What Is Trading Ahead?

Trading ahead occurs when a market maker trades using the firm's account to make a trade instead of matching available bids and offer from other market participants. Market makers are not allowed to trade ahead of customer or other broker dealer orders, and trading ahead is a violation of FINRA regulations.

Key Takeaways

  • Trading ahead occurs when a market maker trades using the firm's account to make a trade instead of matching available bids and offer from other market participants.
  • Trading ahead is when a market maker knowingly enters proprietary orders ahead of, or along with, customer orders that are executed at the same or better price before the customer order.
  • Trading ahead gives market makers an unfair information advantage to the detriment of retail investors and traders.
  • Trading ahead is banned by FINRA as well as most major exchanges.

Understanding Trading Ahead

For instance, if a customer order has submitted an order to sell 100 shares at $10.00 and there is a bid for $10.05 present, a market maker could not sell the $10.05 bid ahead of the customer. Likewise, if the best bid were instead $10.00, the market maker could only sell $10.00 once the customer has executed all 100 shares at that price.

Trading ahead is a violation of market trading practices. A market maker who uses securities from their own account ahead of the orders placed in the open market for execution is considered to be in violation of trading ahead.

The act of trading ahead can occur through the development of standard market practices. Rules established by the Financial Industry Regulatory Authority (FINRA) have been instituted to monitor and penalize market trading specialists who violate trading ahead rules. Similar rules have also been set by individual exchanges.

Market Making

Market makers, also known as specialists, are a key part of the infrastructure that facilitates secondary market trading. They work to match buyers and sellers in the open market through a bid-ask trading system that allows them to profit from bid-ask spreads generated on each trade.

The primary goal of market makers is to facilitate trading through the matching of buyers and sellers. However, if a trading scenario in which only one leg of the transaction is offered a specialist can trade from their own account to complete the trade.

Trading ahead is illegal when a market maker knowingly chooses to trade with their own account to complete a transaction when unexecuted orders are available from investors that could be filled at the same price or better. This act may provide an advantageous trading price to the market maker while inhibiting the fair market price for the open market. Trading ahead could also create an unsubstantiated profit for the market specialist.

Regardless of the motivation, trading ahead is considered a disruption to the orderly and efficient market trading standards which regulators seek to uphold for all investing participants; unless, the trading ahead is done without knowledge of the existing orders.

Market Rules for Trading Ahead

Trading ahead was initially prohibited by NYSE Rule 92. Subsequently, in order to reduce regulatory duplication and streamline compliance, the NYSE and AMEX replaced Rule 92 with FINRA Rule 5320 which became effective from September 12, 2011.

FINRA Rule 5320 provides detailed direction on trading ahead and its prohibitions. It is also informally known as the "Manning rule." The ruling requires that market makers have documented policies and procedures regarding trading rules and that firms adhere to the documentation rules outlined in FINRA Rule 5310. Rule 5320 also provides for many exceptions to the prohibition of trading ahead.

Exceptions include large orders and institutional orders, no-knowledge exceptions, riskless principal exceptions and ISO exceptions. Additionally, a market maker can satisfy an exception if they immediately execute a customer's order up to the size and price (or better) than what they executed for their own book.