Wednesday, July 15, 2009

frontrunning and tailgating

Wikipedia | Front running is the illegal practice of a stock broker executing orders on a security for its own account while taking advantage of advance knowledge of pending orders from its customers. When orders previously submitted by its customers will predictably affect the price of the security, purchasing first for its own account gives the broker an unfair advantage, since it can expect to close out its position at a profit based on the new price level. Front running may involve either buying (where the broker buys for their account, before filling customer buy orders that drive up the price) or selling (where the broker sells for its own account, before filling customer sell orders that drive down the price).

Allegations of front running occasionally arise in stock and commodity exchanges, in scandals concerning floor brokers and exchange specialists.

For example, suppose a broker receives an order from a customer to buy a large block of 400,000 shares of some stock, but before placing the order for the customer the broker buys 20,000 shares of the same stock for his own account at $100 per share, then afterward places the customer's order for 400,000 shares, driving the price up to $102 per share and allowing the broker to immediately sell his shares for, say, $101.75, generating a significant profit of $35,000 in just a short time. This $35,000 is likely to be just a part of the additional cost to the customer's purchase caused by the broker's self-dealing.

This example uses unusually large numbers to get the point across. It is, however, highly uncommon for brokers to process buy orders totaling $40,800,000 in a single transaction. In practice, computer trading splits up large orders into many smaller ones, making front-running more difficult to detect. Moreover, the 2001 change to pricing stock in pennies rather than fractions of no less than 1/8 of a dollar facilitated front running by reducing the extra amount that must be offered to step in front of other orders.

By front-running, the broker has put his or her own financial interest above (or in front of) the customer's interest and is thus committing fraud. In the U.S. he or she might also be breaking laws on market manipulation or insider trading.

Tailgating

A practice similar to front running is called "tailgating". Tailgating means the action of a broker or adviser purchasing or selling a security for his or her client(s) and then immediately making the same transaction in his or her own account. This is not illegal like front running, but it is not looked upon favorably because the broker is most likely placing a trade for his or her own account based on what the client knows (like inside information).