Trading ahead happens when a market maker using his own account places orders before or at the same time as the customer’s limit order, in order to profit from it. Although this practice may be illegal - when a market maker or broker-dealer is trading ahead of its customer - it can also be used as a way of anticipating large institutional investors' orders.
What is trading ahead of a customer?
Trading ahead of a customer happens when a broker or market maker receives an order for a customer and proceeds to execute orders on his own account based on the information received.
How does trading ahead of a customer work?
Whenever a customer places an order, the market maker will try to match their bid or ask other market participants. If the market maker chooses to engage in trading ahead, instead of trying to combine the same ask and bid, they will create their own order to match the customer’s bid or ask.
Trading ahead of customers example
Let’s consider that a certain customer decides to buy stock A, and places a limit order to buy 10 shares at $100 a share. If there is another market participant willing to sell those same shares at $99.99, the broker-dealer cannot buy the $99.99 ask. Otherwise, it could easily profit from the customer’s trade.
Is trading ahead illegal?
Trading ahead is illegal whenever there is a conflict of interest. Such situations arise when brokers or market makers knowingly trade ahead of customers’ orders. Since they have access to the order flow, they know exactly what orders are coming through. This constitutes a FINRA violation.
Why is trading ahead is illegal?
Trading ahead is illegal because it creates a conflict of interest between the broker-dealer that should be working on behalf of the customer. It would also be unfair for these firms to have a trading advantage over other market participants. This poses a threat to the efficient market hypothesis, and it tries to manipulate price discovery.
It becomes easy to place an order prior to or at the same time, as a customer’s order. This is illegal according to FINRA 5320 rule (Manning rule).
What is the FINRA 5320 rule?
FINRA (Financial Industry Regulatory Authority) rule 5320 forbids firms that are regulated that take orders from customers, from trading the exact same financial instrument. Therefore, FINRA member firms will not be able to trade ahead unless the customer’s order is executed at the desired price, or at a lower price.
There is an exemption to rule 5320, for large orders either:
- Over or equal to $100,000
- 10,000 or more shares
There are also other exceptions to FINRA 5320 rule:
- No-knowledge exception
- Riskless principal exception
- ISO exception
Trading ahead legally
Although trading ahead of customers is illegal, there are exceptions, and the term can also be used to describe trades where investors try to anticipate large market moves. Traders and investors might choose to trade ahead, knowing large index funds will soon place an order. This type of trading ahead is legal, and since it is exempted by rule 5320.
There are several types of trading ahead that can be used, and some are exempted from rule 5320, but in some cases, it is still illegal. However, some of these types might also be illegal, if the trading is based on insider information. It includes trading ahead of:
- Index fund rebalancing
- Earnings announcements
- Research reports
Trading ahead of index fund rebalancing
Index funds are constantly forced to rebalance their portfolios. Based on the market capitalization of the different stocks on the index. Knowing this traders are able to place orders before index funds rebalancing.
Profiting from the expected large orders of institutional investors. There are also high-frequency trading systems that are automated to take advantage of index fund rebalancing.
Trading ahead of earnings announcements
Trading before earnings releases is also a common way of profiting in the short term. However, it can also be used illegally if the trader has insider information about the earnings.
Stocks tend to experience large movements either up or down after earnings. Depending on whether the company beats analyst estimates or has lower results than what was expected. This creates significant short-term moves that traders take advantage of.
Trading ahead of research reports
Research firms will often release research reports, and place trades before releasing their research. This is especially common in research firms that publish short reports and short a stock prior to the release.
FINRA 5280 rule aims to eliminate this practice, by enforcing that tradings desks of broker-dealers are not able to trade based on the research. As this is considered access to nonpublic information.
This has proven to be extremely profitable especially when such research firms are widely known, and their reports can affect the stock price instantly.
Trading ahead vs front running
Although both concepts are similar, there are slight differences.
Front-running is when a dealer knows its customer’s order will trade for his own account prior to executing the customer’s trade. Since the dealer is able to understand how the customer’s order could affect the current market price this gives an unfair advantage over other market participants.
Trading ahead involves executing your own order at better prices without first executing the customer’s limit order. This also creates a situation where the broker-dealer has an unfair market advantage, and it also creates a conflict of interest.