What does front-running mean?
Front-running is trading stock or other financial assets by a broker with inside information about a forthcoming transaction that will significantly impact its price. Based on intimate knowledge, a broker may front-run when their business is preparing to give buy or sell advice to customers that would likely alter asset prices.
Most incidents involving the use of non-public information are unlawful and immoral. Front-running is also known as tailgating.
How does it work?
A simple front-running example: A significant client orders 500,000 XYZ Co. shares from a broker. The stock price will rise soon after such a significant buy. The broker puts the request on hold and buys XYZ stock for their portfolio. The client’s order goes through—the broker profits by selling XYZ shares quickly.
This front-running is unethical and unlawful. The broker profited from secret information. Execution delays may have cost the customer money.
While front-running is comparable to insider trading, the broker works for the client’s brokerage instead of the client’s business.
Front-running is different from insider trading, which is sometimes mistaken. Before a critical announcement, company insiders trade on advanced information about business actions, such as buying or selling shares.
Exploiting Analyst Advice
Taking an unpublished analyst’s advice is another front-running approach.
Analysts evaluate specific firms’ ability to advise the broker’s clients in a separate section. Their stock “buy,” “sell,” or “hold” recommendations are continuous. They go to clients first, then to the financial media for widespread coverage.
Front-running is when a broker uses that suggestion for personal advantage before the company’s clients.
There is some gray area. For instance, a professional short-seller may hold a short position and disclose their rationale. This resembles a short-seller version of a pump-and-dump scam when speculators inflate or devalue investments for personal benefit.
There’s a difference. This short-seller discloses their financial stake at the time of the suggestion. The short-seller material is factual and not designed to deceive.
SEC Rule 17(j)-1 prohibits most front-running while setting ethical standards for portfolio managers and brokers. This regulation prohibits insiders from profiting from client trades.
Front-running index
Index funds commonly engage in front-running, which is not unlawful.
Index funds mimic a financial index’s portfolio. Due to price changes, additions, or removals, the index composition changes frequently to balance it. That pushes fund managers to acquire or sell index components.
The prices of those equities tell traders when index funds adjust their components. Buy or sell shares to get an edge and front-run the trade.
Anyone who pays attention may see that information; thus, this is lawful.
Example
The Financial Industry Regulatory Authority (FINRA) imposed sanctions on Citadel Securities in 2020 for front-running against its clients from 2012 to 2014.
The financial regulator said that Citadel deleted hundreds of thousands of big OTC orders from its computerized trading systems, forcing human traders to execute them. Citadel also “traded for its account on the same side of the market at prices that would have satisfied the orders,” breaking client commitments.
FINRA revealed Citadel traded against clients in roughly three-quarters of idle orders in one month. Citadel compensated their clients and paid a $700,000 fine without admitting guilt. [2]
Is front-running illegal?
Yes, front-running is often unlawful. SEC Rule 17(j)-1 prohibits most front-running.
Is order flow payment front-running?
Payment for order flow (PFOF) rewards brokers for prioritizing customer orders with a particular market maker or trading business. This strategy discourages client-best execution, but it is not front-running because the business receiving the flow trades with the customer and does not place trades in the same direction in front of them.
Trading Ahead: Front-Running?
Trading ahead occurs when a broker or market maker utilizes their firm’s account to trade instead of matching bids and offers from other market participants. Trading ahead is prohibited, but authorities don’t consider it front-running.
Conclusion
- When traders use inside knowledge, front-running is unlawful and immoral.
- Front-running happens when a broker uses unreleased market-moving information.
- Gray regions exist. An investor may publicly explain a stock purchase or sale—honesty and transparency matter.
