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Concepts & Tutorials

Front Running

At Yahoo, I write on the practice of Front-Running.

You’re waiting in a long queue for a movie ticket. The person in front of you buys all the remaining tickets, and turns around and offers them to the rest of the queue at 25% higher rates. You have just been “front-run” and have no choice but to pay up. Feels outrageous?

Next, consider booking a Maruti car hugely in demand. You put only Rs. 50,000 down, for which the waiting period is now three months. After three months, newer buyers are willing to pay you Rs. 25,000 extra if you “give up” your booking so they can avoid the wait. You just made a killing. Still outraged?

Finally, consider buying a house way before the builder has even started digging the foundation; come two years, and once the building is half done and all the units are sold, you sell your allocation to a desperate buyer for a massive return on your investment. Not quite outraged, I’m sure.

Why should “black tickets” outrage us, and not the others? The line between speculation and front-running is a thin one. It’s considered unfair where regulations want it to be, and where there might be an agreeable degree of fairness.

One case where it is illegal, is in stock trading. When you call a broker and ask him to buy a huge number of a small cap company’s shares, he can go and buy those shares first and then place your order, while at the same time selling to you at a higher price. This is illegal front-running, because your broker is using your privileged information to trade against you.

In the 90s, there was very little transparency. With very few electronic terminals and hand-signal based trading, brokers would tell you your purchase got executed at a higher price than actually happened. Front-running wasn’t just common, it was expected. To counter this, SEBI now mandates that brokers must give you contract notes with details that allow you to verify the trade with the exchanges (Check the BSE or NSE).

But front-running is lucrative, and it continues. In February, a portfolio manager at the Foreign Institutional Investor Passport Capital, was caught by SEBI for front-running. Before placing an order for the company, he would call his friends, who bought from the market and profited from the rise which usually accompanies a large order. SEBI had earlier caught an HDFC Mutual Fund employee front-running the fund similarly with his college friends.

Brokers allowed “after-market” orders for clients who couldn’t trade during the day — such orders were placed in a queue to be executed on the next day, at the start. But brokers began to front-run those orders as well — if they know that a large “at-market” order for a stock exists, it doesn’t take much to put in their buys first. To resolve this problem, the BSE and NSE created a pre-open auction process that shouldn’t stiff investors.

Recently, stocks have jumped up on unfounded rumours like a potential delisting or a possible merger. In a slow market, when it doesn’t take much to move a stock, such rumour mongers can make a killing.

Initial public offers in India need to allocate shares to retail investors, to high-networth individuals and to institutions separately. This allows for a fair distribution — versus the US, where institutions lap up shares of companies and unload them to the general public on the listing day. Recently the shares of LinkedIn listed at $90, after the company sold them at half that price to institutions. This is legal, apparently, but not as fair as the Indian approach.

Electronic terminals have changed the front running game, which used to work easily when a broker had to be called to place a trade. Now, fund managers can place orders themselves, directly on an exchange through computer software. With the advent of algorithmic trading, participants can choose algorithms that will try to get the best price by splitting the order down into unidentifiable chunks (you never want to reveal the presence of a large order).

But front-running has also gone electronic. In the US, before placing an order directly in the market, exchanges took to quickly “flashing” these orders to high frequency trading algorithms — for a fee. A trader explained to the New York times how such flash orders helped these algorithms front-run investors, by simply figuring out the maximum they were willing to pay. A past-president of the BSE used his position to get information about other brokers’ positions from the BSE surveillance department.

Dipak Patel from Passport Capital gave back some of his profits from the practice, and after two years, can work in the securities industry again. The aforementioned BSE Ex-President, after being told to stay away for a couple of years, now has a thriving brokerage practice. So if you’re caught, you have to lie low for two years or so and in some cases, pay back your gains. But even if a person was banned from the markets, he could trade in a family member’s name. And to have to pay back only the gains means there is no penalty. And if you’re not caught…

This is not disincentive enough; if something is illegal, then the punishment should be big enough to deter people from the act.  Front-running in stocks is an abusive practice that reduces investor confidence in markets. If SEBI is serious about cutting down front-running, it needs to penalize wrong-doers a lot more.

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