Definition
Front Running is an unethical trading practice where a broker or other entity executes orders on a security for its own account while taking advantage of advance knowledge of pending orders from its customers. In other words, it involves trading shares based on early information about future transactions that are likely to influence the price of the securities. It’s called “front running” because they are essentially jumping ahead of their clients’ trades.
Key Takeaways
- Front Running in finance refers to the unethical practice of a broker trading an equity in his own account based on advanced knowledge of pending orders from his customers or clients. The aim is to leverage the price impact of those orders to make a profit.
- Because front running involves profiting from non-public information, it is considered illegal and unethical in most jurisdictions. In those places where it’s still technically legal, it’s heavily frowned upon and can negatively impact a broker’s professional reputation.
- This tactic can damage the financial markets by making them less transparent and less fair. This is because front running can lead to distorted prices, misleading transaction volume data, and a general loss of confidence in market integrity.
Importance
Front running is a critical term in finance, signifying an unethical trading practice that involves a broker executing orders on a security for its account based on the knowledge of impending transactions that could influence the price of the security.
Essentially, the broker takes advantage of their advanced knowledge and executes an order in advance of their clients’ orders.
This practice is important to understand because it is illegal and considered insider trading, as it undermines the fairness and transparency of financial markets.
Regulators across the world view it as a fraudulent activity because it erodes investors’ confidence and can lead to market manipulation.
Therefore, front running is considered a breach of fiduciary duty and could be subject to legal ramifications.
Explanation
Front running is a controversial practice mainly employed by brokers or other market participants with the intention of achieving potential gains from the advanced knowledge of pending orders and trades. This insider knowledge essentially gives the front runner an unfair advantage when making trades because they can predict the future price movements.
For instance, if a broker has a client planning to buy a large amount of a particular stock, they could buy shares of the same stock beforehand knowing that it’s going to increase in price because of their client’s large order. The practice essentially betrays the trust of the client for personal gain, often undermining the confidence in market fairness.
Front running may lead to the manipulation of securities prices and could impact the stability of the financial markets. While it’s generally viewed as unethical, it’s also illegal in certain jurisdictions.
Securities and Exchange Commission (SEC) in the U.S., for instance, prohibits front running. However, enforcing regulations against it is often challenging due to the difficulty in proving that it took place, making it a considered risk in modern financial environments.
Examples of Front Running
Insider Trading Case on Wall Street: The most common example of front running can be witnessed in insider trading cases on Wall Street. For instance, in 2017, an IT consultant was accused of front running after he allegedly took advantage of a software malfunction from a bank to trade on information before it was publicly available. He was alleged to have front-run trades on at least 12 occasions over a period of two years, which led to profits of nearly $600,
Commodity Market Case: In another case in the commodities market, a trader used information from his clients’ intent to purchase a large quantity of copper in the future. Utilizing this inside information, the trader bought a large quantity of copper for his own portfolio, ahead of his clients, driving the price up. When clients eventually placed their orders, they ended up buying the commodity at an inflated price.
Forex Market Case: The FX market, which is decentralized, also exhibits instances of front running. In 2014, several foreign exchange (forex) traders were fired or suspended due to allegations of front-running ahead of large client orders. Known as the “Forex Scandal,” traders from different banks formed a group to manipulate the forex rates. They employed front running to make massive profits ahead of their clients’ trades.
FAQ Section: Front Running
What is Front Running?
Front Running is the unethical practice in trading where a broker or other entity executes orders on a security for its own account while taking advantage of advance knowledge of pending orders from its customers. They essentially are able to profit from the price changes that will occur once the pending orders have been carried out.
Is Front Running illegal?
Yes, Front Running is considered illegal and unethical in most jurisdictions due to its nature of creating an unfair market condition. Many financial regulatory authorities across the world have rules against this practice and it can lead to severe penalties.
What is the impact of Front Running on the average investor?
Front Running can have a detrimental effect on the average investor because it can impact the overall fairness and transparency of the market. This practice can lead to mistrust in the stock market and may result in inflated or deflated prices which could affect the overall return on investment for individuals.
How is Front Running detected and prevented?
Regulatory bodies use a combination of routine surveillance, advanced algorithmic detection techniques and reports of fraudulent activity to detect Front Running. Preventive measures include stringent rules and regulations, transparency measures, as well as penalties for breach of trust.
Related Entrepreneurship Terms
- Insider Trading
- Market Manipulation
- Arbitrage
- High-Frequency Trading
- Fiduciary Duty
Sources for More Information
- Investopedia – This is a reliable source for anything finance-related, including detailed explanations of terms like Front Running.
- U.S. Securities and Exchange Commission (SEC) – The SEC’s official site can provide insight into front running from a regulatory perspective.
- Financial Industry Regulatory Authority (FINRA) – As a non-governmental organization that regulates member brokerage firms and exchange markets, this site also boasts a large informational database.
- Financial Times – As a international daily newspaper with a focus on business and economic news, it also provides serious discussions and definitions of complex financial terms like Front Running.
