Front running

Front running is the illegal practice of a stock broker executing orders on a security for their own account (and thus affecting prices) before filling orders previously submitted by their customers. After the broker has made their original transactions, they can expect to close out their position at a profit based on the new price level. Front running may involve either buying (where the broker buys for their account, driving up the price before filling customer buy orders) or selling (where the broker sells for their own account, driving down the price before filling customer sell orders).

Allegations of front running occasionally arise in stock and commodity exchanges, in scandals concerning floor brokers and exchange specialists.

Explanation

For example, if a broker buys 20,000 shares of a stock for $100 per share just before buying a large block of 400,000 shares for a customer, they may drive the price up to $102 per share. If the broker is able to sell their newly purchased shares at $101.75, they will have made $35,000 in a few minutes. This $35,000 is likely to be only part of the additional cost to the customer's purchase caused by the broker's self-dealing.

The broker has put their own financial interest above (or in front of) the customer's interest and is thus committing fraud. In the U.S. they might also be breaking laws on market manipulation or insider trading.

Other uses of the term

In his book "Trading & Exchanges", Larry Harris outlines several 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 $33.30 is announced to the market, many traders may seek to buy for $33.31. 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 his or her 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." Though most brokers would consider this type of front running to be unethical, it probably would not be illegal if the information were gathered legally. If the information were gathered from corporate insiders, it would be a form of insider trading.

References

*Larry Harris, Trading & Exchanges, Oxford Press, Oxford, 2003. Chapter 11 "Order Anticipators."

See also

* Domain name front running

External links

* [http://www.financeprofessor.com/financenotes/lessonsoftheweek/frontrunning.html Finance Professor]
* [http://www.ustreasurymarket.com USTreasuryMarket.com: Front running in government bond market, described by former trader.]