Overview on Trading Ahead
Trading ahead is a practice where specialists or market makers put their interests ahead of the investor's financial goals. It occurs when market makers abuse their position and trade using their firm's account instead of matching the available bid-ask prices from investors. It is prohibited for market makers to trade ahead of other market participants.
Example of trading ahead
A market maker receives orders from two investors. Investor X wants to sell 100 shares of Company C at INR 45.50, and Investor Y intends to buy 100 shares of XYZ at INR 45.50. Ideally, these orders should be executed against each other. However, the market maker matches his own firm's 100 shares of XYZ against the buy order. That is, he sells his own firm's 100 shares instead of fulfilling the order that came from Investor X. This puts Investor X on the back foot. The immediate next transaction will be Investor X's order to sell 100 shares of Company C. The price of Company C's shares will likely fall below INR 45.50 as the sales order will put downward pressure on it. Trading ahead allowed the market maker to sell the Shares with his firm at a higher price. Trading ahead is often confused with front-running.
Trading ahead v/s Front-running v/s Insider trading
Trading ahead of a customer limit order is when market makers receive an order and then trade at prices equal to or better than the customer limit order, leaving the customer order unexecuted. Front-running is entering into a trade based upon impending non-public information regarding a block deal or an analyst recommendation. Block deals are transactions involving a massive number of shares and can substantially influence share prices. In front-running, a market maker acts on insider information for personal gain. It can be distinguished from insider trading, where a company insider works based upon advanced knowledge of corporate activities like a merger deal.
Market Makers
Market makers, also called specialists, are responsible for matching buyers and sellers or bid-ask prices. They are a crucial part of the secondary market trading infrastructure. They profit from the difference between the bid-ask prices or the 'spread' generated on each trade.
Example of front-running
An individual possessing non-public knowledge that will likely affect the stock price can take undue advantage. Consider the example below.
An equity research analyst prepares a research report on Company M. The report is bullish and suggests a strong buy. The information has not been made public yet. The analyst expects many people to buy the stock after the report's publication, which will boost the share price of Company M. He possesses non-public information based on which he decides to buy the company's stock. This will leave him in a favourable position when the stock prices rise on the report's publication.
Market rules for Trading Ahead
Initially, New York Stock Exchange (NYSE) Rule 92.2 prohibited trading ahead. Eventually, FINRA Rule 5320 replaced NYSE Rule 92.2 to prohibit a FINRA member firm from placing the firm's interests above the financial interests of its clients. (FINRA stands for Financial Industry Regulatory Authority and is responsible for regulating US brokerage houses and exchange markets.)
FINRA Rule 5320, also known as the “Manning Rule”, requires specialists to adhere to FINRA Rule 5310 and to have their own documented policies regarding trading rules. The rule also highlights the exceptions to the prohibition of trading ahead. Exceptions include large and institutional orders, no-knowledge exceptions, etc. Moreover, market makers may satisfy an exception if they immediately execute a customer's order up to the size and price (or better) than what they executed for their firm.
Indian market regulator SEBI has expressly prohibited insider trading. However, no specific market rules exist for trading ahead in the Indian stock market.