Front Running refers to the unethical practice of a broker or trader executing orders on a security for its account while taking advantage of advanced knowledge of pending orders from its customers. It involves placing orders to buy or sell securities ahead of a large order from another investor, potentially increasing the security’s price. Front Running is considered an unfair practice because it allows the broker or trader to profit at the expense of their clients.
What Is Front-Running?
Front Running is an unethical practice in which a broker or trader takes advantage of confidential information about pending client orders to execute trades for its benefit. “Front Running” refers to placing orders ahead of a large order to profit from the expected price movement. It involves prioritizing the broker’s or trader’s interests over the best interests of their clients.
The Securities and Exchange Commission in the United States defines Front Running as “the practice of executing orders on a security for its account while taking advantage of advance knowledge of pending orders from its customers.” This practice can undermine market integrity and erode investor confidence.
How Front-Running Works
Front Running typically involves a broker or trader accessing confidential information about pending orders from their clients. They may have insights into the intentions of large institutional investors or other market participants. Armed with this information, the broker or trader can take advantage of the expected price movement by placing their orders ahead of the client’s.
The mechanics of Front Running can vary, but here is an example to show the concept:
- A prominent institutional investor contacts their broker and expresses their intention to buy a significant number of shares of a particular stock.
- The broker, engaged in Front Running, realizes that the client’s order will likely drive up the stock’s price.
- Instead of immediately executing the client’s order, the broker places their order to buy the stock at a lower price.
- Once the broker’s order is filled, the stock price increases due to the client’s order.
- The broker then sells the shares they purchased at a higher price, realizing a profit.
- Finally, the broker executes the client’s order at a higher price than initially intended due to the increased market price.
Example of Front-Running
John, a retail investor, contacts his brokerage firm to place an order to buy 1,000 shares of XYZ Company. The brokerage firm employs a trader, Lisa, who engages in Front Running.
Upon receiving John’s order, Lisa realized it was a significant order that could potentially drive up the price of XYZ Company’s stock. Instead of immediately executing John’s order, Lisa decides to place her order to buy XYZ Company’s stock ahead of John’s order.
Lisa’s order is filled, and the price of XYZ Company’s stock rises due to the increased demand. Once stock prices reach a certain level, Lisa sells the shares she purchased earlier, realizing a profit. Lisa executed John’s order only after selling her claims, but at a higher price than initially intended due to the increased market price.
In this example, Lisa has engaged in Front Running by prioritizing her financial gain over John’s best interests. She used her knowledge of John’s pending order to profit from the expected price movement.
Index Front-Running
Another form of Front Running is indexing Front Running. This practice involves trading securities to take advantage of anticipated index composition changes. Index providers periodically rebalance their indices by adding or removing securities based on specific criteria. These changes can impact the prices of the affected securities.
Unscrupulous traders or brokers may engage in index Front Running by purchasing or selling securities anticipating the index changes. By front-running the index rebalancing, they can benefit from the expected price movement resulting from the buying or selling pressure associated with the rebalancing.
Index Front Running can be challenging to detect and prevent since the information about the upcoming index changes is typically known only to a select group of individuals. Regulators and market participants employ various measures to mitigate the risks associated with index Front Running and maintain market integrity.
Difference between Front Running and Insider Trading
Front Running is often compared to insider trading due to similarities in its unethical nature. However, there are differences between these two practices.
Insider trading involves trading securities based on material non-public information about a company. Insiders, such as company executives, employees, or individuals with access to confidential information, use this privileged information to make trades for personal gain.
On the other hand, Front Running involves trading securities based on knowledge of pending orders or anticipated market movements. It typically occurs when a broker or trader exploits their position or advanced expertise to prioritize their trades over their clients or the general public.
The critical difference lies in the source of information and the relationship with the affected parties. Insider trading involves accessing non-public information, while Front Running focuses on taking advantage of impending orders or anticipated market movements.
Both practices are considered unethical and illegal in many jurisdictions, as they undermine fair and transparent markets. Regulators actively monitor and investigate instances of insider trading and Front Running to maintain market integrity and protect the interests of investors.
FAQs
Is Trading Ahead Front-Running?
Trading ahead is when a broker or market maker uses their firm’s account to make a trade instead of matching available bids and offers from others in the market. Trading ahead is illegal, but it is not considered by regulators to be the same as front-running.
Is Payment for Order Flow Front-Running?
Payment for order flow (PFOF) is when a broker receives compensation for routing customer orders first to a particular market maker or trading firm. This practice has been criticized for discouraging best-execution for customers, but it is not considered front running since the firm receiving the flow will trade with the customer, not place trades going in the same direction in front of them.