Streetwise Professor

January 18, 2014

Forget Manipulation. Is Is Even Frontrunning?

Filed under: Derivatives,Economics,Regulation — The Professor @ 10:45 pm

Emails from two readers raise some interesting points about the alleged front-running of Fannie and Freddie by swap dealers.

And that’s one of the points.  Swap dealers. These were principal-to-principal transactions: the dealers were the principals to the trades.  Front running  traditionally involves violation of an agency relationship.  A broker that has a fiduciary relationship with a customer who trades ahead of that customer’s order is front running.  The dealers have no fiduciary duty to their counterparties, as far as I know.

Also, F&F were repeat players, and could refuse to trade with dealers they thought were taking advantage of information about their order flows.  Back in the block trading days, firms that “bagged the street” by selling blocks when they were in possession of private information had a difficult time of finding counterparties.  As a face-to-face market, something similar should have worked in the swap market.

This correspondent also suggests that F&F might have benefitted from this, and may have let dealers know what was coming so the dealers could hedge, meaning if anybody was hurt here, it was the futures traders who were picked off by the dealers placing their hedges. (But then again, given that this would have happened over a long period of time, the futures quotes should have compensated the traders for the risk of being picked off in this way.)

So, there is some doubt that this is even front running, let alone manipulation.

The other correspondent wonders whether the new Dodd-Frank language banning “any act, practice, or course of business that is fraudulent, deceptive or manipulative.”  That could be.  The same language is in SEC Rule 10b-5, and this has been used to prosecute front running.  So it wouldn’t be surprising to see this used to in the Fannie and Freddie case.

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  1. when the Fed really moves, we will see what frontrunning is really like.

    Comment by Jeffrey Carter (@pointsnfigures) — January 19, 2014 @ 9:21 am

  2. If an agent trades for private advantage ahead of client orders, that would indeed be classic front-running. If a principal trades ahead of a counterparty (eg by offering the market down while discussing a block trade with that counterparty, then buying the block at the present, artificially-lowered, price), that would probably be technically defined as insider trading.

    In either event, though, the illicit profit opportunity arises from advance knowledge of material non-public information, i.e. somebody else’s upcoming order flow. Arguably, any distinction between front running and insider trading is minor and definitional. What you need, to gain by either, is the same.

    The inside information is available to everyone involved in the trade including, of course, the party allegedly being front-run. Call me cynical, but if Trader A at Company B is persistently getting in front of orders from Trader C and Company D, with our without the involvement of Broker E at brokerage F, I’d start from the assumption that each of A, C and E has the same temptation. Prima facie each has the same likelihood of succumbing to the temptation to front-run.

    In fact, A maybe has a greater appetite to engage in front-running. He may imagine he can identify himself with his company. He may think that if it all comes out, he can claim plausibly in self-defence to be the blameless victim of others’ skullduggery, because Trader A = Company B. This defence is not available to the others in the frame. But of course it’s not true, either, when the brown envelope comes around.

    Personally I’d consider A at least as likely to be the culprit. If he’s innocent but didn’t notice himself being front run, I’d still wonder why I employed him.

    Comment by Green as Grass — January 20, 2014 @ 4:27 am

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