What is Front-Running?
Front-running is when a broker or other entity enters into a trade because they have foreknowledge of a big non-publicized transaction that will influence the price of the asset, resulting in a likely financial gain for the broker. It also occurs when a broker or analyst buys or sells shares for their account ahead of their firm's buy or sell recommendation to clients.
Front-running is also known as tailgating. Front-running is illegal and unethical because it takes advantage of private information that is not available to the public. If a big transaction is made public, then buy or selling ahead of it is not illegal.
How Front-Running Works
Front-running is the practice of a broker or trader making trades just before a large non-publicized order to gain an economic advantage. For example, a broker receives a request from a client to buy 500,000 shares of XYZ Company. He holds the client's order until after personally executing an order for the same stock for his account. Later when he places the client's request, there is a rise in share price, due to the size of the client's order. This rise creates an instant profit for the broker.
This form of front-running is unethical and illegal as it gives an unfair advantage to the broker or trader. Front-running, much like insider trading, provides unfair advantages to the broker who has nonpublic information that will affect the asset's price.
It is also considered front-running if an analyst purchases or sell shares prior to their firm releasing a buy or sell recommendation. The trader knows the recommendation will impact the price of the asset in question, so placing a trade right before releasing the recommendation is unethical and illegal. There is some grey area here, as firms may have many positions.
Firms and individuals are allowed to have positions in assets they recommend or discuss, but their position must be revealed at the time of the recommendation or discussion. Also, having a position isn't illegal, but attempting to profit from non-public information is. A short-seller may accumulate a short position and then reveal their research to the general public on why they shorted the stock. This not illegal, because the short-seller is trying to profit from overall conditions, and not simply trying to profit from releasing their information. The latter would be a short-sell version of the pump and dump.
- Front-running is illegal and unethical when a firm or someone is acting on non-public information in order to make a profit.
- Illegal front-running includes when a broker places a trade ahead of a large price-affecting client order, or when a firm's employee places a trade just prior to the firm releasing a major recommendation or news story.
- Buying when indexes or funds reveal they will purchasing an asset is not illegal since the information is public.
Index funds also experience front-running, although index front-running is not illegal. Index funds track an index by mirroring the index's portfolio. Because the index changes its composition of stocks periodically, traders can see when an index fund will update its portfolio. As a result, traders step in front of the trade by buying or selling shares to gain a profit or prevent a loss.
For example, in 2015, the Standard & Poor’s 500 index (S&P 500) added American Airlines Group Inc. to its holdings. This means that the S&P 500 would need to buy shares of American Airlines so it could be included in their portfolio. Other indexes and funds that track the S&P 500 would be doing the same. Immediately after the announcement, traders bought shares because they knew that a large number of shares would have to be purchased by all these indexes and funds. The stock increased by 11% by the time it was added to the index. Some of the advance was due to the buying of the indexes and funds, while some of it was also due to traders buying up the stock after the S&P 500 news release.
This form of index front-running is legal. The information used by investors is public and is seen as offering them no unfair advantage.
Examples of Legal and Illegal Front-Running
Illegal front-running is primarily limited to two types. The first type is acting ahead of a non-public order, and the second is acting ahead of a piece of news that hasn't been made public yet.
Assume a broker sees a market order come in to sell 2000 shares in a thinly traded stock. Selling 2000 shares could decrease the price of the stock by $1. The broker decides to sell 200 shares in his own account first, and then execute the client's order. As expected, the large order causes an instant price drop. The broker covers their 200 share short position and pockets a quick $200.
In another example, assume that a firm is about to release a very negative report on a company. An analyst at the firm short-sells the stock in anticipation that the negative report will cause the price to drop. The report is released and the stock drops. The analyst covers their position and reaps a quick profit. This is illegal. Shorting after the news is released is not illegal since the information is now public.
The trader or broker doesn't necessarily need to make money for the transaction to be considered illegal. Even if they lost money because the market did not react as expected, the activity is still illegal.
Front-running another person's or entity's order is legal if the order is made public. An index may reveal that a certain stock is going to be dropped by the index next month. The index will need to sell the shares it holds in that stock. That could drive down the price, depending on how many shares the index has to the sell and the liquidity of the stock. A short-seller could sell the stock, knowing that the index will be selling as well and putting downward pressure on the price. This is not illegal since the trader is acting on public information.