Last Updated on 24 November, 2021 by Samuelsson
As a trader or investor, it is important you familiarize yourself with different types of trading to know the ones that are acceptable and the ones that can get you into trouble with the law. You not only seek knowledge to make profits from the market but also to know when there is foul play in the market. In that regard, we will be discussing front-running trading in this post. So, what is front-running trading?
Also known as tailgating, front-running trading is a fraudulent practice whereby an individual, a broker, or an investment firm makes a trade in a stock or any other security, based on advance non-public information about an anticipated large transaction that will affect the price of that stock or security.
To help you understand this topic, we will discuss it under the following headings:
- What is front-running trading
- Understanding how front-running trading works
- Is front-running trading illegal?
- Forms of front-running trade
- Difference between front-running and insider trading
- How to detect a front-running trade
- Example of a front-running trade
What is front-running trading?
Front running trading is a fraudulent practice where a broker or trading firm purchases a security in advance because they have access to information that is not available to the public regarding a huge transaction that could impact the price of that security.
It is a form of market manipulation that uses insider information. The person who indulges in front-running trading anticipates the price of a security to move based on the non-public information he or she is privileged to have. Thus, front-running is similar to insider trading; the only small difference is that the broker works for the client’s brokerage and gains information from that service rather than gaining insider information from the company that owns the stock in question.
However, not all types of front-running are illegal. For example, index front running is not illegal because the information about the re-composition of an index is public.
Understanding how front-running trading works
Let’s take a look at an illustration to see how front-running works. Suppose a broker receives an order from their major client to buy 250,000 shares of ABC Co. This kind of huge order is definitely going to drive the price of the stock up suddenly, at least in the near term. However, the broker, instead of filling the client’s order will set it aside and purchase some shares of the same stock for themselves before filling the client’s own order. Then the broker immediately goes ahead and sells the shares and makes a profit from them.
This type of front-running is unethical and illegal because the broker made a profit using information that was not yet available to the public. Also, the delay in executing the client’s order may even add additional costs to the client’s money.
A short way of explaining front running is when a broker takes advantage of market-moving information that has not yet being known by the general public. However, they are some grey areas. A trader or an investor may sell or buy a stock and then publish the motive behind doing so – note that in trading, honesty and transparency are very important.
Another way for front running is when you act on analyst suggestions that are not yet publicized.
The analyst work in a different branch from the broker and only focuses on evaluating and creating judgment based on the potential of each individual company in order to advise the companies’ clients. Their suggestions usually go thus: whether to buy, sell or hold a stock. This information is supposed to be available to clients first before being picked up by the financial media companies who now report it widely.
Any broker or individual who acts upon the analyst recommendations for their personal benefit before it gets to the company’s clients has committed front running.
Is front-running trading illegal?
Front running is a kind of market manipulation found in many markets. A typical case will involve individual brokers or trading firms who buy and sells stock out of unmonitored, undisclosed accounts of confederates and relatives.
Individual and institutional investors can also commit front-running violations when they indulge themselves in inside information. A front-running firm or trader either sells for its own account before doing so for its clients (causing a decline in price and filling the client’s orders at a lower price) or buys for itself before filling the client’s buy orders (driving the price up and filling the client’s orders at a higher price).
Front running is prohibited since the firm or individual involved is doing so to profit from non-public knowledge at the expense of its own clients, the public market, or the block trade.
In 2003, many mutual funds and hedge fund companies became involved in a prohibited late trading scandal brought to public knowledge by a complaint brought against Bank of America by Eliot Spitzer (New York Attorney General). An investigation into a suspected front-running activity by the United States Securities and Exchange Commission (SEC) implicated Goldman Sachs, Strong Mutual Funds, Edward D. Jones & Co., inc., Morgan Stanley, Putnam Investments, Prudential Securities, and Invesco.
Furthermore, interviews by the FBI revealed that the banks made about $50 million to $100 million from the illicit trades. Also, there were indications that Wall Street traders might have played a manipulative game in a very important derivatives market by front running the Freddie Mac and Fannie Mae.
As an example to show how this usually happens, let’s assume that a trading firm gets an order from a client to buy a large number of shares – let’s say about 700,000 shares – of OBJ Co., but before filling the order for the client, the firm bought about 35,000 shares of OBJ Co., for themselves at a price of $50 then places the client’s block order of 700,000 shares, which pushes the price to $56 per share. The firm then sells its share at $55.50. With this, the firm makes a profit of $192,500 risk-free in a very short time.
This example uses a significant amount of numbers to get the point across. However, in the real world of computer trading, large orders are broken down into several smaller parts – this has made front running very difficult to detect. But the United States Securities and Exchange Commission (SEC) in 2001 made some changes to the pricing of stocks from fractions of less than 1/8 of a dollar to pricing them in pennies giving an enabling ground to front running by reducing the additional amount of orders that must be made to step in front of other orders.
By front running, the broker has put their personal financial interest above that of their clients’ interest thereby committing fraud. In the United States of America, they might be violating rules on insider trading and market manipulation which can be punishable and attracts severe fines.
Forms of front-running trade
Not all forms of front running are illegal though. However, you must take note of how it works and why it is not seen to be an illegal practice. Below are some forms of front running:
When large trades are anticipated
This is the form of front running that is mostly committed by brokerage firms or brokers and is the most common form type of front running that exits. In this type, a broker receives an order to purchase a large number of shares of a company and realizes that this type of transaction is significant enough to impact the price of the company’s stock in a short time. So, the broker decides to purchase shares of the same company for themselves before executing the customer’s order.
For instance, say the broker receives an order from a client to purchase 100,000 shares in Company A. The broker knows that the large buy transaction is likely to drive up the price of the company’s stock. Thus, he decides to purchase for himself some 3,000 shares in Company A before executing the client’s order. In this particular situation, the broker has violated their professional ethics and has committed an illegal activity by breaching their fiduciary obligations to the client.
When news that can impact the price of a security is anticipated
This form of front running occurs when a trader gains access to information that is non-public about an upcoming event that will significantly impact the price of a security and goes ahead to execute a trade in that security before that news goes public. For instance, an analyst is preparing a trade recommendation for Apple Inc. The report is yet to be published to its client, and the analyst knows that the recommendation has a very strong bullish bias.
Anticipating that after the report is published, investors will rush to buy Apple’s stock which will drive the stock price up, the analyst purchases some shares of Apple for themselves before the report is published thereby making a profit after the stock price increase. This is considered illegal in many markets.
Index front running
This form of front running is not an illegal practice; in fact, it has been adopted as a trading strategy. Index funds, which tracks market indices, have become extremely significant in the financial markets. Whenever a new company’s stock is added to a market index (e.g. US30), the announcement is usually made before the actual addition of the stock.
For example, the NASDAQ announces that XYZ inc. will be added to the Nasdaq 100 Index in two days’ time. The day before adding the stock, high-frequency traders will purchase the company’s shares before index funds that track the Nasdaq 100 Index buy the company’s stock. The index funds’ purchase of the stock will push the price higher because of the large volume of their orders allowing the high-frequency traders to profit from front running the index funds.
Difference between front-running and insider trading
Insider trading is a process whereby an individual purchases stock of a company because they gained access to information about the company that is expected to significantly affect the price of the company’s stock. This information is known as insider information, and the practice is called insider trading. It is a prohibited practice by the Securities and Exchange Commission and violating this rule comes with heavy penalty as the public does not have this important insider information of the company thereby putting them at a disadvantage.
Front running, on the other hand, is a type of insider trading where a broker or trading firm gains information that is non-public from their client and takes advantage of it before executing their customer’s orders.
How to detect a front-running trade
The most effective way to curb front running is by strictly monitoring trades and maintaining high ethical standards in transactions. They can be controlled by the Securities and Exchange Commission if they choose to be internally vigilant and are persistent in doing so.
Another important strategy for preventing front running is to punish offenders severely. The lack of strictness or care in internal control of dealings is one of the contributing factors to the losses suffered by investors. A person managing other people’s money has a limited amount of trust and if that trust is trampled upon it will be difficult to gain it back.
Front running is a form of market manipulation that can be found in all markets around the world. It is considered unethical and illegal. While this manipulation is majorly carried out by prop trading firms or brokers with the intention of earning profits at the expense of their clients, in certain climes, individual traders may also find themselves in such positions when they exploit non-public analyst’s recommendations.
Traders should desist from indulging in such practice because, if found guilty of this, it can lead to very serious legal complications. You should therefore maintain a high level of ethical standards when trading.
However, not all front running is illegal. Index front running is an acceptable practice and has been adopted as a trading strategy.