What is the difference between front-running and insider trading?
Both affect mutual fund unit holders and stock market investors.
Our seventh-largest fund house, Axis Mutual Fund, has suspended two fund managers including its chief dealer and is investigating improprieties in the funds they have handled. While it is yet unknown what is the exact nature of these violations, domestic mutual funds have come under investigation for front-running.
Front-running is not insider trading, though the culprits make money in both by trading in shares. In front-running, a dealer within an institutional money manager like a mutual fund or a share broker abuses knowledge of orders that the mutual fund has for the day and tries to profit from them.
What are the differences between the two?
How to make a cheat sheet in a front-running fraud
The fund manager decides what to buy or sell. Informs his dealer who executes the trade on behalf of the fund house. It has a dealing room in an isolated area where these trades happen all day long. Only dealers and fund managers are allowed entry. And the crime takes place here.
The dealer to make profit enters the market minutes before punching the fund house order. Mutual funds place large orders which sharply move the stock price.
The dealer buys or sells the stock minutes before a mutual fund places its trades, buying or selling the stock.
The idea is to profit from the big investor’s moves, either by buying or selling shares.
What is insider trading?
It is when a company insider, official, employee or senior executive, takes advantage of unpublished price-sensitive information (UPSI) to trade in the company’s stock and make profits from such transactions.
It is done by a company’s employee to make profit by dealing in the company’s shares.
Front running can be done in just about any stocks or sectors by unrelated people, having knowledge of large investors’ plans to trade in the markets.
What is the Impact on investors?
Insider trading gives an unfair advantage on the basis of non-public information.
SEBI (Prohibition of Insider Trading) Regulations clearly define the insider and what constitutes unpublished price-sensitive information.
Public shareholders like mutual funds are at a disadvantage as company insiders have access to UPSI, take undue advantage and use accounts of their associates to execute such trades.
SEBI has put in place certain checks and balances to prevent insider trading. For example, SEBI’s code of conduct for listed companies states that trading restrictions on insiders can come into force from the end of every quarter till 48 hours after the declaration of the company’s financial results.
In front-running, if the dealer benefits, how does it harm the unit holders of the fund house?
Knowing that the mutual fund is going to buy a certain stock, he can build a position immediately in another account. And as the price rises with the mutual fund buying it in large quantities, he can sell the stock and make a quick profit.
Similar is the case when the dealer knows that the mutual fund is going to sell a stock. Then, the mutual fund scheme is deprived of a market-driven price, as the presence of more participants who have taken positions in the market, the stock price gets impacted.
When the fund house finally enters, the stock price is already manipulated.
A one-off incident does not materially impact a stock’s price. But a dealer repeatedly front-running a large investor can make lots of money.
Worse still, if the buying is large enough, it can create a large jump in the stock price. So, when the mutual fund is buying, it is buying at a higher price than it would have otherwise.
The dealer will not execute such fraudulent trades in his own account, but through his associates and their accounts, to avoid getting caught. These accounts are mule accounts in stock market vocab.
Front-running also impacts other stock market investors, as the latter trade at prices manipulated by the dealer for his own gain.
Most mutual funds have strong control measures to check front-running. Access to dealing room is strictly controlled. Surveillance cameras keep an eye on the dealing room. No mobile phones are allowed inside the dealing room.
All conversations are on recorded lines. Declarations need to be made of personal holdings as well as those defined as relatives. Pre-clearance is required when trading in shares in personal account or in those of relatives.
However, all such controls are possible within the premises of the fund house. Work from home has made it difficult to ensure these controls in letter and spirit. Calls still get recorded, but who is interacting within his own premises cannot be controlled.
How has SEBI dealt with front running?
When SEBI has found violations, it has imposed monetary penalties. Dealers, fund managers and the outside brokers with whom they have worked in collusion get penalised. Rarely the CEO of the fund house pays a monetary penalty. Unlike US SEC, it is rarer in India to penalise or debar a CEO of an Asset Management Company. On the gravity of the securities fraud, SEBI pulls up the fund house’s trustees and the Board of Directors.
Sometimes, proceedings get settled through consent mechanism of SEBI, also known as settlement process, where the institution under investigation, settles the case with SEBI in lieu of payment of monetary penalty and voluntary restrictions. In one of the first cases of insider trading that came to light in public domain, a large fund house’s head had to pay Rs 15 lakh fine, as part of SEBI’s consent proceedings. The fund house and its trustee board had to pay Rs 20 lakh each.
A consent mechanism is usually of two types; one where the fund house neither admits nor denies the findings of fact or conclusion of law, and the second category where there is admission. In the first the penalty amount is higher in comparison to the cases where fund house admits the charges.
And how is the consent fine decided? SEBI relies on the formula prescribed in the Regulations where it takes into account the size and nature of the offence, impact on the market, the company and conduct of the culprit.
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