Front Running
Front running is a prohibited trading practice where a market participant trades on advance knowledge of pending orders that are likely to affect the price of a security. This practice exploits non-public information about upcoming trades to gain an unfair advantage.
Understanding front running
Front running occurs when a trader, typically a broker or market maker, uses privileged information about incoming customer orders to trade ahead of those orders for their own benefit. For example, if a broker receives a large buy order from a client, they might first purchase the security for their own account, anticipating the price increase that will likely result from the client's order.
Types of front running
Traditional front running
This involves a broker or trader directly using customer order information to trade ahead of those orders. This is the most straightforward and clearly prohibited form of front running.
Electronic front running
With the rise of high-frequency trading, sophisticated systems can detect large orders being placed across multiple venues and trade ahead of their execution. This practice often involves analyzing real-time market data to predict large order flows.
Market impact and detection
Front running can have several negative effects on market quality:
- Increased transaction costs for institutional investors
- Reduced market efficiency
- Damaged trust in market intermediaries
- Potential price distortions
Modern market surveillance systems employ sophisticated pattern recognition to detect potential front running activities. These systems analyze tick data and order flow patterns to identify suspicious trading behavior.
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Prevention and controls
Financial institutions implement various controls to prevent front running:
Information barriers
Often called "Chinese walls," these separate trading operations from areas with access to customer order information.
Order handling procedures
- Strict rules about order processing sequence
- Time-synchronized data streams for audit trails
- Automated pre-trade risk checks to prevent prohibited trading patterns
Regulatory requirements
Regulators require firms to maintain robust surveillance systems and implement controls against front running. This includes:
- Regular trading pattern analysis
- Employee training programs
- Documentation of order handling procedures
- Implementation of real-time trade surveillance systems
Market structure implications
Front running concerns have influenced modern market structure design:
- Development of dark pools to hide large orders
- Implementation of sophisticated order execution algorithms
- Use of pegged orders to minimize information leakage
- Advanced transaction cost modeling to detect potential front running impact
The practice remains a key concern for market participants and regulators, driving continuous evolution in market design and surveillance capabilities.