, is the prohibited practice of entering into an equity (stock) trade,optionfutures contractderivative, orsecurity-based swapto capitalize on advance, nonpublic knowledge of a large (block) pending transaction that will influence the price of the underlying security.In essence, it means the practice of engaging in a Personal Securities Transaction in advance of a transaction in the same security for a clients account.Front running is considered a form of market manipulation in many markets.Cases typically involve individual brokers or brokerage firms trading stock in and out of undisclosed, unmonitored accounts of relatives or confederates.Institutional and individual investors may also commit a front running violation when they are privy toinside information. A front running firm either buys for its own account before filling customer buy orders that drive up the price, or sells for its own account before filling customer sell orders that drive down the price. Front running is prohibited since the front-runner profits from nonpublic information, at the expense of its own customers, the block trade, or the public market.
In 2003, severalhedge fundandmutual fundcompanies became embroiled in an illegal late trading scandal made public by a complaint againstBank of Americabrought by New York Attorney GeneralEliot Spitzer. A resultingU.S. Securities and Exchange Commissioninvestigation into allegations of front-running activity implicated Edward D. Jones & Co., Inc.,Goldman SachsMorgan Stanley, Strong Mutual Funds,Putnam InvestmentsInvesco, andPrudential Securities.7
Following interviews in 2012 and 2013, the FBI said front running had resulted in profits of $50 million to $100 million for the bank. Wall Street traders may have manipulated a key derivatives market by front runningFannie MaeandFreddie Mac.8
The terms originate from the era when stock market trades were executed via paper carried by hand between trading desks.9The routine business of hand-carrying client orders between desks would normally proceed at a walking pace, but a broker could literallyrun in frontof the walking traffic to reach the desk and execute his own personal account order immediately before a large client order. Likewise, a broker couldtail behindthe person carrying a large client order to be the first to execute immediately after. Such actions amount to a type ofinsider trading, since they involve non-public knowledge of upcoming trades, and the broker privately exploits this information by controlling the sequence of those trades to favor a personal position.10
For example, suppose a broker receives a marketorderfrom a customer to buy a large blocksay, 400,000 sharesof some stock, but before placing the order for the customer, the broker buys 20,000 shares of the same stock for his own account at $100 per share, then afterward places the customers order for 400,000 shares, driving the price up to $102 per share and allowing the broker to immediately sell his shares for, say, $101.75, generating a significant profit of $35,000 in just a short time. This $35,000 is likely to be just a part of the additional cost to the customers purchase caused by the brokersself-dealing.
This example uses unusually large numbers to get the point across. In practice, computer trading splits up large orders into many smaller ones, making front-running more difficult to detect. Moreover, the U.S.Securities and Exchange Commissions 2001 change to pricing stock in pennies, rather than fractions of no less than 1/8 of a dollar11, facilitated front running by reducing the extra amount that must be offered to step in front of other orders.
By front-running, the broker has put his or her own financial interest above the customers interest and is thus committingfraud. In the United States, he or she might also be breaking laws onmarket manipulationorinsider trading.
Front-running may also occur in the context of insider trading, as when those close to theCEOof a firm act throughshort salesahead of the announcement of a sale of stock by the CEO, which will in turn trigger a drop in the stocks price. Khan & Lu (2008: 1) define front running as trading by some parties in advance of large trades by other parties, in anticipation of profiting from the price movement that follows the large trade. They find evidence consistent with front-running through short sales ahead of large stock sales by CEOs on theNew York Stock Exchange.
While front-running is illegal when a broker uses private information about a clients pending order, in principle it is not illegal if it is based on public information. In his bookTrading & Exchanges, Larry Harris outlines several other related types of trading. Though all these types of trading may not be strictly illegal, he terms themparasitic.
A third-party trader may find out the content of another brokers order and buy or sell in front of it in the same way that a self-dealing broker might. The third-party trader might find out about the trade directly from the broker or an employee of the brokerage firm in return for splitting the profits, in which case the front-running would be illegal. The trader might, however, only find out about the order by reading the brokers habits or tics, much in the same way that poker players can guess other players cards. For very large market orders, simply exposing the order to the market, may cause traders to front-run as they seek to close out positions that may soon become unprofitable.
Large limit orders can be front-run byorder matchingor penny jumping. For example, if a buylimit orderfor 100,000 shares for $1.00 is announced to the market, many traders may seek to buy for $1.01. If the market price increases after their purchases, they will get the full amount of the price increase. However, if the market price decreases, they will likely be able to sell to the limit order trader, for only a one cent loss. This type of trading is probably not illegal, and in any case, a law against it would be very difficult to enforce.12
Other types of traders who use generally similar strategies are labelled order anticipators. These include sentiment-oriented technical traders, traders who buy during an assetbubbleeven though they know the asset is overpriced, and squeezers who drive up prices by threatening to corner the market. Squeezers would likely be guilty ofmarket manipulation, but the other two types of order anticipators would not be violating any US law.12
Front running is sometimes used informally for a brokers tactics related to trading on proprietary information before its clients have been given the information.
In insurance sales, front running is a practice in which agents leak information (usually false) to consumers about a competitor insurance company that leads the consumer to believe that the companys products or services are inferior, or worthless. The agent subsequently obtains a sale at the consumers expense, earns a commission, and the consumer may have given up a perfectly good product for an inferior one as the result of the subterfuge.
For example, analysts and brokers who buy shares in a company just before thebrokerage firmis about to recommend the stock as a strong buy, are practising this type of front running. Brokers have been convicted of securities laws violations in the United States for such behavior. In 1985, a writer for theWall Street JournalR. Foster Winans, tipped off brokers about the content of his columnHeard on the Street, which based upon publicly available information would be written in such a way as to give either good or bad news about various stocks. The tipped off brokers traded on the information. Winans and the brokers were prosecuted by the prosecutorRudolph Giuliani, tried and convicted of securities fraud. Their convictions were upheld by theUnited States Supreme Courtin 1986.13
Principalagent problem(An economic theory applicable to front running, where stock brokers are agents, and brokerage clients are principals)
The New Market Manipulation, 66 Emory Law Journal 1253(2017)
United States Securities and Exchange Commission.SEC Charges Dallas-Based Trader With Front Running.
, Rule 5270: Front Running of Block Transactions.
Benjamin, Jeff (September 8, 2013).Image Repair: Mutual funds still recovering 10 years after scandal. [Investment News].
suspects front running of Fannie, Freddie in swaps market
New York Times.How Traders Use Front-Running to Profit From Client Orders.
(First ed.). New York: Oxford University Press.ISBN
Khan, Mozaffar; Lu, Hai (August 1, 2008). Do Short Sellers Front-Run Insider Sales?.
High-Frequency Trading called legalized front-running.
USTreasuryMarket.com: Front running in government bond market, described by former trader.
Reuters.com: E*Trade charged by SEC for front running during 1999 to 2005.
Capital asset pricing modelalphabetasecurity characteristic line)
This page was last edited on 14 May 2019, at 14:40