MARKET TECHNOLOGY

Top Three Triggers to Identify

Front-Running
Do you know who is trading ahead of you?
It could take fund managers an entire day – or even several days – to execute large
orders. Generally, they do their best not to cause a price impact in the process, but FRONT-RUNNING:
sometimes it is unavoidable. Someone in the firm who knows such an order is about
Entering into an equity
to be executed could potentially use that information for their own personal gain.
trade, options or futures
According to the UK’s Financial Conduct Authority (FCA), front-running or pre- contracts with advance
positioning is when someone enters into a transaction on the basis of (and ahead of) knowledge of a block
an order that he or she is to carry out for another. As an example, front-runners place transaction that will
a buy order ahead of their fund’s buy orders, or a sell order ahead of their fund’s sell influence the price of
order. Tailgaters wait until their fund actually executes a large buy order or sell order, the underlying security
and then sell or buy off the price impact. Importantly, regulators around the globe are
to capitalize on the
cracking down on this form of market abuse.
trade. This practice is
Buy-side firms could be exposed to front-running in the normal course of business. To expressly forbidden by
this end, they need to monitor for three important triggers: personal account trading, the SEC. Traders are
leveraging material nonpublic information, and preferential treatment. not allowed to act on
nonpublic information to
trade ahead of customers
Personal account trading
lacking that knowledge.
According to an academic study, financial experts generate short-term abnormal
returns relative to other retail investors when they trade for their own personal
accounts.1 In many cases, their outperformance is attributable to their superior ability RULES FOR IDENTIFYING
to trade based upon public information. As long as the employee is not violating SUSPICIOUS ACTIVITY
securities laws or their firm’s policy on personal trading, there is typically no cause IN PERSONAL ACCOUNT
for retribution. TRADING:
However, some experts trade through their own personal account, or someone else’s
1. Trades beneficially
account, based on valuable, private information that is obtained through their profession
(whether a buy or sell)
or professional networks prior to the information becoming publicly available.
before a significant
Regulators in most developed countries require asset management firms to have price rise or fall
a personal account dealing policy that includes measures to reduce the risk of
front-running and insider dealing. For example, in the US certain employees of an 2. Trades beneficially in
investment company who are identified as having regular access to material private front of subsequent
information must report to their employer all of their personal stock holdings fund trades (e.g. PA
annually, and all of their personal stock transactions quarterly.2 Finnish insider buy followed by a fund
trading laws require that all “access employees” must publicly disclose all of their buy)
personal trades in any stock listed on the Nasdaq Nordic Helsinki Exchange.3
3. Trades beneficially
after a fund trades (e.g.
1. Berkman, Henk; Koch, Paul; and Westerholm, P. Joakim. “Personal Trading by Brokers, Analysts, and Fund
Managers”. November 2017. Page 46. fund buys and there)
2. Ibid. Page 7.

3. Ibid. Page 45-46.

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Consider the following two cases brought against asset managers in the US
and Singapore.
1. In 2016 Mark Lyttleton, a fund manager at BlackRock, was sentenced to one
year in prison in the UK for trading securities on BlackRock’s restricted list.
He traded shares of EnCore Oil ahead of an announcement of a proposed
takeover, as well as options in Cairn Energy ahead of an announcement of
drilling results in Greenland. The trading went through a Panama-registered
company that he bought in 2010 and placed in his wife’s maiden name. The
trades were executed through a Swiss asset manager.4
2. That same year, the Monetary Authority of Singapore charged two dealers
at First State Investments (FSI), Leong Chee Wai and Toh Chew Leong, and a
broker at UOB Kay Hian, E Seck Peng Simon, for front-running. Leong was
accused of possessing price-sensitive inside information on FSI's intended
trades and procuring Simon to purchase 548,000 and short sell 290,000
Allgreen Properties shares through Simon's personal trading account at UOB
Kay Hian. Leong was also charged with possessing inside information on
FSI's intended trades in Allgreen Properties' shares and conspiring with Toh
to procure Simon to purchase 743,000 and short sell 2.23 million shares
through Simon's trading account.5
Trading on inside information ahead of an announcement – whether it is done
through fund managers’ personal accounts or while managing their portfolios
– is illegal in most countries. To promote fairness in capital markets, there are
strict regulations to prevent insider trading from occurring. Compliance teams Historically, the United States has
are responsible for monitoring all employee trading activity, making sure been the leader in laws against
that regulatory requirements are being upheld and that the firm’s reputation insider trading. In 1909, the U.S.
remains intact. Supreme Court ruled in Strong v.
Repide that because a company
director could affect the value
Leveraging material nonpublic information
of his company’s shares, keeping
Fund managers often meet with companies to get updates on their strategy buyers ignorant of his expected
and performance. Should a fund manager obtain material nonpublic actions while selling his own
information, the company’s securities are put on a restricted list, and the shares would be deceitful, and as
buy-side firm’s trading system should make it impossible for anyone in the a result, considered fraudulent
organization to trade them. Further, someone who has access to an analyst activity. The first law passed
report is prohibited from trading based on that information prior to its
against insider trading was the
publication. There is a chance, however, that someone who knew that a
passage of the Securities Act of
company’s securities were going to be restricted, or an analyst report was
1933.7
about to published, could trade before those events actually occurred.
Academic studies have found increased short selling in the days ahead of
analyst downgrades and abnormal buying by institutions in the days before
the initial release of analyst buy recommendations. Studies have also revealed
increased short selling on the days when corporate insiders sell, before the
trades are officially reported to the public.6

4 Bray, Chad. “Former BlackRock Manager Sentenced in Insider Trading Case.” December 2016. https://
www.nytimes.com/2016/12/21/business/dealbook/former-blackrock-manager-mark-lyttleton-prison-
insider-trading.html.

5 Gabriel, Anita. “MAS prosecutes its first ‘front-running’ case for insider trading.” August 26, 2016. http://
www.businesstimes.com.sg/companies-markets/mas-prosecutes-its-first-front-running-case-for-alleged-
insider-trading-amended.

6 Berkman, Henk; Koch, Paul; and Westerholm, P. Joakim. “Personal Trading by Brokers, Analysts, and
Fund Managers.” November 2017. Page 5-6.

7 Thompson, James H. "A Global Comparison of Insider Trading Regulations." February 2013. http://www.
macrothink.org/journal/index.php/ijafr/article/viewFile/3269/2976.

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To illustrate, Consob, the Italian regulator, fined Gartmore fund manager,

Guillaume Rambourg, €300,000 for front-running a position in 2006 after
receiving a broker note on Banca Italease before it was made public. Citigroup
analyst, Roberto Casoni, disclosed details of his valuation methodology, final
recommendation and target price for the bank. He, too, was fined £52,000
by the UK’s FSA (the FCA’s predecessor) for market misconduct. Others were
penalized in this incident as well. Consob fined Vanni Vechini, an analyst at
Gartmore, €100,000. Fund managers at Schroders, Oddo Asset Management
and Dexia Asset Management were fined €250,000, €130,000 and €150,000
respectively. The case resulted from a routine internal compliance check,
indicating that Rambourg was favoring certain executing brokers, which
appeared to breach best execution regulations.8
Acting upon information before it is public knowledge goes against global
regulatory standards. Fund managers who are found guilty of front-running
and tailgating could face substantial fines and penalties, as well as the demise
of their business. In order to safeguard against this practice, compliance teams
must ensure the proper technology solutions are in place to protect against
manipulative behaviors and conflicts of interest.

Preferential treatment and conflicts of interest

When portfolio managers are responsible for a number of accounts, conflicts
of interest may cause them to favor one account or fund over another. Often Global regulators are very much
the goal is to enhance performance or gain higher fees for the same trade. focused on prohibiting conflicts
As an example, a fund manager’s compensation structure may vary between of interest, including the Financial
two different accounts: one fee could be based on assets under management Conduct Authority (FCA) which
and the other based on performance. Suppose the fund manager allocated passed regulation in regard to
the best performing trades to the account where compensation is based on side by side management, and has
performance because he or she has an opportunity to earn a higher fee. This issued fines and penalties against
would be considered a conflict of interest and a breach of regulations since asset managers that don’t comply.
assets are not being allocated fairly and equally. “Ensuring that conflicts of interest
are properly managed is central
Short-selling provides another opportunity to allocate unfairly, causing a
conflict of interest. A portfolio manager could short-sell a security for one to the relationship of trust that
account, push the price lower, and then tailgate by going long in the same must exist bet nd their customers.
security for a different account that pays higher fees. As the price deflates and It is also a fundamental
inflates, the portfolio manager could sequence the trades in a particular order regulatory requirement…Not doing
to take advantage of the price impact and favor one account over the other. so risks customers’ interests
being overlooked in favor of
The SEC in the US began cracking down on unfair trade allocation in 2013,
commercial or personal interests.”
and filed charges against a few firms. In 2013, Oliver Capital Management
Georgina Philippou, Acting
was fined $15 million for allocating more profitable trades to hedge funds in
Director of Enforcement and
which the company founder and his family invested. In 2015, Mark Welhouse
of Welhouse & Associates was forced to repay clients $418,000 for delaying Market Oversight at the FCA.
allocations to either his or his clients’ accounts until later in the day after he
saw whether the securities appreciated in value. In 2016, Phillips Group was
charged with unfairly and systematically allocating profitable trades to a set
of accounts while others were harmed.9

8 Craig, Phil. “UK regulator cleared managers fined in Italy.” April 1, 2010. https://www.fnlondon.com/
articles/uk-regulator-cleared-managers-fined-in-italy-20100401.

9 Baert, Rick. “Trade allocation policies being scrutinized by SEC.” May 30, 2016. http://www.pionline.
com/article/20160530/PRINT/305309978/trade-allocation-policies-being-scrutinized-by-sec.

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Some hedge funds disclose that they give preferential treatment to certain
clients in side letters. If all parties agree to this in advance, preferential SIDE BY SIDE MANAGEMENT
treatment technically is not illegal, although side letters have come under
The process of evaluating funds
increasing scrutiny by the regulators.
and accounts ‘side by side’ for
To ensure that firms are allocating all assets fairly and equally, compliance fair and transparent allocations
teams must conduct side-by-side management analysis. This can be a tall
order without the correct technology in place. Mapping all securities and
trades in an Excel spreadsheet is time consuming. Moreover, systems that WHY IS SIDE BY SIDE
are not tailored for the specific needs of hedge funds and asset managers MANAGEMENT IMPORTANT?
cause an influx of false positives, which clutters the compliance workload
and targets cases that do not warrant investigation. Learning to mitigate Ensures that portfolio managers
and control the risks arising from conflicts of interest is essential to avoid are allocating all assets in
hefty fines and penalties, and protect the firm’s reputation. accordance with regulatory
mandates, and not basing these
decisions between specific
Recommendations for controlling the risks accounts on gaining better fees,
Reputation is essential to a buy-side firm’s competitive profile. With market commissions or personal benefits
abuse tactics posing a constant threat, it is essential that asset managers
comply with all regulations and protect themselves from the potential
demise of their business. Compliance officers need to quickly and efficiently
identify potentially abusive behavior – whether it is in manipulating the
market or unfair treatment of investors.
Recommendations for buy-side firms:
• Deploy a holistic surveillance solution that monitors across compliance
siloes and all aspects of trade and order flow, including orders, amends
and cancels as well as electronic communications.
• Utilize technology that provides insights on market abuse and trading
anomalies, analyzes patterns and unusual volume, and alerts against
potential front-running or insider trading.
• Implement a surveillance system that can accurately conduct side-by-
side management analysis to ensure that all assets are allocated fairly
and equally, in addition to monitoring employee personal trading account
behavior.
• Ensure that your surveillance system is tailored for buy-side specific
needs in order to eliminate an abundance of false positives.
With recent global regulatory requirements constantly changing, buy-side
firms must be willing to adapt to the evolving environment. Adhering to
these recommendations and having the correct technology in place can
help firms avoid substantial fines and penalties, as well as uphold their
reputation.

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Nasdaq Buy-side Compliance FOR MORE INFORMATION

Nasdaq has over 20 years of expertise in the surveillance industry,
developing market abuse monitoring and detection technology for market
participants. Today, Nasdaq’s Risk & Surveillance solutions provide
surveillance to over 150 market participants on the buy- and sell-side. Please visit our website:
http://business.nasdaq.com/market-
Developed specifically for the buy-side community, Nasdaq Buy-side
tech/market-participants/Nasdaq-
Compliance identifies and analyzes when changes have occurred in the
market that may indicate front-running or tailgating, and then scores fund Buy-Side-Compliance/index.html
managers based on their transaction history. Its proprietary risk-scoring
model detects price movements and narrows the focus amidst huge
amounts 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.
The solution looks for personal trading that was done before significant
market events, and cross-references the personal account trading data with
the fund’s trading data. Then it builds a profile of who is trading most often
in front of the funds as well as their success rate.
To ensure that employees do not trade on material nonpublic information,
best practice is to do a pre-trade check against the restricted list, stipulate
a minimum holding period and do a post-trade review to monitor for
suspicious activity. Nasdaq Buy-Side Compliance looks at news flows and
company announcements – especially ones that are unscheduled – matches
them against significant price movements, and identifies who traded before
the news was released. That activity is compared to the trader’s behavioral
score based on their transaction history provided by the asset management
firm.
Finally, Nasdaq Fair Investor Allocation, the “side-by-side management”
functionality within Nasdaq Buy-Side Compliance, ensures that portfolio
managers allocate all assets fairly and equally, and in accordance with
regulatory mandates. It processes firms’ transaction information and
delivers a cloud-based, managed solution that provides measurable
evidence of best executions and allocations for every client. The solution
runs proprietary clustering algorithms to group together and compare
trades, and it shows in-depth information on execution timing, execution
prices and capital allocation. Then it generates a report, providing evidence
to regulators and compliance officers that assets are being allocated fairly
and equally.
Nasdaq Buy-side Compliance is tailored for the buy-side, and ensures that
all trades are scrutinized, high-risk traders get immediate attention, reports
are managed proactively, regulators get a prompt response, and the firm’s
reputation is upheld. Further, it reduces the number of investigations as
well as the time it takes to conduct them, therefore improving operational
efficiency in compliance.

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