Front Running: Is It Insider Trading or Not?

Is it insider trading when a trader acts on prior information on a stock?

Published: Aug 4, 2010

The financial markets generate a lot of number on a per second basis. There are people who have made it a profession to convert this information into trends, buy-sell signals, charts and pivot tables. Over the last 18 years of financial journalism, I have realised that every number has a story to tell. And these numbers as a trend normally never lie. I am forever looking for these trends.

HDFC Mutual Fund recently came under the Security and Exchange Board of India’s (Sebi) scanner for front running. The dealer was banned from trading. Front running involves a trader in a securities firm acting on prior information that is almost equivalent to insider trading. Can this activity be curbed?

mg_31872_frontrunning_280x210.jpgIt spooks the investors
The biggest pension funds who want to invest into Indian markets worry about front running. Their prime concern is processes and how Indian AMCs (asset management companies) are keeping themselves clean. This is getting to be a reputation problem and it looks like this problem cannot be stopped, at least for now.

Scale of the crime
If there is a pipeline with a capacity of 10,000 litres that comes to your housing society colony and one person steals a litre or two from this pipeline, will the harm be substantial enough for the society? If a mutual fund wants to buy 1 lakh shares of company A and the dealer puts in his personal order ahead of the fund and makes profits, will this harm the investors in the mutual fund? The damage will be miniscule. There’s no point in spending too much efforts trying to catch this trader. And if this trader starts making a lot of money in a short span of time, he will get noticed. There is no way he can escape. It is like stealing 500 litres of water from the same pipeline. Someone will notice that theft.

Control
That totally depends on the processes. Front running is like day trading. So if the processes are strong and the dealer is tracked at all levels from the time he gets the information to the time he executes the trade, it will be easy to catch him if he is front running. Eg: If he knows a fund is going to buy one lakh shares of stock A, he will put his order minutes before the fund’s order goes through. If the dealer were to be made “incommunicado” then there is no way he can relay this information. Sebi has put up an investigative report on how the front running exactly took place inside HDFC MF on its Web site.

Anticipate Human Behaviour
Most funds say that the systems and processes are proper but one individual can beat these systems by being unethical. The argument is unacceptable. If systems are proper that means front running should not be possible. There will always be some individuals who will try to beat the system. Process have to be continuously upgraded to catch these people.

What the Law Says
Front running is not insider trading but comes close to it. It comes under the charge of prohibition and protection of fraudulent and unfair trade, Sebi Regulation 2003 (prohibition and prevention of fraudulent and unfair trade relating to securities market). Penalty for the crime will mean a ban from dealing in the market and a monetary penalty of Rs. 25 crore or three times the trade committed by the investor.


(This story appears in the 13 August, 2010 issue of Forbes India. You can buy our tablet version from Magzter.com. To visit our Archives, click here.)

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