What Is Front-Running?

Front-running is an unethical and illegal trading practice in which a broker with advance knowledge of a specific market order in a currency or other financial security for a client earns a profit by placing an order for their own account in advance of the client's larger order.

Front-running is akin to insider trading, in that the perpetrator has advance knowledge of the larger client order and buys ahead of it, in effect profiting from the runup in the price of the security due to the size of the large order.

Front-running differs from spoofing, in which a trader tries to profit by placing fake large orders in order to try to drive up the price of a security or currency. Front-running also differs from insider trading in that the institution placing the larger order often is disadvantaged, as its trade is executed at a lower price while the trading firm hired to make the trade earns a profit at the client's expense.^[1]

Punishment For Front-Running

Front-running occurred as part of the high-profile case in which a trader at HSBC was found guilty of earning an illegal profit by placing currency trades ahead of a large order for one of the bank's clients.

Mark Johnson, the bank's former global head of foreign-exchange cash trading, was found guilty by a federal jury in Brooklyn, N.Y., in June 2018 on charges that he and another currency trader at the bank earned more than US$7.3 million in profits for the bank and their own account by placing trades in advance of a US$3.5 billion currency trade for one of the bank's clients.

According to the charges, HSBC in 2011 won the right to convert US$3.5 billion worth of US dollars into British pounds for Cairn Energy PLC, a Scotland-based oil and gas company. In advance of placing that trade, which is large enough to disrupt the market and drive up the price of the pound, Johnson and Stuart Scott, HSBC's former European head of currency trading, bought millions of pounds for the bank.^[2]

The Cairn trade took place on 7 December 2011. According to the prosecutors, Johnson and Scott sold out of their position in the pound about an hour before the Cairn trade took place, at which time the price of the pound had dropped. As a result, Cairn realised less than it should have when its order was eventually executed.^[2]

Exploiting Confidential Information

"Mark Johnson exploited confidential information provided by a client of the bank to execute trades that were intended to generate millions of dollars in profits for him and the bank at the expense of their client," Bridget M. Rohde, the acting U.S. Attorney in Brooklyn, said in a statement.^[2]

Johnson was found guilty of eight counts of wire fraud and one count of wire-fraud conspiracy. A sentencing date hasn't been set (as of this writing in July 2018), but Johnson faces as many as 20 years in prison on the wire-fraud charges. Johnson contended that he acted in the client's best interest and that his actions were within normal currency trading.^[2]

In October 2017, HSBC was fined US$175 million by the U.S. Federal Reserve for failing to adequately supervise its foreign-exchange trading desk, specifically Johnson and Scott.^[3]

Front-Running Not Unique To Forex Market

Front-running isn't unique to currency trading. "Mutual funds have long complained that their big trades are front-run as word leaks out, leaving them with an inferior price," according to a New York Times report.^[4]

In 2009, the U.S. Securities and Exchange Commission reached settlements totaling more than US$69 million in disgorged profits and penalties with 14 specialist trading firms for allegedly front-running orders for their clients. The firms included units of E*Trade, Goldman Sachs and TD. The SEC said the firms made more than US$58 million that should have gone to their clients.

The SEC said the specialist firms had an obligation to put their clients' orders ahead of their own interests. "These firms violated the public trust by abusing the privileged position they had as specialists on the various exchanges," James Clarkson, the acting director of the SEC's New York regional office, said at the time.^[5]

While clients pay brokers a fee for an equity or bond order, front-running is more of a grey area in over-the-counter markets like the forex market, where traders often make money by trading ahead of the execution.^[1]

Summary

Front-running is an unethical and illegal practice in which a broker with advance knowledge of a client's large order for a currency or security earns a profit by placing orders for their own account in advance of the client's larger order, at the expense of the client.

While not peculiar to currency trading, it falls into a more grey area compared to other securities markets, such as stocks and bonds.