The US Securities and Exchange Commission (SEC) is investigating whether Merrill Lynch used knowledge about some of the share trades the brokerage conducted for its clients to make a profit on its own account.

The US watchdog’s probe centres on whether some current and former Merrill Lynch executives engaged in a practice known as "front running" which is when a brokerage receives a large order to buy or sell a particular share from a client and quickly executes its own trade in the same stock before addressing the client’s transaction.

The investigation is one of several the SEC is conducting into both Merrill Lynch and Wall Street as a whole as the watchdog seeks to clamp down on insider trading. The probe that emerged today relates to a number of Merrill Lynch trades from 2002 to 2006. One particular transaction is understood to relate to an order from Fidelity Investments, the mutual-fund operator.

The SEC declined to comment. Merrill Lynch stated it always co-operates with regulatory inquiries.

The investigation is understood to be fairly advanced although the SEC is not thought to have decided whether to file a civil lawsuit.

The SEC is also looking into how Merrill Lynch valued some of its investments in high-risk sub-prime mortgages i.e. home loans granted to individuals with a poor credit rating, and whether the bank should have disclosed the extent of the risks in its portfolio earlier.

Merrill Lynch reported an $8.4 billion (£4.2 billion) writedown in the third quarter, much of it relating to mortgage investments. It is expected to announce a further $10 billion to $20 billion sub-prime-related losses when the brokerage reports its fourth quarter figures.

Merrill Lynch is also expected to announce on Thursday that it has agreed a second capital injection, of about $4 billion, from investors thought to include the Kuwait Investment Authority. The infusion would follow a $6.4 billion investment last month from Temasek, the Singapore government-owned fund and Davis Selected Advisors, the US asset manager.

In a further sign that regulators are turning the screws on Wall Street, it emerged yesterday that the Financial Industry Regulatory Authority (Finra) is reviewing whether investment banks purposely bought shares in the target companies of deals they advised on.

A company’s shares typically soar once news of an impending takeover leaks because most deals are agreed at a significant premium to the recent stock price.

Finra, formed last year by the merger of the National Association of Securities Dealers and the enforcement unit of the New York Stock Exchange, began its investigation after seeing new research which suggested that some banks might be guilty of insider trading.

The research found that during the financial quarter before a US merger announcement, the investment banks leading the discussions for the acquiring company either bought shares, or increased existing holdings, in the target company 19 per cent of the time.

In those same deals, just 10.5 per cent of the banks not involved in that role – that is, acting for the target company, acting in some other subsidiary role or not involved in the transaction at all – bought shares over the same period.

The report examined more than 1,600 US deals between 1984 and 2003, together with quarterly filings of institutional share ownership, and was compiled by three professors of finance in Europe, including Andrei Simonov, of the Stockholm School of Economics.

Stephen Luparello, a senior Finra official, said the research definitely warranted an investigation although he acknowledged that the facts in the study "can have benign or nefarious explanations".

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