Front-running happens more commonly when a broker trades an asset, based on nonpublic information knowing that the trade they will execute will influence the price. This practice is illegal, and therefore punishable by law.
Since stockbrokers have access to customers’ orders before they are filled, they may use this information to place trades if they are sure that the order could influence the market price. Front-running is illegal due to the use of privileged insider information and creates a conflict of interest between customers and their brokers.
Types of front-running
Front-running happens more commonly between investors or traders, and brokers. However, the concept can take other forms, depending on the information used.
Front-running may also happen in companies. When companies are about to disclose material nonpublic information, an insider might realize that the new set of information could impact the price of the security. In order to profit from this yet unknown information, they might trade prior to the release.
It may also happen in relation to analysts. For instance, if an investment bank will update a rating on a stock, an insider might trade knowing that the rerate could move the stock price. This use of non-public information is also illegal.
Index front-running is another example that has become more common in today’s markets. Since an index fund is an average-weighted fund trying to mimic a certain index, price fluctuations force portfolio managers of index funds to readjust their portfolios. Therefore, traders might front-run these trades, expecting index funds to either buy or sell a particular security.
Another example is when a stock is going to be included in a particular index. Traders expecting this might build a position in the stock, expecting index funds to eventually buy the shares. Although most types of front-running are illegal, index front-running is not. Since the information is publicly available, every market participant has access to it and may trade based on that.
Index front-running is common practice on Wall Street. Through the use of high-frequency trading, algorithms are able to calculate how the index will adjust its portfolio based on price fluctuations. This allows them to place trades in real-time, in order to front-run index funds. There are several high-frequency trading books that can help you understand how this works in more detail.
Why is front-running illegal?
The market should be an equal level playing field for all its participants. If for some reason there is a market participant that has an edge over all of the other investors, this causes all of the other market participants to question the integrity of the system. Investing or trading based on privileged information is therefore illegal. If it was not, it would be easy for certain individuals in certain positions to continue front-running several trades.
Every market participant should therefore make their decisions based on publicly available information. The use of privileged information and front-running is therefore considered market manipulation. It is illegal and punishable by law.
Front-running and payment for order flow
Payment for order flow has become one of the most controversial topics in financial markets. Ever since the Gamestop event, brokers and market makers are now being targeted by retail investors claiming that markets are rigged. The largest target of this controversy has certainly been Citadel. The company was involved in a front-running lawsuit not too long ago. Citadel has been involved in front-running their client’s orders in the past, and it was fined for that.
Example of front running
Certainly, the most publicized front-running scandal over the last decade was in the case of Fannie Mae, and Freddie Mac. Traders were taking advantage of privileged information to profit in the swaps market.
The profits from this activity were at the time estimated between $50M to $100M. According to the FBI, the process was especially easy. Traders changed the ringtones for contacts of certain large customers, that would alert them before an order was placed.
Since Freddie Mac and Freddie Mae had to regularly hedge their mortgage portfolios with interest rate swaps, their orders were usually very large in size. This made it easy for traders to exploit this and front-run their orders.
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