All about front-running and what needs to be done to prevent it

What is the avant-garde?

Front-running is a questionable market practice in which a broker, trader or employee learns of a large order to buy or sell shares that will be placed by a fund or large investor and in front of the market. Large orders usually change the market price of a stock. By buying shares just before the big order hits the market and selling them once the price has risen, the leader pockets illegal gains with his advanced knowledge. A reverse strategy is used with sell trades. Insiders can negatively impact a fund’s investors by raising the prices it gets to buy shares or lowering the prices at which it can sell.

Usually there are two parties in a foreground operation. A carrier of information obtains information in advance about the orders of the large investor because he is an employee, dealer or trader for him, and the favorite is usually a friend, acquaintance or relative who performs the actual transactions.

Why is it in the news now?

Last Friday, Axis Mutual Fund issued a public notice removing and replacing two of its fund managers, Viresh Joshi and Deepak Agarwal, from seven of its programs – its banking, technology, consumer and Nifty ETFs and Axis Value, Quant and Arbitrage funds. The move was accompanied by speculation that the managers had been suspended on high-profile charges. Axis Mutual Fund did not explicitly mention the upfront fee, but it did confirm it was investigating “potential irregularities” with the help of outside advisers.

Is this a common wrongdoing among mutual funds?

Anticipation is not an offense specific to the mutual fund industry. Front-running can occur in any situation where an employee, broker, trader or broker executing trades for a large investor – be it a mutual fund, portfolio investor foreigner, pension fund, insurer or HNI obtains advance information on large buy or sell orders that are about to be placed and trades on that information. In India, SEBI detected cases of front-running in a portfolio of foreign investors, brokers, brokerage houses and mutual funds. In June 2021, SEBI placed an order against three dealers of Reliance Securities and their connections to direct the transactions of Tata Absolute Return Fund, an alternative investment fund.

Earlier, he unearthed evidence that a relative of a trader employed at a foreign portfolio investor, the Fidelity Group, regularly directed the transactions of eleven entities of the group. In 2006-07, SEBI found evidence that an HDFC Mutual Fund stock broker passed trading information to Ikab Securities and Investments. He imposed fines on the ringleaders and the mutual fund.

Are regulations in place to prevent such practices?

Yes, the Securities Market Prohibition of Fraudulent and Unfair Business Practices (SEBI) Regulations 2003 clearly defines upstream operation and characterizes it as a fraudulent and unfair practice. SEBI has invoked this section several times to place orders against favorites.

What more should be done to prevent it?

Exchange monitoring mechanisms are the most useful for uncovering cases of front-running. Surveillance software that tracks real-time trading in the market is well equipped to spot similar trading patterns between large investors and individuals, which forms the basis of the regulator’s high-profile investigations.

Therefore, eradicating such cases requires rigorous scrutiny of surveillance data by exchanges and prompt reporting of any suspicious transactions to SEBI. Having clear whistleblower policies in place with anonymity for the informant at exchanges, large institutions and brokers trading in the markets can help signal a connection between market participants at an early stage.

SEBI will also need to consider stiffer penalties for informants and forerunners when investigations find hard evidence of wrongdoing. Soft measures such as temporarily banning entities from securities markets, imposing a moderate fine, or settling with the accused without admitting the violation, may not be enough.

Published on

May 09, 2022