It could take fund managers an entire day - or even several days - to execute large orders. Someone in the firm who knows a large order is about to be executed could potentially use that information for their own personal gain through front-running or tailgating.
According to the UK's Financial Conduct Authority (FCA), front running or pre-positioning is when someone enters into a transaction on the basis of (and ahead of) an order that he or she is to carry out for another. Essentially, that person is attempting to benefit from inside information and take advantage of the anticipated impact of the order on the market. In the case of a buy-side firm, front-runners place a buy order ahead of their fund's buy orders, or a sell order ahead of their fund's sell order. Tailgaters wait until their fund actually executes a large buy order or sell order, and then sell or buy off the price impact.
Identifying front-running: Where are the risks?
Buy-side firms could be exposed to front-running during the normal course of business. One scenario is when there has been a sizable inflow into the fund with large assets under management. Other fund managers who become aware of the inflow will know that it will have an impact on security prices and will enter their orders before the other fund.
Another scenario is when fund managers meet with companies to get updates on their strategy and performance. Should a fund manager obtain nonpublic information, the company's securities are put on a restricted list, and the buy-side firm's trading system should make it impossible for anyone in the organization to trade them. There is a chance, however, that someone who knew that the company's securities were going to be restricted could trade before the securities were actually restricted.
Asset managers have the knowledge and skills to make profitable trades on their own behalf. As long as individuals are not violating securities laws or their firm's policy on personal trading, there is typically no cause for retribution. That said, front-runners will often try to cover their tracks by trading through a new personal account - perhaps in someone else's name - with a different broker instead of through an established account.
Maintaining a good reputation is critical for buy-side firms. When investors learn of improper behavior, they lose confidence and withdrawal their funds, potentially leading to the demise of the business. Additional reputation impact can spread via word of mouth, causing further exits. To this end, it is paramount that buy-side compliance teams need to utilize technology to quickly identify and eliminate abusive behavior such as front-running.
Technology to detect front-running must be able to identify and analyze when changes have occurred in the market that may indicate front-running or tailgating. Nasdaq Buy-side Compliance does this and then scores fund managers based on their transaction history. Its proprietary risk-scoring model detects price movements and narrows the focus amidst a huge amount of normal trading. By stripping away the noise in the market, Nasdaq Buy-side Compliance uses behavioral science to determine what triggered people to trade in a particular security and in a way that moved the price.
Overall, as firms look to enhance their compliance capabilities, they must look for technology that can relieve the huge burden from the shoulders of compliance teams, reduce the number of false positive investigations as well as the time it takes to conduct them, and improve operational efficiency in compliance.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.