Quick Answer
Front-running happens when a broker-dealer or agent, knowing a pending customer order is likely to move the market, trades their own account ahead of that order. The pending order itself counts as material nonpublic information, so trading ahead of it is a fraud violation even if the agent never profits.
Front-running differs from the manipulation tactics covered so far because it exploits advance knowledge of a real customer order, not fake trading activity.
Definition
Front-running occurs when a broker-dealer or agent, with knowledge of a pending customer order (or block transaction) that is likely to affect the market price, executes a trade for their own account (or a favored account) before executing the customer's order.
The front-runner profits by trading ahead of the price movement the customer's order is expected to cause.
Why Front-Running Is Prohibited
- It breaches the duty to deal fairly with the customer by trading ahead of their order
- The agent uses material nonpublic information (the pending customer order) for personal gain
- The customer may receive a worse price because the agent's order has already moved the market
- Prohibited under the USA antifraud provisions as a fraudulent and deceptive practice and a misuse of material nonpublic information
Exam Tip: Gotchas
- A pending customer order is material nonpublic information. The customer's order itself is MNPI to the agent. Trading on that knowledge is a fraud violation regardless of whether the agent heard any news about the underlying company.
Examples
Example 1 (buying ahead of a large buy order): A customer places a large buy order for 50,000 shares of XYZ stock. Before entering the customer's order, the agent buys 1,000 shares of XYZ for their personal account, anticipating the price will rise once the large order is executed.
Example 2 (selling ahead of a large sell order): An agent learns that an institutional client is about to sell a large block of bonds. The agent sells bonds from their own account first, before the institutional sale depresses the price.
In both cases, the agent's personal trade comes first, and the customer's trade comes second; the agent "runs" ahead of the customer.
Key Elements
- Knowledge: Agent knows about a pending customer order
- Timing: Agent trades for their own account before executing the customer order
- Impact: Customer's order is likely to affect the market price
- Violation: Trading ahead of the customer + misuse of material nonpublic information
Exam Tip: Gotchas
Front-running does not require that the agent actually profit. The violation occurs when the agent trades ahead of the customer's order. Even if the agent's trade does not ultimately move the market or generate a profit, placing the order with knowledge of the pending customer order is the violation.
What Should You Check on Exam Day?
- Front-running requires knowledge of a pending customer order likely to move the price, plus the agent's own trade placed ahead of it.
- The pending customer order is itself material nonpublic information; misusing it is a fraud violation regardless of whether news about the company is involved.
- No profit and no market impact are required. Trading ahead with the required knowledge is the violation by itself.