Have you ever heard of something called a prop desk? The word “prop” is the short form for “proprietary” and refers to what is known as a proprietary trading desk or book.

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If you are an investor in the stock market and haven’t heard of it, you would be well advised to learn as much as you can about it – and the sooner you do so, the better.

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Recently, we were asked for our views on dealing with brokers who have prop desks; the concern being that if the activities of such desks go unchecked, some stockbrokers could potentially engage in “front running.”

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Front running is when brokers buy the very shares that their clients want to buy, and buy them ahead of their clients.

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The rationale for doing this is to buy shares at a price lower than that for client, in the hope that these brokers will benefit when the share price goes up.

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Such brokers expect that the price of such shares will go up when their client starts buying them, which is usually the case when their client’s order is large or when the stock they want is illiquid.

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We gathered market intelligence and asked around various broking houses in the region and were amazed to learn that a good many of them not only have such desks, but lack adequate monitoring systems.

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Put simply, traders use a prop desk to reap profits for the broking house. Generally speaking, profits from the prop book – that is, a broking house’s own order to buy shares – are used to pay staff bonuses or reward them.

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The flip side is, of course, that the brokers could lose money on the desk too.

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In theory, Chinese walls – or firewalls, in cyber-speak – are supposed to exist between the execution of a client’s order and the prop book.

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The broking house should have solid and satisfactory compliance checks and balances so that the clients’ trading division and the prop desk division are kept entirely separate, and the personnel within each division are kept in the dark about the other’s specific activities.

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If done well, this will prevent front running ahead of orders from clients. The question, then, would be whether the Chinese walls have enough integrity, given the huge sums that brokers can rake in from proprietary trading.

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Globally, there have been situations where investment bank salesmen, who encourage their retail or institutional clients to buy specific securities, assist their own proprietary traders by encouraging their external clients to buy securities that have performed poorly after the proprietary traders have bought them.

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Many international firms now use brokers who have nothing to do with their clients to handle their prop books so as to separate the conflicting profit flows and also ensure that there cannot even be a hint of front running.

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This has been viewed very positively by many regulators as well as end clients, like fund managers.

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Despite the theory of maintaining clear Chinese walls, we are told that, in practise, some broking houses set aside specific rooms for their prop desks, but do not allocate specific traders to run the prop book.

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We have also learnt that traders can walk in and out of these rooms, placing trades along the way when they think there is an opportunity to make a profit.

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These are the same people executing orders for large institutional clients.

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Clearly a box-ticking measure, such as giving prop desks a separate site physically, is not effective without a separation of activities to stop such front running.

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The other issue that was highlighted was that some international broking houses operate prop books in the region but declare that they don’t have any within the local jurisdiction in which they operate.

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These groups create a specific global entity to operate the prop book. With such an opaque set up, it is very difficult for the local authorities to track if there is any commingling between clients and in-house proprietary trading.

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These broking houses are then able to buy, say, Malaysian stocks for their prop book, while the stock position is held in Hong Kong within their Hong Kong prop book.

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The Malaysian division of this international entity does not have to declare to anyone that they have a prop book.

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Given this, we suggest the following:

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●  Brokers with prop desks should declare these to clients and regulators;

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●  They should tell regulators of any offshore prop desks that they have;

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●  Place an adequate system to identify potential conflicts of interest;

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●  Ensure that there is no commingling of client and proprietary trades;

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●  Have effective compliance and control measures to track in-house trading trends; and

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●  Audit regularly, the clients' as well as prop book orders.

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In fact, just on Thursday, US President Barack Obama announced new measures to restrict proprietary trading, which he considers one of the riskier practices.

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It is clear from what we have shared above that there is still a great need to make prop desk activity tighter and as transparent as possible to all.

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So investors and regulators alike should ask their brokers harder questions. Otherwise, they could well end up as the victims of the latter’s self-interests.