The US Securities and Exchange Commission (SEC) has launched an inquiry into Wall Street’s top banks, after mutual funds accused them of leaking share trading information to favoured hedge fund clients.

The American financial watchdog is examining the trading activity of ten big investment banks, including Merrill Lynch, Morgan Stanley, UBS and Deutsche Bank, as it seeks to determine whether they tipped off clients before large share trades.

The investigation, described by the SEC as a “fact-finding effort”, is aimed at establishing the extent of insider trading on Wall Street.

Hedge funds and other investors can make substantial profits if they know about big market-moving stock trades before they are made public, by “front-running” or trading ahead of the disclosure.

This can work against the mutual funds’ trades by affecting the share price before they execute the deal.

It is understood that the SEC’s investigation was prompted by complaints from mutual funds that the practice of front-running was becoming increasingly common.

The pool of money at the disposal of hedge funds has soared to more than $1,000 billion (£508 billion) in recent years and they now control between 30 per cent and 50 per cent of trading on most of the world’s leading stock markets.

This has made them a huge source of income for Wall Street banks, whose prime brokerage units split about $10 billion last year for lending securities, processing trades and holding assets on behalf of hedge funds, according to Tabb Group, the consultancy.

Morgan Stanley is estimated to make more than $2 billion a year from prime brokerage, according to Sanford C Bernstein, the research firm.

The SEC has sent letters to those Wall Street firms with big prime brokerage units as it seeks to determine whether they have leaked sensitive information to clients.

The letter, signed by Lori Richards, director of the SEC’s office of compliance inspections and examinations, asks to see all share and option-trading data that the firms conducted, both for themselves and their clients, in the last two weeks of September. It will be examining Wall Street’s trades in tandem to see if any improper trade was placed.

Miss Richards said: “We are always concerned about information leakage into the market which could leave investors at a disadvantage. This is a fact-finding effort, not an examination based on specific tips about misconduct at any particular firm.” If the commission finds any evidence of possible insider-trading, it will commence a formal investigation.

Merrill Lynch, Morgan Stanley, Deutsche Bank and UBS declined to comment on whether they had received a letter from the SEC.

Precedent set

In the biggest case of Wall Street being punished for favouring clients, the SEC, the financial watchdog, and Eliot Spitzer, then New York attorney-general, fined 12 brokerage funds $1.5 billion. The banks, including Bear Stearns, Citigroup, Goldman Sachs and Lehman Brothers, were accused of allowing researchers to slant their company reports in a bid to secure lucrative investment banking business. The banks denied any wrongdoing.

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