Front Running: Definition, Legality, Example and Impact

The stock market is a place where shares of companies are bought and sold by investors. It’s an exciting place to be, however, at the same time, it can also be complicated. One term you might come across when reading about the stock market is “front running.” This blog will explain the meaning of front running, what it means in finance, and give you a simple example to help you understand it better.

What is Front Running?

Front running in the stock market, also known as ‘forward-trading’ or ‘tailgating’, is unethical and illegal. It happens when a broker or trader takes unfair advantage of non-public knowledge of a large, upcoming trade to make a profit. This person, who has inside information about the trade, buys or sells stocks before the large trade takes place, affecting the share price in a way to benefit from the expected movement in the share’s price.

What is Front Running in Finance?

In finance, front running can be seen as market manipulation. It breaks the trust between a client and their broker. When a broker receives an order from its client to buy or sell a large quantity of shares, they might be aware that this order will significantly affect the stock’s price. Instead of acting in the best interest of their client, the unethical broker might decide to indulge in personal trading first for his own gain. When the client’s order is placed depending on the quantity the stock price is affected. This behavior can alter the market movements and harm other investors.

Why is Front Running Illegal?

Front running is illegal because it gives the person who is practicing this exercise an unfair advantage. It is considered somewhat similar to insider trading. When a broker or trader uses non-public information to make a profit, it undermines the fairness and ethics of the financial markets. Investors rely on publicly available information to trade and earn profits so it’s important that everyone has a fairground and an equal opportunity to succeed. 

The Impact of Front Running

Front running can have severe negative impacts on the stock market and investors:

• Unfair Prices: Front running impacts stock prices causing them to move unfairly. This makes it difficult for other investors to make informed decisions based on true market conditions.
• Loss of Trust: Investors depend on the public information available in the market and trust the brokers with their investments. When investors get to know that brokers are engaging in front-running practices they lose trust in the market. They might also lessen their trading activities which will ultimately impact the financial markets.
• Legal Consequences: Brokers and traders caught front-running can face severe legal penalties, including fines and sometimes, even imprisonment. Their firms can also suffer reputational damage.

Front Running Example

Let’s use a simple example to understand front running in a better way.

Imagine you contact a broker named Sarah. You have decided to buy 10,000 shares of Company ABC and place this large order through Sarah. Before Sarah executes your order, she realizes that buying such a large number of shares will likely increase the price of Company ABC’s stock. So, Sarah decides to buy 1,000 shares of Company ABC for herself before she places your order. After Sarah buys her shares, she then places your order for 10,000 shares.

As expected, Company ABC’s stock price rises because of your large purchase. Sarah then sells her 1,000 shares at a higher price, making a profit. Meanwhile, you end up paying more for your shares than you might have if Sarah had placed your order right away.

In this example, Sarah engaged in front running. She used the knowledge of your large order to benefit herself, which is unfair and illegal.

How to Prevent Front-Running

Regulators and financial institutions have instilled several measures to prevent front-running. Some of these measures are:

• Surveillance and Monitoring: Stock exchanges and regulatory bodies monitor trading activities closely to detect similar trading patterns that might indicate front running.
• Strict Regulations: Stringent laws and regulations prevent front-running. Brokers and traders must adhere to strict ethical guidelines to ensure fair trading practices.
• Whistle-blower Initiatives: Some regulatory bodies have programs that encourage individuals to report unethical practices like front running while keeping their identity anonymous. Whistleblowers can provide valuable information helping the regulators by flagging such activities at an early stage.

Wrapping up

Front running is an unethical and illegal practice in the stock market where a broker or trader uses inside information about a large upcoming trade to make a profit. This practice undermines the fairness of the financial markets and can lead to a loss of trust among investors. Everyone involved in the stock market needs to act ethically and follow the guidelines to ensure a fair and transparent trading environment.

Understanding what front running is and its impact on the market can help you be more informed and vigilant as an investor. Always work with reputable brokers and stay informed about market regulations to protect your investments. Rupeezy has been a part of the industry for the last 20 years and is one of the fastest-growing stock brokers. The Rupeezy app is tailored to meet the needs of investors and traders in the Indian stock market. Open a Demat account on Rupeezy to start your trading journey!