Retail prop trading continues its rapid expansion, but how well are retail prop firms regulated?
In addition to examining the current state of global proprietary firm regulation, prospective retail prop traders must understand the difference between retail and professional prop trading, how prop firms operate, how they earn revenues, and what risks are involved.
What Is the Current State of Prop Firm Regulation?
Retail prop firms are unregulated but duly registered companies. So, how can prop firms operate without a license or regulation?
Retail prop firms offer demo accounts, and no trading takes place. They are service providers, and traders pay a fee or subscription, like for a magazine or a gaming platform. No money changes hands, no trading occurs, and no trading income exists. Therefore, no financial regulation applies, as retail prop firm trading represents the troubling gamification of trading.
Prop firms that allow traders to manage live portfolios use the firm’s capital, and the prop traders are not liable for losses. However, designation as a live portfolio manager is only granted to a small minority of the retail prop sector.
Key Prop Firm Facts Retail Traders Must Understand
- Retail prop traders at non-US prop firms pay for an evaluation based on their desired account size. Traders who pass it will get their account, but it is a demo account. Retail prop traders will not manage live portfolios or generate income, with few exceptions that apply to less than 1% of funded traders.
- While prop firms can copy the trades of trusted retail prop traders into live portfolios if they choose, most prop firms earn their revenue from failed prop firm challenges, which cater to beginners who have no business attempting the high-stress, performance-based, pressured world of prop trading. In most cases, no trading takes place, and the 90%+ failed challenges are sufficient to pay the small percentage of funded traders and make a profit for the prop firm.
- Most US-based prop firms offer retail traders funded accounts via monthly subscriptions and live accounts with tight risk management and restrictive trading conditions. The same principle applies to evaluation-based retail prop firms.
How an Evaluation-Based Retail Prop Firm Operates
Let’s look at an example of how retail prop firms can generate revenues from traders, without any live trading taking place.
Assume 10,000 traders pay an average one-time evaluation fee of $99. The retail traders trade in a demo account, while the prop firm earns $990,000 in revenue.
Let’s say 800 traders pass the evaluation and become funded traders with an average portfolio of $25,000 (please remember that the $25,000 is in a demo account). At this point, consider if 3,500 of the traders who failed their challenge give it another chance, paying $99 again, and earning the prop firm a further $346,500 in revenue, with 100 passing the challenge the second time.
Let’s say 700 of the 900 funded traders violate the strict trading rules and lose their account, with 500 of those traders who lost their account giving it another chance, paying an additional $99, and making the prop firm another $49,500 in revenue. In this scenario, the retail prop firm generated $1,386,000 in revenues with $0 payouts.
So, if 90 traders qualify for a $3,500 payout, the prop firm pays out $315,000 total to these 90 traders and has a $1,071,000 gross profit (the most substantial expense for retail prop firms is marketing, followed by technology).
Up to this point, no trading has occurred.
Since no live trading occurs, retail prop firms require no regulation. The best way to think of retail prop firms is that traders pay a fee to play a financial game with a small chance to receive a cash payout. This echoes the post-Covid boom in play-to-earn mobile games popular across Asia.
What the Present Lack of Regulation Means in Practice
The current absence of regulation means no protection for traders. Since the entire retail prop trading sector functions like an online game rather than a professional financial operation, regulatory protection is not warranted.
Anyone of legal age who can afford the fee can participate in the online financial game known as retail prop trading. The worst case is when retail prop firms offer beginner education, as this can create a false sense of preparedness.
Here Is the Twist
Retail prop firms promise payouts to traders, and the only reason traders purchase evaluations is because they hope to comply with the strict rules to qualify for a payout. Therefore, retail prop trading moves further from financial regulation and more into the gambling sector. Think of going into a casino, playing in an online casino, or purchasing a lottery ticket, winning, and the operator refusing to pay the winnings. The lack of regulatory oversight means traders who never received a payout have few options. They could hire a lawyer, but the legal costs would dwarf the payout, with the highest average payout lower than $4,000.
Prop firms can monitor performance and choose to profit from strategies with limited risk by allowing professional traders to copy select trades or strategies under their oversight. They can reverse-engineer strategies and earn money from strategies after they revoke access to traders. It is like stealing the patent for an invention and then commercializing it.
Since retail trading is not a professional financial business but mirrors online gaming and gambling, financial regulation should not apply. The same rules for gaming and gambling should apply, and retail prop firms should clearly state this to prospective traders. Currently, most prop firms have a statement on the bottom of their homepage written in fine print that all trading remains simulated in demo accounts.
Prop firms ensure that enough traders receive a payout to generate sufficient positive comments and attract more traders. These examples reinforce the message that if traders follow the rules and accumulate demo profits, they receive payouts.
Likely Future Regulation
Financial regulators cannot keep up with policing legitimate financial operations. Therefore, they lack the resources and should never consider regulating financial online games, regardless of their popularity. Consumer protection laws apply, and the best-case scenario is regulatory oversight from the authorities that oversee gambling to ensure that retail prop firms pay traders who meet the requirements.
What Future Regulation Will Mean for Prop Firms and Their Clients
Any attempt by financial regulators to intervene would cross regulatory jurisdictions with the gaming and gambling industry. Still, a joint task force between financial, gaming, and gambling regulators could provide more transparency.
Here Are a Few Potential but Unlikely Outcomes
- Prop firms would clearly state that their offer is an online financial game with a warning as a screen-wide pop-up when traders and gamers visit their website
- Regulators could require prop firms to only accept traders with a proven history meeting select criteria (for example, a minimum of three years trading a live portfolio with a minimum balance of $10,000 and 20+ monthly average trades with an average lot size of 1.0 standard lot)
- Third-party assessment tests to ensure traders meet basic requirements for prop trading
Some Final Thoughts
Retail prop trading could be considered an online financial game rather than a professional financial operation. While a talented trader could become one of the few to earn a payout through compliance with tough trading rules, the majority risk losing the entirety of the evaluation fee they have paid to the prop firms. Moreover, without regulatory protection, it is challenging for traders to hold a prop firm accountable if it does not meet its commitments.
