Principal trading works in a fairly straightforward fashion. A financial institution, such as a broker or a bank, buys and sells securities using its own funds and not on behalf of its clients. Therefore, the institution is the one that bears the risks and benefits associated with holding these assets. Once the price of the assets reaches a desired level, the institution then sells them for a profit. Principal trades may be characterized by high volumes, such as those done by banks and brokers with billions of dollars in expendable capital, who typically hold large positions for substantial profits. 

"I think just don't try and compete with the big money machine, the funds, the hedge funds, the professional traders, the institutional traders.. these people have got microsecond low latency connectivity
they, definitely know the news before you do.. they've already priced it in they've already made their money and so you can't compete with that. So just avoid trying to compete with the thing, the areas in which you've got no chance of doing better than them. There are areas where they actually have no advantage over you and why not go for that.. where you're really on a level playing field with them" - Trevor Neil

Essentially, financial institutions engaged in the principal trading act as market makers and enhance liquidity for every other market participant. Institutions may resort to principal trading to trade a broad range of securities, such as stocks and CFDs, Forex, commodities, etc. 

Similarly to principal trading, proprietary, or prop trading, involves financial institutions using their own capital to buy and sell securities on the market. Typically, the trading teams of the institution are assigned a capital budget they can use to identify favorable short-term speculative trades on the market and make the most of them using a variety of complex trading tools. Often, prop trading involves the use of high-frequency algorithmic trading with limited human input. 

The primary focus of proprietary trading is to take advantage of short-term fluctuations in the market to generate profits, as opposed to the market-making capabilities of principal trading. 

Institutions use a number of different metrics to evaluate their proprietary trades, such as risk/reward ratios and risk-adjusted return on capital, or RAROC. 

Now that we have covered principal and proprietary trading individually, we can identify the key similarities and differences between the two methods of trading used by financial institutions. 

Similarities

• In both cases, institutions use their own capital to fund trading activity. For example, financial institutions may use principal or proprietary approaches for Forex trading to offset foreign exchange risk or profit from it
• Both principal and proprietary trading involve taking on risks in exchange for profits for the financial institution involved
• Trading in both cases is done by a designated team of highly skilled traders that are assigned a definite amount of capital they can use to execute trades 

Differences 

• In principal trading, the financial institution acts as a market maker by buying and selling on the market and creating liquidity for other players as well. Principal trading involves buying and selling assets for the inventory of the financial institution, while prop trading serves a purely speculative purpose
• Typically, principal trading is less risky than proprietary trading, as it is not solely focused on making short-term profits from market movements 
• Principal trading is subject to much less regulatory scrutiny than proprietary trading, as it is considered to be a regular banking activity, while prop trading is speculative 
• Profits from principal trading are more stable, as they are generated by trading spreads, while prop trading profits depend on market movements 

• Principal and proprietary trading are two ways financial institutions participate in capital markets using their own funds 
• Principal trading creates liquidity in the market and generates profit from the spread between buying and selling prices 
• Proprietary (prop) trading is done to generate short-term profits by effectively timing market movements 
• While there are some similarities between principal and proprietary trading, they serve entirely different purposes and as subject to a different degrees of regulatory scrutiny
• Principal trading is considered to be a safer and more stable alternative, while proprietary trading is exposed to more market risk