Front running is the illegal practice of a stockbroker 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).
In 2003, several hedge fund and mutual fund companies became embroiled in an illegal late trading scandal made public by a complaint against Bank of America brought by New York Attorney General Eliot Spitzer. A resulting U.S. Securities and Exchange Commission investigation into allegations of front-running activity implicated Edward D. Jones & Co., Inc., Goldman Sachs, Morgan Stanley, Strong Mutual Funds, Putnam Investments, Invesco, and Prudential Securities.
For example, suppose a broker receives a market order from a customer to buy a large block—say, 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-dealing.
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 the customer's interest and is thus committing fraud. In the United States, he or she might also be breaking laws on market manipulation or insider trading.
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 Exchange.
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.
Other types of traders who use generally similar strategies are labelled "order anticipators." 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" may refer to the practice of high-frequency private equity traders (HFT), as a form of "legalized" front running, where they connect to various exchanges with direct peering fiber networks and try to detect orders as they propagate from a broker's order router and then use fast transit paths to beat those orders at reaching their destination. HFT private equity fund traders use expensive equipment, especially GPUs and FPGA technology to place many small orders at very high speeds that indicate buying/selling pressure and attract HFT momentum. Those with the most expensive equipment to shorten lags in reaching other exchanges then anticipate more orders and so to place orders on those exchanges to catch the rest of the order, at a more advantageous price. According to an estimate from Frederi Viens of Purdue University, profits from HFT in the U.S. has been declining from an estimated peak of $5bn in 2009, to about $1.25bn in 2012. Also, according to Harvard Political Review writer Austin Tymins, HFT private equity fund Citadel LLC made billions of dollars front-running the trades of large institutional investors, many of which are investing on behalf of middle-class clients. These estimates show that Citadel LLC makes several times of all of the HFT private equity funds profits singlehandedly, using such strategies. John Dizard of Financial Times argues that this behavior takes advantage of political reforms in fragmented market structure and the lack of liquidity in the National Market System. Using HFT strategies, 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 because of Regulation NMS.
"Front running" is also 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 firm is about to recommend the stock as a strong buy, are practising 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 the prosecutor Rudolph Giuliani, tried and convicted of securities fraud. Their convictions were upheld by the United States Supreme Court in 1986.
- "Front-running; an Unethical Behavior". www.cmic.sec.gov. SEC. Retrieved 25 July 2014.
- Benjamin, Jeff (September 8, 2013). "Image Repair: Mutual funds still recovering 10 years after scandal". [Investment News].
- Harris, Larry (24 October 2002). Trading and Exchanges (First ed.). New York: Oxford University Press. ISBN 0-19-514470-8.
- * , High-Frequency Trading called legalized front-running
- Kroft, Steve (March 30, 2014). "Is the U.S. stock market rigged?". CBS News. Retrieved November 2, 2014.
- Clive Cookson (May 12, 2013). "Time is money when it comes to microwaves". Financial Times. Retrieved May 12, 2013.
- Tymins, Austin (September 30, 2014). "The Rigged Market: A Review of Flash Boys". Harvard Political Review. Retrieved October 30, 2014.
- Tymins, Austin (April 9, 2014). "Defining high-frequency trading's US level of evil". Harvard Political Review. Retrieved June 20, 2014.
- * Carpenter v. United States, Supreme Court decision
- Harris, Larry (2003). "Order Anticipators". Trading & Exchanges. Oxford: Oxford Press.
- Khan, Mozaffar; Lu, Hai (August 1, 2008). "Do Short Sellers Front-Run Insider Sales?". MIT Sloan Research Paper No. 4706-08. SSRN 1140694.
- High-Frequency Trading called legalized front-running.
- 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.