What is Front Running? A Comprehensive Guide

What is Front Running?

Front running is the illegal and unethical activity of dealing in a security on the basis of prior, non-public information about an imminent transaction that will likely shift the price of the security. Simply put, it is people who possess insider information about an imminent large order using this information to their benefit by making trades even before one’s customers or the market in general.

This practice leverages informational asymmetry which pervades the relationship between financial professionals, like brokers, and their clients or the general investing public. Front runners take advantage of this inside information to make profits at the expense of their clients and compromise the integrity and fairness of financial markets.

Front running goes against the very fundamental principles of market efficiency and investor protection. It is a grave violation of fiduciary responsibility on the part of those who manage money and assets belonging to others. Therefore, it is rabidly denounced by regulators, industry bodies as well as ethical and responsible investors.

Types of Front Running Strategies

Anticipating Large Client Orders

One of the most prevalent front running strategies is to expect the price effect of an imminent large customer order. For instance, if a broker knows that a customer is going to put in a substantial buying order for a specific stock, they might decide to buy this stock in their own account ahead of time. This allows them to benefit from the subsequent increase in the stock’s price once the client’s order is executed and the market reacts to the sudden surge in demand.

The opposite situation may also happen, in which a broker front runs a big client sell order by selling the stock first for his own account, so he can buy it back later at a lower price once the client’s trade has already pushed down the market price.

Exploiting Advance Information on Market-Moving Events

Front running may also involve trading by individuals on non-public information about upcoming news or events that are likely to have a material impact on the price of a security. This may be advanced knowledge of:

• Earnings announcements or other company news
• Regulatory decisions or policy changes
• Mergers, acquisitions, or other major corporate transactions

By trading on such inside information before it is made public, front runners manage to gain abnormal profits at the cost of unsuspecting investors.

High-Frequency Trading and Index Fund Front Running

The emergence of high-frequency trading (HFT) has seen the development of new front running tactics that leverage technology superiority and market structure idiosyncrasies. An example of this strategy is called index fund front running, where HFT firms buy stocks shortly before they are to be included in a key market index, for example, the S&P 500.

When there is an announcement of an index addition, index funds that follow the benchmark will have to purchase huge amounts of the new addition stock. HFT companies can take advantage of this by rapidly purchasing the stock ahead of the index funds, pushing the price up, and then selling to the index funds at a higher price. Although this activity is not necessarily illegal, it is an unfair use of informational and technological superiority.

Other Front Running Techniques

In addition to the strategies outlined above, front runners may also engage in more sophisticated manipulative practices, such as:

• Layering: Placing large buy or sell orders that are quickly canceled, to trick other market participants and triggering price movements.
• Spoofing: Submitting orders with no intention of executing them, to induce others to trade in a particular direction.
• Wash trading: Executing trades with oneself or a confederate to create a false impression of market activity and price movements.

These more complex forms of front running further illustrate the lengths to which unscrupulous traders will go to gain an unfair advantage in the markets.

The Impacts of Front Running

Harm to Individual Investors

Front running hurts individual investors by reducing their possible return on investment. When a front runner places a trade before that of their client’s order, they are essentially “jumping the queue” and taking away from the client the chance to trade at the best price. This means that the client’s trade will be done at a less desirable level, slicing into their potential profit or increasing their loss.

With the passage of time, the compounding effect of these front running operations can take a heavy toll on the returns generated by individual investors, especially those with small account balances who are less resilient to bear the brunt. The erosion of potential returns has far-reaching effects on an individual’s capacity to save, invest, and attain financial objectives.

Distortions to Market Prices and Liquidity

The widespread prevalence of front running also creates important distortions in market prices and liquidity. When front runners take action on their informational leads, they can cause abrupt and disproportionate price movements that do not correspond to the underlying fundamentals of the traded securities.

This price uncertainty can interfere with the optimal allocation of capital, as informed market players find it difficult to make rational investment choices in the presence of such artificial price fluctuations. Also, the existence of front running activities may lower overall market liquidity since investors fear engaging in trades that are negatively affected by the stalking behavior of informed traders.

Broader Economic Consequences

The deterioration of market integrity and investor confidence that occurs due to front running has wider economic implications that reach beyond the financial industry. If individuals and institutions feel that the markets are stacked against them, they will be less likely to take part, thus shrinking the general pool of available capital to be invested in economic development.

Furthermore, misallocation of capital due to front running can cause inefficient investment and less optimally allocated capital, eventually undermining economic productivity and innovation. Damage to market reputation can also undermine the ability of firms to raise capital and finance their activities, restricting economic growth and employment opportunities.

Regulatory Efforts to Combat Front Running

Securities Laws and Anti-Manipulation Rules

Securities laws and anti-manipulation explicitly prohibit front running and other forms of market manipulation. In the United States, the Securities Exchange Act of 1934 and the Dodd-Frank Wall Street Reform and Consumer Protection Act have provisions that target front running and other predatory trading practices.

In Europe, the Market Abuse Regulation (MAR) and the Markets in Financial Instruments Directive (MiFID II) have introduced stringent rules and hefty penalties for individuals and firms found guilty of engaging in front running or other market abuse activities.

Oversight by Financial Regulators

To enforce these legal prohibitions, financial regulators such as the U.S. Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), and their counterparts in other countries have dedicated significant resources to monitoring market activity and investigating suspected instances of front running.

These regulatory bodies have the authority to impose fines, suspend trading privileges, and in extreme cases, pursue criminal charges against those found to have engaged in front running and other manipulative practices. High-profile enforcement actions, such as the SEC’s case against the brokerage firm Merrill Lynch in 2016, have sent a strong message about the consequences of such misconduct.

Technological Solutions

In addition to legal and regulatory approaches, the financial industry and policymakers have also explored technological solutions to address the front running problem. These include:

• Enhanced trade monitoring and surveillance systems that can identify suspicious trading patterns and alert regulators to potential front running activities.
• Measures to reduce latency and improve the speed and fairness of order execution, such as the implementation of “speed bumps” in certain trading venues.
• Distributed ledger technologies like blockchain, can increase transparency and reduce the informational asymmetries that enable front running.

While these technological interventions hold promise, they also face challenges in keeping pace with the ever-evolving tactics of front runners and other market manipulators.

Challenges and Limitations

In spite of the numerous regulatory and technological measures to fight front running, the practice remains prevalent, pointing to the intrinsic difficulties and limitations in managing this complex problem.

One of the chief barriers is identifying genuine trading strategies from prohibited front running, especially in the context of high-frequency trading and other advanced market practices. Regulators have to continually adapt their techniques of detection and remain vigilant to new variants of front running.

In addition, the international character of capital markets and the cross-border flows of capital may make enforcement challenging, as front runners can seek to take advantage of jurisdictional gaps or regulatory differences between jurisdictions.

Ethical Considerations and Best Practices

Fiduciary Responsibilities of Financial Professionals

Financial planners, brokers, and other industry participants have an ethical and legal obligation to act in the best interest of their clients. The fiduciary obligation requires them to put their client’s goals and needs ahead of their own. It also requires them to refrain from participating in any action that would sully the integrity of the investment process.

Front running constitutes a blatant abuse of this fiduciary obligation with its underlying conflicts of interest and possibilities of personal gain at the clients’ expense. Front runners are basically violating the public trust and client trust by taking advantage of their informational privileges.

Importance of Transparency and Disclosure

Hand in hand with the issue of fiduciary duty is the requirement for transparency and full disclosure in the financial services industry. Investors have a right to know how their money is being managed and the possible influences on the investment decisions being taken on their behalf.

Since front running, by nature, goes unnoticed, its strength lies in secrecy with material information. To fight such a strategy will call for joint action toward ensuring that there is better transparency through policies like:

• Strengthening disclosure guidelines for financial advisors
• More reports and audit trails in trading business
• Increased awareness and education by the public concerning the risks of front running

Only by lighting up these onerous processes can the financial sector hope to restore the trust and confidence of private investors.

Enhancing Market Fairness and Investor Protection

The drive to eliminate front running is part of a broader imperative to ensure the fairness and integrity of financial markets. Investors, both institutional and individual, need to have confidence that the playing field is level and that their investment decisions are not being undermined by the predatory actions of informed insiders.

Solving the front running issue requires a multi-faceted strategy that targets the particular strategies used by unethical traders and the structural and regulatory vulnerabilities that enable such activities to occur. This can include:

• Strengthening anti-manipulation regulations and enforcement regimes
• Enhancing order execution procedures and minimizing informational asymmetries
• Increasing investor education and empowerment
• Promoting a culture of ethical behavior in the financial services sector.

Conclusion

Front running is a grave risk to the fairness and integrity of financial markets because it contains conflicts of interest in its very nature and is open to enrichment for individuals at the expense of the investing public and clients. As this authoritative guide has illustrated the practice is not limited but is multifaceted, ranging from brokers using informational advantages to high-frequency traders leveraging technological speed benefits.