Table of Contents
What is Front Running?
Front running, or tailgating, refers to the act of trading a financial asset based on non-public, material information about a future transaction that will affect said asset’s price.
While not always illegal, front running is typically viewed as a form of market manipulation and insider trading. It’s a white-collar crime because the insider information provides an undue advantage to the few in the know.
DID YOU KNOW?
The terms ‘front running’ and ‘tailgating’ supposedly date back to the days when brokers executed trades via paper. You had to physically bring the order to trading desks. Brokers would actually sprint to the trading desk before (front running) or just after (tailgating) a colleague’s big order.
We at the Zero Theft Movement are dedicated to eradicating the rigged parts of the economy so that all Americans can thrive. Illegal front running games the market in the favor of a few, where they can unfairly minimize their risk while maximizing their gains. Furthermore, it can harm investors by creating sudden fluctuations in the market (e.g. the ‘2010 Flash Crash’).
How Front Running Works
Here’s a simple example of how illegal front running commonly works: Let’s say a broker receives an order to buy a million shares of X company. The sheer size of the purchase will likely cause the price of the stock to instantly shoot up. Whether that lasts is uncertain, but the immediate spike will occur.
The broker, having non-public, material information, first purchases some X company stock for their own portfolio and then executes the trade for their client. That’s why it’s called ‘front running’: a broker trades with insider knowledge about a future transaction getting ahead of a big-ticket trade. After the price spike occurs, the broker sells the shares and reaps a considerable profit.
In the example, you can see how a trader can game the stock market by front running. The practice eliminates much of the risk, nearly guaranteeing rewards. Furthermore, the client could lose a lot of money by the broker putting off the trade. We’re talking about trading hundreds of thousands or even millions of shares, multiplying the total potential losses.
For an actual case of front running, the Securities and Exchange Commission (SEC) charged Daniel Bergin (a senior equity trader) with front running in 2013. The Agency alleged that “Bergin illicitly profited by at least $520,000 by routinely purchasing securities in his wife’s accounts earlier the same day he placed much larger orders for the same securities on behalf of firm clients. Bergin concealed his lucrative trading by failing to disclose his wife’s accounts to the firm and avoiding pre-clearance of his trades in those accounts. Bergin also attempted to hide his wife’s accounts from SEC examiners.”
Thirty brokerage firms paid about $900 million to settle the civil suit contending they “schemed with one another for years to fix prices on the NASDAQ stock market,” the New York Times reported. They allegedly did so by not using odd-eighth NASDAQ quotes. See what the ZT community has uncovered about the matter.
Other Forms of Front Running
Other types or forms of front running exist, some illegal and some not. We’ll check out:
- Access to nonpublic news/information
- Index front running
Access to nonpublic news/information
Instead of front running before a bulk trade, this method involves trading before nonpublic, material information goes public.
Let’s say the quarterly earnings report of X company has yet to go public. The CEO discloses to close shareholders to buy (if the report’s positive) or sell (if negative) the company’s stocks.
Or a government official finds out an industry they’ve invested in will face tighter industry regulations and sells before that information goes public.
You can see how insiders can realize massive gains or avoid massive losses through the exploitation of information most in the public do not know about. Either way, acting on said information or informing others about it is a criminal offence.
Index front running
Index front running, a legal practice, essentially refers to when traders watch the stocks in index funds and place orders based on fully public information.
Index funds essentially mirror the portfolios of market indices (e.g. Nasdaq, S&P 500, Dow Jones, etc.). They often get rebalanced as stocks can change significantly in price, or be added or removed. Announcements are always made before a new stock gets added to or removed from to a market index. That makes the material information public for all.
Traders can closely monitor the stocks in these index funds, so they know whenever an update will occur. They can trade before the actual addition or removal of stocks happens in order to gain a competitive edge.
The Grey Area
Ethical concerns arise even with index front running when it comes to variances in speed between main street investors and high-frequency trading (HFT) firms. The latter have supercomputers that can make millions of trades in milliseconds. Because HFT firms can process transactions at breakneck speeds, they can identify large block trades being carried out by investors, allowing them to front-run the trades, pushing up the prices of trades before they have been fully executed.
Jacob Adrian, a 2016 J.D. candidate at Duke University School of Law, discusses the considerable inequality between HFT firms and the average investor. He writes, “Put simply, because some firms are able to purchase faster access to market information, those who do so have a distinct advantage over those who do not. This creates a textbook two-tiered system of ‘haves’ and ‘have nots.’”
Source: The Wall Street Journal
Furthermore, the ability to trade in bulk effectively instantaneously can seriously affect prices for main street investors. What you or any other regular investor might be purchasing a stock without knowing its actual price. Imagine if this kind of trading occurs in dark pools, privately owned, largely unregulated exchanges that do not expose trade information until the purchase or sale has been completed and reported.
Dark pool trading accounts for ~30% of all trading. Do you think billions of concealed trades are happening without us even knowing it?
Potential Cases of Front Running
In the following three potential cases involving front running, please recognize how the alleged use of the practice can often hurt innocent clients.
Former New York Attorney General Eliot Spitzer famously took the fight to Wall Street during his time in office. His work led to the 2003 mutual fund scandal, where he and the SEC investigated and arguably exposed many high-profile investment institutions.
To just look at one case a bit closer, take a look at this quote from an SEC litigation release on two traders who’d worked for Putnam Securities: “Scott and Kamshad, for their own personal accounts, [allegedly] engaged in excessive short-term trading of Putnam mutual funds for which they were portfolio managers…Scott and Kamshad’s investment decision-making responsibility for those funds afforded them access to non-public information about the funds, including current portfolio holdings, valuations and transactions. The complaint further alleges that Scott and Kamshad’s short-term trading violated their responsibilities to other fund shareholders, that Scott and Kamshad failed to disclose their trading and that, by their trading, they potentially harmed other fund shareholders.”
According to Investment News, “Once the initial sparks were set, the Securities and Exchange Commission kept piling on the lumber, with charges, enforcement proceedings and fines against such household names as Alliance Capital Management LP, Columbia Management Advisors Inc., Edward D. Jones & Co. Inc., The Goldman Sachs Group Inc., Invesco Funds Group Inc., Janus Capital Group Inc., Marsh & McLennan Cos. Inc., Morgan Stanley & Co. LLC, Prudential Securities and Wachovia Corp.”
In a 2017 press release, the New York Department of Financial Services (DFS) announced it had “fine[d] Credit Suisse AG $135 million for unlawful, unsafe and unsound conduct in its foreign exchange trading business.”
According to the press release, the DFS investigation “found that front-running…was encouraged by executives of eFX, Credit Suisse’s electronic trading platform. From at least April 2010 to June 2013, Credit Suisse employed an algorithm designed to front-run clients’ limit and stop-loss orders. Credit Suisse programmers designed the algorithm to predict the probability that a client’s limit or stop-loss order would be triggered. Credit Suisse traders would apparently enter the market with that information, knowing that the market might move in a specific direction if the stop-loss or limit order was triggered. From April 2010 through June 2013, Credit Suisse executed approximately 31,000 limit orders and 41,000 stop-loss orders that may have been a source of profit through front running. Additionally, because front-running can occur on orders that ultimately remain unfilled, Credit Suisse may have profited as well from front running many tens of thousands of additional client orders.”
In 2020, the Financial Industry Regulatory Authority (FINRA) fined Citadel Securities $700,000 for “trading ahead of its clients,” according to a Bloomberg report.
FINRA, in its investigation, alleges that “From at least September 2012 to mid-September 2014, the OTC Desk, in many instances, traded ahead of those inactive OTC customer orders in violation of FINRA Rule 5320 [prohibition against trading ahead of clients] and failed to display them as required by FINRA Rule 6460.”
Front Running, the Quick Heist?
Illegal front running represents one way Wall Street can rig the stock market in its favor, often at the expense of the public. This not only leads to unethical and undue profits, it can even destabilize the market. As seen in the aforementioned Flash Crash.
The finance and insurance industries represent 7.4% (or $1.5 trillion) of the U.S.’s total GDP. With an industry of that size, the potential bounties appear endless. The potential economic damage, though, is sizable as well. Just think about the questionable behavior that led to the 2008 subprime mortgage crisis. Consider the people still feeling the effects of the historic collapse.
The Zero Theft Movement, along with our growing community, works to calculate the most accurate estimate for the monetary costs of corruption in the United States. We achieve this collectively through our independent voting platform.
The public investigates potential problem areas, and everyone votes on whether (1) theft is or isn’t occurring in a specific area of the economy, and (2) how much is being stolen or possibly saved. Through direct democracy, we can collectively decide where the problem areas are and start working on addressing them systematically.
Only through hard evidence can we prove where the rigged parts of the economy exist and force Congress to hold all the bad actors accountable.
The Zero Theft Movement does not have any interest in partisan politics/competition or attacking/defending one side. We seek to eradicate theft from the U.S economy. In other words, how the wealthy and powerful rig the system to steal money from us, the everyday citizen. We need to collectively fight against crony capitalism in order for us to all profit from an ethical economy.
Terms like ‘steal,’ ‘theft,’ and ‘crime’ will frequently appear throughout the article. Zero Theft will NOT adhere strictly to the legal definitions of these terms (since congress sells out). We have broadly and openly defined terms like ‘steal’ and ‘theft’ to refer to the rigged economy and other debated unethical acts that can cause citizens to lose out on money they deserve to keep.