The Client Order, the Proprietary Desk and the 40-Lot Head Start
A senior adviser at an NZX derivatives participant receives a client instruction at 10:05am to buy 150 NZX dairy futures contracts (WMP) over the day. The market's average daily volume is 220 contracts. At 10:12am the adviser's firm's proprietary desk buys 40 contracts for its own book. The adviser then executes the client order in slices from 10:20am to 3:00pm. The client's fills average USD 3,082/tonne. The proprietary position is sold at 3:05pm at USD 3,094/tonne. The adviser did not disclose the proprietary trade to the client. The firm's conflicts policy says proprietary trading is permitted 'subject to best execution'. A junior dealer asks whether this is acceptable.
1. Identify the conduct and market-integrity issues in the sequence of events.
Read the worked answer
The sequence suggests front-running or pre-positioning ahead of a known client order. The proprietary desk bought 40 contracts, about 18% of average daily volume, after the firm knew about a 150-contract client buy order in an illiquid market. That can move the price against the client and give the firm a profit from information it holds as agent. The 12-point gain on 40 contracts is 40 x 10 tonnes x USD 12 = USD 4,800, before costs.
Key issues are: misuse of confidential client order information; failure to disclose the conflict; possible breach of best execution; and failure to manage information barriers between the advisory and proprietary desks. The policy wording 'subject to best execution' is too vague. Even if pre-hedging can be legitimate in some markets, it requires a documented policy, client disclosure or consent where appropriate, strict timing and size limits, and evidence that the client was not disadvantaged.
2. What should the firm have required before permitting the proprietary trade?
Read the worked answer
The firm needed a specific conflicts-of-interest policy covering client order information and proprietary pre-hedging. It should have required the proprietary desk to be walled off from client order flow, or at minimum to obtain approval under a documented pre-hedging framework before trading. That framework should define when pre-hedging is allowed, the maximum size relative to the client order and market volume, the timing, and how the client is disclosed or consented to.
The firm should also have monitored best execution: comparing the client's average price with the market before and after the proprietary trade, and checking whether the 40-lot purchase worsened the client's fills. The trade should have been recorded in the order and conflicts registers, with a rationale. If the firm could not demonstrate a client benefit or proper disclosure, the proprietary trade should not have occurred.
3. How should the junior dealer respond, and what records should be preserved?
Read the worked answer
The junior dealer should not ignore the issue or discuss it informally with the adviser. They should escalate promptly to compliance or the appropriate control function, in writing if possible, and preserve all relevant records: the client instruction and timestamps, the order slices, the proprietary trade tickets and times, communications between the adviser and proprietary desk, the client's average fill, market data around the trades, and the conflicts policy.
The dealer should avoid altering or deleting messages and should not tip off the adviser in a way that compromises the review. Compliance should assess whether client order information was misused, whether the client should be remediated, whether the trade should be reported to the market operator, and whether the adviser or desk should be restricted pending the outcome. The junior dealer should cooperate with the investigation and document their own actions.