Front running
Encyclopedia
Front running is the illegal practice of a stock broker
executing orders
on a security
for its own account while taking advantage of advance knowledge of pending orders from its customers. When orders previously submitted by its customers will predictably affect the price of the security, purchasing first for its own account gives the broker an unfair advantage, since it can expect to close out its position at a profit based on the new price level. The front running broker either buys for his own account (before filling customer buy orders that drive up the price), or sells (where the broker sells for its own account, before filling customer sell orders that drive down the price).
Allegations of front running occasionally arise in stock and commodity exchanges, in scandals concerning floor broker
s and exchange specialists.
.
This example uses unusually large numbers to get the point across. In practice, computer trading splits up large orders into many smaller ones, making front-running more difficult to detect. Moreover, the U.S. Securities and Exchange Commission's 2001 change to pricing stock in pennies rather than fractions of no less than 1/8 of a dollar facilitated front running by reducing the extra amount that must be offered to step in front of other orders.
By front-running, the broker has put his or her own financial interest above (or in front of) the customer's interest and is thus committing fraud
. In the U.S. he or she might also be breaking laws on market manipulation
or insider trading
.
Tailgating means the action of a broker
or adviser purchasing or selling a security
for his or her client(s) and then immediately making the same transaction in his or her own account. This is not illegal like front running.
.
While front-running is illegal when a broker uses private information about a client's pending order, in principle it is not illegal if it is based on public information. In his book Trading & Exchanges, Larry Harris outlines several other related types of trading. Though all these types of trading may not be strictly illegal, he terms them "parasitic
".
A third-party trader may find out the content of another broker's order and buy or sell in front of it in the same way that a self-dealing broker might. The third-party trader might find out about the trade directly from the broker or an employee of the brokerage firm in return for splitting the profits, in which case the front-running would be illegal. The trader might, however, only find out about the order by reading the broker's habits or tics, much in the same way that poker players can guess other players' cards. For very large market orders, simply exposing the order to the market, may cause traders to front-run as they seek to close out positions that may soon become unprofitable.
Large limit orders can be "front-run" by "order matching" or "penny jumping". For example if a buy limit order for 100,000 shares for $1.00 is announced to the market, many traders may seek to buy for $1.01. If the market price increases after their purchases, they will get the full amount of the price increase. However, if the market price decreases, they will likely be able to sell to the limit order trader, for only a one cent loss. This type of trading is probably not illegal, and in any case, a law against it would be very difficult to enforce. Harris still considers it "parasitic".
Other types of traders who use generally similar strategies are labelled "order anticipators" by Harris. These include "sentiment-oriented technical traders," traders who buy during an asset bubble even though they know the asset is overpriced, and squeezers who drive up prices by threatening to corner the market. Squeezers would likely be guilty of market manipulation
, but the other two types of order anticipators would not be violating any US law.
"Front running" is sometimes used informally for a broker's tactics related to trading on proprietary information before its clients have been given the information.
For example, analysts and brokers who buy shares in a company just before the brokerage is about to recommend the stock as a strong buy, are practicing this type of "front running". Brokers have been convicted of securities laws violations in the United States for such behavior. In 1985, a writer for the Wall Street Journal, R. Foster Winans
, tipped off brokers about the content of his column Heard on the Street, which based upon publicly available information would be written in such a way as to give either good or bad news about various stocks. The tipped off brokers traded on the information. Winans and the brokers were prosecuted by then-prosecutor Rudolph Giuliani, tried and convicted of securities fraud. Their convictions were upheld by the United States Supreme Court in 1986.
Stock broker
A stock broker or stockbroker is a regulated professional broker who buys and sells shares and other securities through market makers or Agency Only Firms on behalf of investors...
executing orders
Order (exchange)
An order in a market such as a stock market, bond market, commodity market or financial derivative market is an instruction from customers to brokers to buy or sell on the exchange.These instructions can be simple or complicated...
on a security
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
for its own account while taking advantage of advance knowledge of pending orders from its customers. When orders previously submitted by its customers will predictably affect the price of the security, purchasing first for its own account gives the broker an unfair advantage, since it can expect to close out its position at a profit based on the new price level. The front running broker either buys for his own account (before filling customer buy orders that drive up the price), or sells (where the broker sells for its own account, before filling customer sell orders that drive down the price).
Allegations of front running occasionally arise in stock and commodity exchanges, in scandals concerning floor broker
Floor broker
A floor broker is an independent member of an exchange who can act as a broker for other members who become overloaded with orders, as an agent on the floor of the exchange. The floor broker receives an order via Teletype machine from his firm's trading department and then proceeds to the...
s and exchange specialists.
Explanation
For example, suppose a broker receives an order from a customer to buy a large block of 400,000 shares of some stock, but before placing the order for the customer the broker buys 20,000 shares of the same stock for his own account at $100 per share, then afterward places the customer's order for 400,000 shares, driving the price up to $102 per share and allowing the broker to immediately sell his shares for, say, $101.75, generating a significant profit of $35,000 in just a short time. This $35,000 is likely to be just a part of the additional cost to the customer's purchase caused by the broker's self-dealingSelf-dealing
Self-dealing is the conduct of a trustee, an attorney, a corporate officer, or other fiduciary that consists of taking advantage of his position in a transaction and acting for his own interests rather than for the interests of the beneficiaries of the trust, corporate shareholders, or his clients...
.
This example uses unusually large numbers to get the point across. In practice, computer trading splits up large orders into many smaller ones, making front-running more difficult to detect. Moreover, the U.S. Securities and Exchange Commission's 2001 change to pricing stock in pennies rather than fractions of no less than 1/8 of a dollar facilitated front running by reducing the extra amount that must be offered to step in front of other orders.
By front-running, the broker has put his or her own financial interest above (or in front of) the customer's interest and is thus committing fraud
Fraud
In criminal law, a fraud is an intentional deception made for personal gain or to damage another individual; the related adjective is fraudulent. The specific legal definition varies by legal jurisdiction. Fraud is a crime, and also a civil law violation...
. In the U.S. he or she might also be breaking laws on market manipulation
Market manipulation
Market manipulation describes a deliberate attempt to interfere with the free and fair operation of the market and create artificial, false or misleading appearances with respect to the price of, or market for, a security, commodity or currency...
or insider trading
Insider trading
Insider trading is the trading of a corporation's stock or other securities by individuals with potential access to non-public information about the company...
.
Tailgating
A practice similar to front running is called "tailgating".Tailgating means the action of a broker
Stock broker
A stock broker or stockbroker is a regulated professional broker who buys and sells shares and other securities through market makers or Agency Only Firms on behalf of investors...
or adviser purchasing or selling a security
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
for his or her client(s) and then immediately making the same transaction in his or her own account. This is not illegal like front running.
Other uses of the term
Front-running may also occur in the context of insider trading, as when those close to the CEO of a firm act through short sales ahead of the announcement of a sale of stock by the CEO, which will in turn trigger a drop in the stock's price. Khan & Lu (2008: 1) define front running as "trading by some parties in advance of large trades by other parties, in anticipation of profiting from the price movement that follows the large trade". They find evidence consistent with front-running through short sales ahead of large stock sales by CEOs on the New York Stock ExchangeNew York Stock Exchange
The New York Stock Exchange is a stock exchange located at 11 Wall Street in Lower Manhattan, New York City, USA. It is by far the world's largest stock exchange by market capitalization of its listed companies at 13.39 trillion as of Dec 2010...
.
While front-running is illegal when a broker uses private information about a client's pending order, in principle it is not illegal if it is based on public information. In his book Trading & Exchanges, Larry Harris outlines several other related types of trading. Though all these types of trading may not be strictly illegal, he terms them "parasitic
Parasitism
Parasitism is a type of symbiotic relationship between organisms of different species where one organism, the parasite, benefits at the expense of the other, the host. Traditionally parasite referred to organisms with lifestages that needed more than one host . These are now called macroparasites...
".
A third-party trader may find out the content of another broker's order and buy or sell in front of it in the same way that a self-dealing broker might. The third-party trader might find out about the trade directly from the broker or an employee of the brokerage firm in return for splitting the profits, in which case the front-running would be illegal. The trader might, however, only find out about the order by reading the broker's habits or tics, much in the same way that poker players can guess other players' cards. For very large market orders, simply exposing the order to the market, may cause traders to front-run as they seek to close out positions that may soon become unprofitable.
Large limit orders can be "front-run" by "order matching" or "penny jumping". For example if a buy limit order for 100,000 shares for $1.00 is announced to the market, many traders may seek to buy for $1.01. If the market price increases after their purchases, they will get the full amount of the price increase. However, if the market price decreases, they will likely be able to sell to the limit order trader, for only a one cent loss. This type of trading is probably not illegal, and in any case, a law against it would be very difficult to enforce. Harris still considers it "parasitic".
Other types of traders who use generally similar strategies are labelled "order anticipators" by Harris. These include "sentiment-oriented technical traders," traders who buy during an asset bubble even though they know the asset is overpriced, and squeezers who drive up prices by threatening to corner the market. Squeezers would likely be guilty of market manipulation
Market manipulation
Market manipulation describes a deliberate attempt to interfere with the free and fair operation of the market and create artificial, false or misleading appearances with respect to the price of, or market for, a security, commodity or currency...
, but the other two types of order anticipators would not be violating any US law.
"Front running" is sometimes used informally for a broker's tactics related to trading on proprietary information before its clients have been given the information.
For example, analysts and brokers who buy shares in a company just before the brokerage is about to recommend the stock as a strong buy, are practicing this type of "front running". Brokers have been convicted of securities laws violations in the United States for such behavior. In 1985, a writer for the Wall Street Journal, R. Foster Winans
R. Foster Winans
R. Foster Winans is a former columnist for The Wall Street Journal who co-wrote the "Heard on the Street Column" from 1982 to 1984 and was convicted of insider trading and mail fraud. He was indicted by then-U.S...
, tipped off brokers about the content of his column Heard on the Street, which based upon publicly available information would be written in such a way as to give either good or bad news about various stocks. The tipped off brokers traded on the information. Winans and the brokers were prosecuted by then-prosecutor Rudolph Giuliani, tried and convicted of securities fraud. Their convictions were upheld by the United States Supreme Court in 1986.
External links
- Finance Professor
- USTreasuryMarket.com: Front running in government bond market, described by former trader.
- Definition and examples of front running on Wikinvest
- Reuters.com: E*Trade charged by SEC for front running during 1999 to 2005.