What is front running?

In Brief:

• Front running exploits non-public order information for personal or company gain, violating financial market fairness.
• Regulators prohibit front running, enforcing this with penalties including hefty fines, license revocations, and potential criminal charges.
• AI is both a tool to detect front running in traditional markets and a means to execute it more efficiently in cryptocurrency trading.

Front running definition

Front running is an illegal and unethical practice across global financial centers and markets. Front running occurs when someone, like a broker or trader, has advance knowledge of a pending order or future transaction that will affect an asset’s price, and they trade that asset for their benefit gain before the transaction is executed.

Front running hitting the headlines

In 2018, HSBC Holdings agreed to pay $101.5 million to resolve charges related to a front running scheme. The case involved HSBC traders misusing confidential client information for their own benefit in foreign exchange (FX) transactions.

HSBC’s former Head of FX cash trading was found guilty in a related criminal case. As a result, the bank implemented stricter measures to improve its control environment, including algorithmic trading and enhanced compliance programs.

How stock front running can occur

There are three notable types of front running trading, which firms and individuals should be aware of. These are:

1. Broker-dealers and client

Here a broker receives a large client order, anticipates the price impact, and trades for their own company account before executing the client’s order. The intent here is to profit from the anticipated price movement impact of the large client order.

2. Personal account dealing and client

In this scenario, a trader with knowledge of a client order uses their personal account to front run the client’s trade. This violates the duty to prioritize client interests.

3. Client and client

This is where one client’s trade appears to front run another client’s order. This may be coincidental, but warrants investigation to determine whether malpractice is involved.

The role of AI in front running

Artificial intelligence has become a double-edged sword in the battle against front running. In traditional stock markets, AI-powered surveillance systems help detect and prevent front running by analyzing vast amounts of trading data and identifying suspicious patterns.

However, in cryptocurrency markets, sophisticated AI algorithms are being used to create more efficient front running bots. Typically, a front run bot can quickly scan pending transactions, predict price movements, and execute trades faster than human traders.

As AI technology advances, regulators and market participants face the challenge of staying ahead of increasingly complex front running strategies while leveraging AI’s potential to maintain market integrity.

Key regulations around front running

Front running is regulated differently across jurisdictions, but it is universally considered a form of market abuse. Numerous regulatory bodies implement rules and sanctions to maintain market integrity and protect investors from unfair trading practices such as front running.

In the U.S., three main regulatory bodies tackle front running:

1. Financial Industry Regulatory Authority (FINRA) prohibits front running under Rule 5270
2. The Securities Exchange Commission (SEC) bans the practice in its Code of Ethics, Rule 17j-1, Section D
3. The Commodity Futures Trading Commission classifies front running as prohibited abusive trading activity in Section 37.203(a)

In the U.K. and Europe, front running is similarly prohibited:

1. The U.K.’s Financial Conduct Authority (FCA) defines it as insider dealing in U.K. MAR 1.3
2. The European Securities and Markets Authority categorizes it as market abuse in Article 7(1)(d) of the 2020 MAR Review Report.
3. In the EU, Regulation (EU) No 596/2014 Section 30 covers front running

Front running sanctions: How are regulators holding bad actors accountable?

Sanctions for those carrying out front running can be severe, reflecting the seriousness of the offense. Penalties may include:

• Substantial fines, often in the millions of dollars
• Disgorgement of profits gained through front running
• Suspension or revocation of trading licenses
• Bans from working in the financial industry
• Criminal charges in egregious cases, potentially leading to imprisonment

The severity of sanctions against those who front run trades typically depends on factors such as the scale of the activity, the amount of profit gained, and the level of intent.

Regulatory bodies including the SEC, FINRA, and FCA have the authority to impose these sanctions, underpinned by their mission to deter future misconduct and maintain market integrity.

How can firms prevent and detect front running?

The stringent penalties associated with stock front running emphasize the importance of firms implementing effective compliance measures to prevent and detect this form of market abuse. Some of these measures include:

Monitoring measures:

• Deploying advanced trade surveillance systems using AI and machine learning
• Running real-time monitoring of order flows and execution patterns
• Implementing strict internal controls and segregation of duties
• Monitoring personal trading accounts belonging to employees

Reporting and training measures:

• Conducting regular audits and compliance reviews
• Organizing mandatory employee training on ethical trading practices, covering specific topics such as front running, wash trading, and price rampling
• Ensuring the existence of whistleblower policies and programs to encourage reporting of suspicious activities
• Requiring time-stamping and sequencing of orders to track their progression, and comprehensively analyzing trading data, including timestamps and price movements

Summary

Front running in finance remains a significant threat to market integrity across both traditional and cryptocurrency markets. As regulators intensify their efforts to combat this illegal practice, firms must stay vigilant. Implementing robust surveillance systems, maintaining comprehensive records, and leveraging advanced compliance tools are crucial steps in detecting and preventing front running. By prioritizing these measures, financial institutions can protect their clients, preserve market fairness, and avoid severe regulatory penalties – all of which ultimately fosters trust in the financial ecosystem.

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