Regular readers of our site are familiar with the economic crimes carried out by some unsavory financial professionals. These include Ponzi schemes by fund managers, LIBOR rigging by colluding traders and accounting shenanigans by shell companies.
The latest entrants into the world of fraud are foreign currency exchange (FX) manipulators front running their orders.
How Does Front Running Work?
Front running occurs when someone places a trade for themselves with prior knowledge of an incoming order. It‘s an illegal activity and also clearly places the firm’s interest ahead of the customer. Here’s how it works:
A financial professional (order clerk, market maker, trader, stock broker, etc.) receives a large customer buy order, but delays in executing it right away. Predicting that the order will have a significant impact on the underlying price of the security, the professional makes a trade for themselves ‘in front’ of the customer’s order. Only after completion do they execute the customer order.
This delay in filling the trade results in a few consequences. First, the trader who front ran the order is highly likely to have manufactured a profit for himself because the large order presumably moved the market higher (remember, the trader owns their own shares at a lower price). This is also referred to as self-dealing.
Second, it may have caused the client’s order to be executed at a higher price, causing the customer to overpay. Of course, this depends on how egregious the front running order was. If it was small, there may not be an impact in a large, liquid market. But any trade in the less-liquid realm of penny stocks, it’s likely to have an exacerbated consequence. This is also a clear violation of fiduciary standards.
Finally, the firm executing the order usually receives a commission or fee from the customer, typically an institution, to execute the transaction. Talk about adding insult to injury!
Front Running Cases
The earliest cases originated from floor traders who literally ran in front of another trader, who they suspected had a large buy order in hand. If they could reach a trader shouting offers to sell first, they could almost certainly make money.
Although a moot point in 2017 due to automation, running is no longer allowed on the floor of exchanges.
Today, most front runners commit their crimes from behind desks. In the news recently, HSBC’s former Head of Global Foreign Exchange Cash Trading was convicted of fraud by a New York Court.1 A classic example of front running, he and another trader got wind of a major currency order coming to the firm. Their client, Scottish oil and gas company, Cairns Energy, needed to buy $3.5 billion worth of British pounds as part of a currency conversion from a foreign acquisition.2
Considering the massive order size, the main conspirator was giddy with anticipation, allegedly crying “Oh [expletive] Christmas”.3 Even without the front running, executing the currency transaction as agent was to be very profitable for HSBC and the sales traders-the commission alone was roughly $5 million.4
But that wasn’t enough. Armed with the knowledge of the pending order, the two individuals began buying UK pounds ahead of the order, tipped off using code words on recorded phone lines.5 When the order was officially made they ramped up the price, yielding an additional $3 million for the firm. The result was not only an illegal profit for the firm, but it also harmed the client who paid a higher price for the pounds than warranted.6
In total, it was an $8 million windfall for HSBC and the traders. It should be noted that HSBC itself avoided prosecution-it is only the individuals being charged. HSBC certainly isn’t the only major bank to have some bad apples.
Every major investment bank, or their employees, has been involved in front running or some type of self-dealing in their history.
Automated Front Running
While front running is typically performed by actual market participants, another iteration of the crime may be underway-high frequency trading, HFT. This strategy involves placing electronic orders that execute in milliseconds.
This technology morphed out of the decision by exchanges to trade stocks in penny increments, not fractions, known as decimalization.
The trades are executed by computer programs (algorithms-essentially lines of codes with specific instructions).
Once considered an intensely quantitative effort, a trading algorithm today can reportedly be created with less than 100 lines of code on Python.7
After a customer order is entered, a HFT algorithm shifts into gear and gets in front of that order. HFT trades can move faster than other trades- often in millionths of a second. For example, HFT shop Virtu Trading reported to the SEC that they were profitable 1237 out of 1238 trading days during a 2016 stretch.8 HFT critics claim its high-tech front running.
Ironically, decimalization was supposed to make the costs cheaper for customers as well as reduce the improprieties of human market makers. As Michael Lewis’s Flash Boys reveals, it may have done the opposite.
Supporters contend that algorithmic trading is actually the best way to prevent this type of abuse as it takes out the human element entirely. They also argue it adds liquidity and can lower customer costs and in other ways.
Here’s an example of how one algorithmic trading strategy might reduce the potential for fraud. A large buy order is automatically chopped up and parceled out to several exchanges at different intervals during the day. This way, no party is capable of detecting the large order (or its origin).
The identity of the seller can also remain anonymous without the human interaction. If a major hedge fund with a large position in a particular stock was detected as starting to sell, it might cause a waterfall effect on the share price, costing the fund millions.
Masters of Fraud Degree
If you’re interested in combating such nefarious activity consider making it a career. There is high demand in finance for fraud investigators, risk managers, auditors, forensic accountants and compliance personnel.
These professionals constitute the front line of defense against frauds such as front running. Many deploy the latest technology including data analysis. Others utilize good-old fashioned methods such as a simple whistleblower program or an experienced operations department.
For those fraud investigators aspiring for a managerial role, consider pursuing an online MBA in Fraud Management degree. This may land you a secure, well-paying position in finance.
Fraud investigators with a Master’s degree report salaries ranging from $102,795 to $106,591.9
Further, a Master’s degree may increase your chances of landing a supervisory role. This can help insulate professionals from the threat of automation for some finance jobs. According to consulting giant McKinsey & Company, ‘management’ is less likely to be replaced by automated technology and fintech challengers.10