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Front running , also known as tailgating , is the prohibited practice of entering into an equity stock trade, option , futures contract , derivative , or security-based swap to capitalize on advance, nonpublic knowledge of a large pending transaction that will influence the price of the underlying security.
A front running firm either buys for its own account before filling customer buy orders that drive up the price, or sells for its own account before filling customer sell orders that drive down the price. Front running is prohibited since the front-runner profits from nonpublic information, at the expense of its own customers, the block trade, or the public market.
In , several hedge fund and mutual fund companies became embroiled in an illegal late trading scandal made public by a complaint against Bank of America brought by New York Attorney General Eliot Spitzer.
Securities and Exchange Commission investigation into allegations of front-running activity implicated Edward D. Wall Street traders may have manipulated a key derivatives market by front running Fannie Mae and Freddie Mac. The terms originate from the era when stock market trades were executed via paper carried by hand between trading desks. Likewise, a broker could tail behind the person carrying a large client order to be the first to execute immediately after.
Such actions amount to a type of insider trading , since they involve non-public knowledge of upcoming trades, and the broker privately exploits this information by controlling the sequence of those trades to favor a personal position. This example uses unusually large numbers to get the point across. In practice, computer trading splits up large orders into many smaller ones, making front-running more difficult to detect.
By front-running, the broker has put his or her own financial interest above the customer's interest and is thus committing fraud. In the United States, he or she might also be breaking laws on market manipulation or insider trading. Front-running may also occur in the context of insider trading, as when those close to the CEO of a firm act through short sales ahead of the announcement of a sale of stock by the CEO, which will in turn trigger a drop in the stock's price.
They find evidence consistent with front-running through short sales ahead of large stock sales by CEOs on the New York Stock Exchange. While front-running is illegal when a broker uses private information about a client's pending order, in principle it is not illegal if it is based on public information. 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". 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. Other types of traders who use generally similar strategies are labelled "order anticipators. Squeezers would likely be guilty of market manipulation , but the other two types of order anticipators would not be violating any US law. In insurance sales, front running is a practice in which agents "leak" information usually false to consumers about a competitor insurance company that leads the consumer to believe that the company's products or services are inferior, or worthless.
The agent subsequently obtains a sale at the consumer's expense, earns a commission, and the consumer may have given up a perfectly good product for an inferior one as the result of the subterfuge. For example, analysts and brokers who buy shares in a company just before the brokerage firm is about to recommend the stock as a strong buy, are practising this type of "front running".
Brokers have been convicted of securities laws violations in the United States for such behavior. In , a writer for the Wall Street Journal , R. Foster Winans , tipped off brokers about the content of his column Heard on the Street , which based upon publicly available information would be written in such a way as to give either good or bad news about various stocks. The tipped off brokers traded on the information.
Winans and the brokers were prosecuted by the prosecutor Rudolph Giuliani , tried and convicted of securities fraud. Their convictions were upheld by the United States Supreme Court in From Wikipedia, the free encyclopedia. This article is about the financial practice. For the practice as applied to domain names, see domain name front running.
Front Running of Block Transactions". Retrieved 25 July Mutual funds still recovering 10 years after scandal". Reminiscences of a Stock Operator. Trading and Exchanges First ed. United States , Supreme Court decision. Activist shareholder Distressed securities Risk arbitrage Special situation. Algorithmic trading Day trading High-frequency trading Prime brokerage Program trading Proprietary trading. Arbitrage pricing theory Assets under management Black—Scholes model Greeks finance: Vulture funds Family offices Financial endowments Fund of hedge funds High-net-worth individual Institutional investors Insurance companies Investment banks Merchant banks Pension funds Sovereign wealth funds.