What is front running?

A recent order of the Securities Appellate Tribunal in India has raised quite a furore over the precise meaning of front running. The Tribunal ruled that Regulation 4(2)(q) of the Fraudulent and Unfair Trade Practices Regulations prohibit front running by intermediaries like stock brokers but not by others.

Many people argue (a) that front running by any entity should be prohibited, and (b) even in the absence of such a prohibition, front running is a fraud on the market that is covered by the general anti fraud regulations. I do not wish to make any comment on the particular case that was decided by the Tribunal, but do think that we should be careful about criminalizing any and all forms of front running. Front running by brokers and other intermediaries is a breach of fiduciary obligation that they owe their clients, but it is not self evident that every Tom, Dick and Harry on the planet has any fiduciary obligation not to front run orders that they expect other people to place. In fact, such form of front running is legal and common through out the world.

The most famous example of such legal front running occurred when the giant fund LTCM (Long Term Capital Management) was near its death in 1998. LTCM brought in Goldman Sachs to help raise new money to recapitalize LTCM. Goldman flatly refused to sign a Non Disclosure Agreement (NDA) when requested to do so, but LTCM was so desperate that they let Goldman do due diligence anyway. What happened thereafter is well described by many people. Here is the description from Sebastian Lullaby’s More money than God: hedge funds and the making of a new elite, New York, Penguin Press (page 239-240):

[Goldman's] proprietary trading desk was selling positions that resembled LTCM’s, feeding on Long-Term like a hyena feeding on a trapped but living antelope. The firm made only a qualified effort to defend what it was up to. A Goldman trader in London was quoted as saying: “If you think a gorilla has to sell, then you sure want to sell first. We are very clear on where the line is; that’s not illegal.” Corzine himself conceded the possibility that Goldman “did things in markets that might have ended up hurting LTCM. We had to protect our own positions. That part I’m not apologetic for.”

The critical point that separates Goldman’s actions from the zone of illegality is its refusal to sign the NDA. This very clearly highlights that the prohibition of front running is rooted in a fiduciary obligation – take that fiduciary duty away and there is nothing immoral or even illegal about trading ahead of somebody else. In fact, the practice is so widespread that in the finance literature, there is a technical term for it – predatory trading (Markus K. Brunnermeier and Lasse Heje Pedersen (2005) “Predatory Trading”, The Journal of Finance, 60(4), pp. 1825-1863). Brunnermeier and Pedersen identify several situations where this kind of front running occurs routinely:

• Hedge funds with (nearing) margin calls may need to liquidate, and this could be known to certain counterparties such as the bank financing the trade.
• Similarly, traders who use portfolio insurance, stop loss orders, or other risk management strategies can be known to liquidate in response to price drops.
• A short-seller may need to cover his position if the price increases significantly or if his share is recalled (i.e., a “short squeeze”).
• Certain institutions have an incentive to liquidate bonds that are downgraded or in default.
• Intermediaries who take on large derivative positions must hedge them by trading the underlying security.

This list is by no means exhaustive – there is a whole industry devoted to front running index mutual funds trading ahead of an index reconstitution or a commodity Exchange Traded Fund rolling over its futures positions to the next month.

Front running can happen even with much more imprecise forecasts of other people’s orders. A paper forthcoming in the Journal of Financial Economics (Sophie Shive and Hayong Yun “Are mutual funds sitting ducks?” available here or in working paper version here) shows that:

We find that patient traders profit from the predictable, flow-induced trades of mutual funds. In anticipation of a 1%-of-volume change in mutual fund flows into a stock next quarter, the institutions in the same 13F category as hedge funds trade 0.29–0.45% of volume in the current quarter. ... A one standard deviation higher measure of anticipatory trading by a hedge fund is associated with a 0.9% higher annualized four-factor alpha. A one standard deviation higher measure of anticipation of a mutual fund’s trades by institutions is associated with a 0.07–0.15% lower annualized four-factor alpha.

On the opposite side there is a paper showing that hedge funds short stock ahead of expected sales by mutual funds experiencing large redemptions (Joseph Chen, Samuel Hanson, Harrison Hong, Jeremy C. Stein (2008) “Do Hedge Funds Profit From Mutual-Fund Distress?”, NBER Working Paper No. 13786)

In short, finance is an ugly world very similar to the African Savannah where the lion lives only if it can outrun the slowest gazelle and the gazelle lives only if it can outrun the fastest lion. We may not like it, but I am not sure that it is practical or desirable to criminalize all this.

I repeat that I am not expressing any view on the case that was before Tribunal; I am only responding to suggestions that any and all forms of front running should be criminalized.

Posted at 5:20 pm IST on Mon, 26 Nov 2012         permanent link

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