What is front running?
Front running is an illegal practice whereby a trader or a dealer buys or sells shares in a company before his organisation buys or sells the same shares. It is called front running because the employee literally runs his deals ahead of his employer's bulk transactions to take the advantage of the subsequent price movement. Some people also term it as forward trading. For example, if a dealer/trader is aware that his firm wants to buy 1 lakh shares of XYZ. Before placing the order for his firm, the trader passes on the information to his known source or buys 10,000 shares on his own account at, say, Rs 100 per share. When he goes to buy 1 lakh shares of XYZ for his company, the price may jump to Rs 103 per share because of the size of the order. The dealer then sells his shares at Rs 102 per share, making a neat profit of Rs 2 per share in a short period, many a time in the same day itself. His organisation is hurt to the extent that it is forced to pay Rs 20,000 more to buy 1 lakh shares, caused due to front running. By front running, the trader acts in an unethical manner, putting his own interest above that of his organisation, thereby causing a fraud. Front running causes a loss and leads to loss of trust amongst the organisation's investors.
What kind of stocks does front running happen in?
Front running could happen in all types of stocks be it large-cap, mid-cap or small-cap stocks. However, mid-cap and small-cap stocks are more susceptible to front running due to their lower float and liquidity. Also, if there is a large order, a small-cap or a midcap stock could fluctuate far more than a large-cap stock. Hence the extent of profit a trader could make by front running in case of a small-cap stock could be far higher than if he were to take a position in a large cap stock.
Action by the regulator
The regulator can take strict action to protect the interest of the common investor. In a recent case, Sebi banned a dealer of a mutual fund and directed the fund and dealer to jointly deposit the estimated losses identified due to front running. It also directed the trustees of the fund to submit within one month, a plan to overhaul the internal control systems and the internal preventive measures to avoid such instances happenning again in the future.
How do organisations deal with it?
Big brokerage houses and asset management companies have strict compliance process for their key personnel. Analysts/ fund managers need to take permission or clearance from their compliance department before buying stocks in their personal account. Those associated with dealing/ fund management, are asked to switch off their mobile phones in the dealing room during trading hours. All phone calls in the dealing room are made from landlines, which are recorded. Such records are stored for periods as long as 7-10 years. The compliance department, proactively watches for any irregularity in trades. If an employee is found to indulge in such activity organisations have the right to take strict action against them which could include termination.
