) and Directive 2013/36/EU (“CRR IV”). In 2013, the Capital Requirements package entered into application, comprising CRD IV and CRR. The framework, collectively known as CRD IV / CRR, mainly designed for banks, also applies to investment firms, including those that trade commodities. The rules mainly address the amount of capital and liquidity that banks and investment firms hold (9) (10). This means that Class 1 firms are effectively regulated as a bank.

Recently in 2024, “The business models used by firms engaged in prop trading (technically, referred to as, funded trader services) can take various forms, some of which may be subject to the MiFID regulatory framework,” the Czech National Bank told Finance Magnates. It added, “In those scenarios, we believe that the relevant MiFID services could be: Reception and transmission of orders in relation to one or more financial instruments; execution of orders on behalf of clients; or dealing on own account. however, in other cases, the exemptions from MiFID apply, and in such cases, the prop trading entity is not subject to the supervision of the Czech National Bank and does not need to be supervised. Also, should there be a suspicion of fraud, we stress that such conduct would be subject to criminal law” (1). In this context, it is worth mentioning that one of the top prop trading companies, FTMO, is domiciled in the Czech Republic.

In May 2024, reports came out stating that the European Securities and Markets Authority (“ESMA”) had conducted a preliminary examination of prop trading companies. It can be assumed that the ESMA is collecting data, analyzing the field, and examining the potential need to regulate the field by enacting specific regulations. Regulatory authorities in Italy (11), Belgium (12), and Spain have also recently issued warnings to the public about the risks involved in the services offered by prop trading companies, after they received several complaints from users (13).

Regulations in the USA

The Volcker Rule restricts banking entities from engaging in proprietary trading and from owning, sponsoring, or having certain relationships with a hedge fund or private equity fund. A bank that does not have (and is not controlled by a company that has) more than $10 billion in total consolidated assets and does not have (and is not controlled by a company that has) total trading assets and liabilities exceeding 5 percent or more of total consolidated assets is excluded from the restrictions of the Volcker Rule (14).

Title 17, Sec 255.3 of the Code of Federal Regulations is about prohibitions on proprietary trading and states that except as otherwise provided in the said subpart, a banking entity may not engage in proprietary trading (15).

Similarly, Section 13 of the Bank Holding Company Act (BHC Act) contains certain restrictions on the ability of a banking entity or nonbank financial company supervised by the Board to engage in proprietary trading and have certain interests in, or relationships with, a hedge fund or private equity fund (covered funds) (16). Also, regarding non-bank entities, the rule is as follows:

“Any nonbank financial company supervised by the Board that engages in proprietary trading or takes or retains any equity, partnership, or other ownership interest in or sponsors a hedge fund or a private equity fund shall be subject, by rule, as provided in subsection (b)(2), to additional capital requirements for and additional quantitative limits with regards to such proprietary trading and taking or retaining any equity, partnership, or other ownership interest in or sponsorship of a hedge fund or a private equity fund, except that permitted activities as described in subsection (d) shall not be subject to the additional capital and additional quantitative limits except as provided in subsection (d)(3), as if the nonbank financial company supervised by the Board were a banking entity.” (17)

One last important note about the approach of the U.S. regarding prop trading is related to the Rules 3a5-4 and 3a44-2 under the Securities Exchange Act of 1934 (“the Exchange Act”) introduced by the U.S. Securities and Exchange Commission (“SEC”) on February 2024. These rules significantly broaden the definition of “dealers” and “government securities dealers.” As a result of this regulation, proprietary trading firms that are classified as dealers or government securities dealers under these rules will face substantial changes. They will be required to register with the SEC and Financial Industry Regulatory Authority (“FINRA”), comply with the Exchange Act and relevant SEC and FINRA regulations (such as net capital requirements), and undergo examination by the SEC and FINRA (18).

It is understood from the provisions that prop trading is accepted as a legitimate service in the U.S. subject to consistent supervision, and that only banking entities, except from the ones exempted from the Volcker rule, are prohibited from providing this service.

Prop Trading in Türkiye

Prop trading in Türkiye is not as recognized as much as it is around the world. Since there are no regulations specific to prop trading in terms of legislation, how these companies would be evaluated is partially left to the discretion of the law enforcers and audit entities.

The most relevant regulatory framework is explained as follows:

The activities of both local and foreign investment institutions in Türkiye are regulated under the Capital Markets Law No. 6362 (“CML”) and the secondary legislation also issued by the Capital Markets Board (“CMB”) of Türkiye.

Capital market institutions that are listed in Article 35 of CML are generally under the supervision and authorization of CMB. The listed institutions are defined in the CML as capital market institutions whose establishment and operating principles are determined by the CMB to provide investment services and activities. Investment services and activities covered by this Law are regulated in Article 37 of the CML, they will also be deemed responsible in accordance with the obligations imposed by the CMB.

Other than CML, there is also the Communiqué on Principles Regarding Investment Services and Activities and Ancillary Services III-37.1 (“Communiqué”) which regulates operational principles for brokerage firms, banks, and capital market companies established to offer investment services and activities. The Communique defines the requirements for obtaining operating licenses for other capital market institutions specified by the CMB, as well as the principles that must be followed in the provision of investment services, activities, and ancillary services.

At its essence, proprietary trading, does not fit into the description of any institutions mentioned in CML’ s relevant articles, and therefore may not be subject to the authorization of and/or other obligations imposed by the CMB.

Nonetheless, it is important to note that for some prop trading is considered a “leveraged transaction”. In Türkiye, as stated in the Press Release on Unauthorized Leveraged Transactions by the CMB dated 23.02.2023, investors residing in Turkey are only permitted to carry out leveraged transactions (“forex”) through institutions authorized by the CMB as per the CML (19). If such transactions are conducted by individuals or entities not authorized by the CMB, it is considered a crime of unauthorized capital market activity. According to the second paragraph of Article 109 of the CML, those involved in unauthorized capital market activities may face imprisonment ranging from two to five years and a judicial fine between five thousand to ten thousand days.

Unlike other countries mentioned above, prop trading in Türkiye is still a very foreign and unregulated concept. It is a rather gray area that has not yet found a place for itself within the currently applicable legislation.

Conclusion

Proprietary trading offers a valuable opportunity for both companies and traders by combining traditional trading methods with virtual trading platforms. The use of virtual trading and demo accounts reduce the risk for traders, offering a chance for those aspiring to become professional traders. As virtual demo trading platforms gain popularity, individual traders now have the chance to trade in live market conditions without risking their personal funds. These platforms have attracted more investors into the field, leading to an increase in the number of prop trading firms globally. Nonetheless, with increasing regulatory scrutiny from lawmakers, new rules regarding transparency and security, especially in virtual trading, are likely to emerge. Prop trading firms will have to adapt their strategies to meet these evolving regulations in order to stay in business.

 

Resources

Sermaye Piyasası Kurulu, İzinsiz Kaldıraçlı İşlemlere İlişkin Basın Duyurusu, 23 Şubat 2023 (https://spk.gov.tr/duyurular/basin-duyurulari/2023/izinsiz-kaldiracli-islemlere-iliskin-basin-duyurusu)

Dr. Ceylan Necipoglu, LLM
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