Insider trading and Front Running are two common terms in the world of securities markets that raise ethical concerns and have serious legal implications. Though often confused with each other, there is a ‘not-very-thin’ line of difference between the terms “Insider Trading” and “Front Running”. They are, however, two different sides of the same coin called Market Abuse.
How Does One Differentiate Insider Trading from Front Running?
In this article, we aim to provide a clear understanding of the differences between Insider Trading and Front Running, and unmask the underlying unfair advantage.
Lets start with a couple of cases. Which of the two scenarios can be categorized as ‘Insider Trading’ and which one as ‘Front Running?’
- Ashok, a finance executive at a listed tech company has just been asked to start working on integrating the financial reporting systems because an acquisition of a major competitor has been under discussion and is now imminent. Ashok buys hundreds of shares of his company before the company announces the acquisition to the public and sells it immediately thereafter the announcement, making a significant profit.
- Lisa, a trader that co-ordinates client orders at an international broking firm, learns that one of their hedge fund clients intend to place a significantly large order for the stock of a specific company in the second half of that day. She quickly buys the stock for her personal portfolio, anticipating the price will rise. After the hedge fund’s order is received and executed over the course of the next two days, the demand pushes the stock price and Lisa sells her shares at a higher price, generating substantial profits.
In the first scenario, where Ashok learns about a company’s acquisition and trades stock based on that non-public information, it can be classified as Insider Trading. In the second scenario, where Lisa receives insider information about a hedge fund’s upcoming large order and trades stock based on that advance knowledge, it can be classified as Front Running.
Let’s dive into the intricacies of these concepts and gain a deeper understanding of how they work.
What is Insider Trading?
There are many factors that can detrimentally impact capital markets as a whole, but the major one is Insider Trading. As discussed in the article “Insider Trading – What is it Really? Insider trading refers to the buying or selling of stocks or other securities based on non-public information, giving an unfair advantage to those who have this information. Insider trading typically occurs when individuals with privileged access to confidential information, such as corporate executives, employees, or board members, use that information to make trading decisions.
Why is Insider Trading Considered Unethical and Illegal?
Insider Trading affects the market as it undermines the integrity and creates an uneven playing field, which causes the implied trust breach. When investors perceive the market as rigged and unfair, their trust erodes, potentially causing them to withdraw their investments. This loss of trust can trigger a cascading effect that destabilizes the entire economy. A significant factor contributing to this erosion of trust is insider trading, which not only undermines the integrity of the financial system but also reinforces the perception of an unjust playing field. To gain a deeper understanding of the detrimental effects of insider trading on various stakeholders and the broader economy, delve into the topic “Insider Trading – Why and Who It Hurts”. In essence, it can be broken down into the following:
Breaching Fiduciary Duty: Individuals in positions of trust owe a fiduciary duty to the company and its shareholders. Engaging in insider trading violates this duty by exploiting confidential information for personal gain.
Undermining Market Integrity: Insider trading erodes trust in the fairness and integrity of the securities market. It creates an uneven playing field, disadvantaging individual investors who lack access to insider information.
Distorting Market Prices: When insiders trade based on non-public information, it can lead to distorted market prices that do not accurately reflect the true value of securities. This harms the efficiency of the market, as investors perceive market as rigged and unfair, thus loose trust and withdraw investments.
What is Front Running?
Front running is another illegal practice in the securities market, often causing concerns over fairness and market manipulation. Front running refers to the illegal practice of using unpublished or confidential information for buying or selling securities ahead of a significant order. This is mostly to benefit from the subsequent predictable price movement on execution of large orders. Front running typically involves a broker or trader executing orders on a security for their own account, either as an organization or as an individual, while having advance knowledge of pending orders from their clients. By doing so, they take advantage of the expected price movement resulting from the client’s order.
The Ethical and Legal Issues Surrounding Front Running
Front running raises ethical concerns like those associated with insider trading. It involves taking advantage of privileged information for personal gain, which undermines the integrity of the securities market. By ‘front-running’ client trades, brokers or traders put their interests ahead of their clients, compromising the trust and fairness essential to a well-functioning market.
What is classified as Front Running?
The following factors are necessary for classifying trading activity as front running:
- Possession of non-public information regarding the big client order, and
- Placing of order by the alleged front runner in securities (directly or indirectly) in advance of the big client order, while in possession of the aforesaid non-public information.
Who are the core players in Front Running?
There are two primary categories of individuals engaged in front running, namely:
- Information carriers are entities that have direct or indirect access to non-public information regarding significant client orders, making them vital participants in front running activities.
- Front runners are participants that execute front running trades using their trading accounts, taking advantage of the advance knowledge gained from the information carriers.
What is the Legal Framework around Front Running?
Like insider trading, front running is also subject to legal regulations. There is a thin line dividing insider trading and front running although abuse of market by a person in possession of UPSI is a common element to both. SEBI has pointed to a difference between the two and often deals with front running cases under the “Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market” (PFUTP) Regulations of SEBI.
How is Front Running different from Insider Trading?
While both insider trading and front running involve unfair advantages and ethical concerns, there are fundamental differences between these practices.
Information Source: In insider trading, individuals exploit non-public information obtained through their positions within a company. In contrast, front running involves taking advantage of advance knowledge about pending orders from clients.
Participants: Insider trading typically involves company ‘insiders’ or ‘connected person’, such as executives or employees, who possess confidential information. Front running, on the other hand, can be executed by brokers, traders, or other market participants who have access to client orders.
Trading Decision: Insider trading involves buying or selling securities based on confidential information, while front running involves executing trades in anticipation of price movements resulting from client orders.
Thus, Insider trading and front running are two distinct practices with ethical and legal implications in the securities markets, they are like two different fruits of the same tree, “Abuse of Market”. Insider trading involves trading based on non-public information, while front running entails executing trades in anticipation of client orders. Both practices undermine market fairness, distort prices, and erode investor confidence. Understanding the differences between insider trading and front running is crucial to safeguarding the integrity of the securities markets and ensuring a level playing field for all participants. While the underlying form of market abuse differs, in practical terms, control applications meant to prevent front running can be quite well managed and integrated with Insider Trading Compliance management systems like Affinis.