Front-Running

Does ‘front-running’ make you think of Usain Bolt streaking past the finish line? Well, front-running in financial markets has nothing to do with sporting glory. Sample these: recently, market regulator SEBI rapped HDFC Mutual Fund on the knuckles for front-running by its employee in 2007. Author Michael Lewis accuses super-fast traders of ‘front-running’ in Flash Boys .

Front-running is a practise where a market participant gets to know of someone else’s impending trade and jumps into the stock before them to pocket a gain. It is high net-worth investors and big institutions who are often the victims of front-running.

This is how it works. Suppose I work in a broking house and my client Mr Crorepati Trader has just asked me to buy 10,000 shares of Kwality Dairy. I know Kwality Dairy is now changing hands at ₹43 in the market, but if I place a buy order for 10,000 shares, the price is bound to spike up. I quickly jump in ahead of my client and place my own order for a 1,000 shares at ₹43. I follow this up with Mr Crorepati’s request, which has the stock shooting up to ₹44. I quickly sell my shares, making a neat gain of ₹1,000.

In the HDFC Mutual Fund episode, fund managers usually conveyed their buy and sell decisions on stocks to equity dealer Nilesh Kapadia. Now looking into the trading patterns for some stocks between April and July 2007, the stock exchanges detected a curious trend. Three individual investors — Rajiv Sanghvi, Chandrakanth Mehta and Dipti Mehta — were buying or selling the same stocks just before HDFC Mutual Fund did. The exchanges smelt a fish and escalated the issue to SEBI. SEBI found that Kapadia was slipping information about the fund’s trades to his friends. It penalised Kapadia and his accomplices and pulled up the fund house for its ‘act of omission’. SEBI also framed detailed rules to prevent dealers in trading firms from using their cell phones or engaging in water-cooler chats during trading hours.

Front-running, like insider trading, is an unfair practise as it skews market prices and forces an investor to pay higher prices.Front-running was rampant in the bad old days when people relied entirely on brokers for market trades. Today, any investor can access a stock’s latest order book online and punch in his own order; so front-running has become less of a risk for the retail investor. But for institutional investors, where the portfolio management function is separated from the dealing function, front-running remains a live risk.

When employees of a fund indulge in front-running, it is at the expense of returns that you earn; front-running forces the institution to buy a stock above its real traded price or sell it below. You also need to worry if you have habit of buying or selling less-known penny stocks after chats with your broker.

As Lewis points out, every investor who operates in the securities markets needs to worry about being ‘front-run’ by the big boys of high-frequency trading. These guys rely on sophisticated computer programmes which snoop around electronic exchanges to unearth large institutional orders.

In the markets, walls have ears. If you want to profit from trading, talk about your smart moves only after you have made them.

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