This item examines an issue that wealth managers at the sharp end of managing clients’ money must grasp - proprietary trading how this can conflict with the best interests of clients.

The following item examines an issue that wealth managers at the sharp end of managing clients’ money need to be aware of – the issue of proprietary trading by firms and how this can conflict with the best interests of clients. Here, Charles Lek, managing director of Lek Securities UK, takes a brief look at this area of finance. This publication is glad to share these insights although it does not necessarily endorse all the views expressed here. The lessons in this article, while drawing on European examples, are global, so we hope readers in Asia and other regions find them useful.

The collapse of Bear Stearns and Lehman Brothers followed by the scandal of MF Global has shown that proprietary trading stands in direct conflict with client interests. In a recent consultation paper published by the European Securities and Markets Authority in preparation for the implementation of MiFID II/MiFIR (ESMA/2014/549) – a range of regulatory changes designed to protect investors in European markets - the European Commission has stressed the importance of selecting a suitable prime broker, especially for wealth managers who have a fiduciary commitment to their clients. One area that many firms overlook is whether their broker is engaged in proprietary trading, either directly or within the group.

In selecting a prime broker, many managers used to simply look at the balance sheet. However, a bigger balance sheet can mean bigger problems when a brokerage house is engaged in proprietary trading. In the wake of the 2008 meltdown, clients have learned the hard way that a balance sheet comprised of proprietary assets means nothing in terms of client protection. MiFID II Article 16 demands that firms make adequate arrangements when safeguarding client assets. Firms must now look past the big numbers and delve deeper into the inner workings of their custodian.

One controversial topic is the use of Title Transfer Collateral Arrangements, or TTCA, which has become a heated concern within the industry. Here, brokers can exercise a right of use, which means that client assets are transferred to the broker to secure a line of credit. This type of arrangement is attracting some real scrutiny especially when it comes to retail investors. Wealth managers must ensure that their clients are not subject to such terms as client funds can easily become yet another asset for brokers to use as security to engage in speculation.

Best execution
Brokerage houses engaged in proprietary trading as well as the safeguarding of client assets can also be problematic when it comes to best execution. MiFID has long stressed the importance of providing clients with best execution. Managers are responsible for ensuring their clients receive the best treatment, and routing orders to firms acting as principal can mean poor execution quality.

Managers also need to be wary of firms that act as agents but which do not allow clients to self-direct orders. Here many brokers advertise low commission as orders are routed to dark pools and liquidity aggregators where brokers earn rebates. Even worse, firms may even route orders as agents back to a proprietary desk within their own group.

Traders and wealth managers are starting to take note that firms engaged in proprietary trading and payment for order flow are actually their biggest competitors. Clients need to ensure their portfolio and trading secrets are kept safe, and when their broker is engaged in speculative trading, it can be difficult to shield client portfolios from prying eyes. The wealth sector spends billions on analytics trying to find the next big thing; and managers need to know that their assets are being held by firms with no vested interest in what clients hold.
Proprietary trading is a very profitable part of many large brokerage houses. This has led many firms to pump billions into their own front end technology, whilst neglecting their client base and in some cases exploiting them.

In today’s markets, clients are demanding more from their providers, however many brokerage houses still offer a light-touch approach. As many prime brokers continue to focus on their own portfolio, wealth managers are forced to employ more third parties to comply with changing regulations, much of which are client centric. The need to outsource means higher overheads and can result in a loss of brand recognition as more third parties sit between managers and their clients.

In today’s markets, portfolio managers need to know that their brokerage house is not on the other side of their trade. This has led many firms to look through the thin veil of low commissions offered by firms engaging in payment for order flow and large balance sheets comprised of proprietary assets. Over the last few years, Lek Securities has witnessed an increase in demand for prime brokerage services, especially under a white labeled Model B clearing arrangement.

By selecting a firm that does not engage in speculative trading, managers can get back to the basics of putting their client’s interests first.