Program Trading & Pre-Hedging

FSA recently banned and fined trader Nilesh Shroff for deliberately disadvantaging his customers by "pre-hedging" trades without their consent. Shroff has been prohibited from performing any regulated function on the grounds that he is not fit and proper and has been fined £140,000.

While Shroff was a senior trader at Morgan Stanley, FSA found that he disadvantaged his clients on seven occasions between June and October 2007 by partially "pre-hedging" program trades without the clients' consent.

At the material time, Mr Shroff's position at Morgan Stanley was executive director, risk-trading program and his role included the management of the programme trading risk book and the facilitation of program trades on behalf of clients. This involved the preparation of pricing and the execution of trades and the ongoing management of the risk portfolio. The overall objective of the risk book was to manage risk from customer trades.

"Program trading" is the term used to describe a transaction or series of transactions by an institution when acquiring or disposing of an entire portfolio or a material part of a portfolio. Program trades can be all "one way" or a combination of buys and sells.

All the program trades made by Mr Shroff on behalf of clients were made on a principal (rather than agency) basis. For a principal trade, typically a number of brokers will be asked to tender to acquire the portfolio from or for the institution, quoting a premium or discount to the mid-price for each security at a designated strike time, which is known as the "snap". The premium or discount (the "risk fee") is expressed in a number of basis points. Transactions with brokers are often conducted via an institution's centralised dealing desk.

Principal trades are attractive to customers who want to undertake a large number of trades at the same time but do not want to assume the risk of the share prices moving against them in the period between the commencement and completion of trading. The broker assumes that risk in return for the risk premium.

The execution of a principal programme trade usually involves the following steps:

1. The customer provides limited information about its portfolio, e.g. sectors and percentages of average daily volume ("ADV"), to a number of brokers to enable them to assess the risk and quote for the trade, but without disclosing the component securities and, usually, whether the customer is a buyer or a seller in respect of each;
2. The customer receives the quotes from the brokers;
3. The customer reviews the quotes and awards the trade to one of the brokers;
4. The customer communicates the award to the winning broker and a snap time is agreed;
5. The customer provides the broker with the full details of the component securities and indicates whether they are buying or selling; sometimes this information is provided before the snap but more usually afterwards. In the case of the trades referred to in this notice, details of the portfolios were provided to Morgan Stanley before the snap;
6. Each stock is supplied to or purchased from the customer by the broker at the snap time at the quoted premium or discount to the mid-market price.

"Pre-hedging" refers to trading by a broker for his firm's benefit in advance of carrying out a trade for his customer, using information provided by that customer. Where customers instructed Shroff to buy particular stocks, he bought those stocks for the firm first, causing the price to increase before he executed the customers' trades. Where the customer order was to sell he first sold on behalf of the firm, decreasing the price. Shroff knew such unauthorised pre-hedging was expressly prohibited by FSA and Morgan Stanley's policies and not in his clients' interests.

It appears that pre-hedging is a kind of front-running in the context of program trading.