Foreign currency trading appears to take place in a highly competitive environment. Since the mid-1990s, major currencies have traded almost continuously between large numbers of counter- parties on multiple electronic platforms in high volumes and with very tight bid-ask spreads. However, in recent years, government regulators and enforcement authorities across the globe undertook investigations into whether many of the world’s largest dealer-banks were acting anti-competitively in the Forex market.

Between 2014 and 2015 reports issued by the U.S. Department of Justice, the Commodity Futures Trading Commission, New York Department of Financial Services, the U.K. Financial Conduct Authority, and the Swiss Financial Market Supervisory Authority all concluded that dealer-banks engaged in a range of collusive conduct aimed at manipulating the Forex bench- marks. The investigators also found that the dealer-banks had engaged in other forms of anticompetitive conduct, including the collusive sharing of information and front-running.

Following these reports, the U.S Department of Justice and the Federal Reserve Board indicted and placed lifetime bans on more than a dozen individual FX dealers and in 2017 a dealer was convicted of wire fraud for his part in a scheme to front-run a $3.5 billion trade. In addition, multiple law-suites have been brought before the courts in the United States and Canada alleging that dealer-banks engaged in anti-competitive behavior that harmed investors. By the end of 2018, these investigations and law-suites produced fines and settlements totaling over $11 billion.

Front Running

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.

Front-running is also known as tailgating. Front-running is illegal and unethical because it takes advantage of private information that is not available to the public. If a big transaction is made public, then buy or selling ahead of it is not illegal. It also occurs when a broker or analyst buys or sells currencies for their account ahead of their firm’s buy or sell recommendation to clients.

Market Clearing Conditions of Forex Market

In particular, How the equilibrium behavior of prices and trading flows change when dealers share information about their customer orders, and when they front-run hedgers’ orders, both unilaterally and collusively. We describe trading between a large number of dealer-banks and two groups of customers called investors and hedgers. Trading takes place between dealers in the wholesale tier of the market, and between dealers and their customers in the retail tier. Dealers are risk-averse and choose their trades and price-quotes optimally in both tiers of the market. Investors are also risk averse and optimally determine the orders they place with dealers in the retail tier. In contrast, dealers receive orders from hedgers that are determined by an exogenous liquidity factor. We provides a rich environment to study  the market-wide effects of information-sharing and front-running.

There are three sets of market clearing conditions to consider:  those for investors’ orders, hedgers’ orders, and inter-dealer trading.  First, the dealer uses the advanced information about the hedgers’ Forex orders to “trade ahead” of those orders.  Dealers receive three types of information during the trading day: (i) public information on the Forex payoff in round i, (ii) market-wide information on prices and aggregate inter-dealer order flows, and (iii) private information on the Forex orders they receive from investors, hedgers, and other dealers.

 All other things remaining constant the dealer initiates Forex purchases (sales) in inter-dealer trading when he knows that he must fill hedgers Forex purchase (sales) orders in the future. Second, the incentive for dealers to front-run hedgers’ orders only arises here because dealers use to the information in those orders to better hedge against future shocks.

How does Front Running Work

Front-running is unethical and illegal as it gives an unfair advantage to the broker or trader. Front-running, much like insider trading, provides unfair advantages to the broker who has nonpublic information that will affect the asset’s price. It is also considered front-running if an analyst purchases or sell shares prior to their firm releasing a buy or sell recommendation. The trader knows the recommendation will impact the price of the asset in question, so placing a trade right before releasing the recommendation is unethical and illegal.

Firms and individuals are allowed to have positions in assets they recommend or discuss, but their position must be revealed at the time of the recommendation or discussion. Also, having a position isn’t illegal, but attempting to profit from non-public information is. A short-seller may accumulate a short position and then reveal their research to the general public on why they shorted the stock. This is not illegal, because the short-seller is trying to profit from overall conditions, and not simply trying to profit from releasing their information. The latter would be a short-sell version of the pump and dump.

Examples of Legal and Illegal Front-Running

Illegal front-running is primarily limited to two types. The first type is acting ahead of a non-public order, and the second is acting ahead of a piece of news that hasn’t been made public yet.

Assume a broker sees a market order come in to sell nearly 1000 Pips drops in a thinly traded Currency pair. Selling Currencies could decrease the price of the currencies in advance. The broker decides to sell in his own account first, and then execute the client’s order. As expected, the large order causes an instant price drop. The broker covers their short position and pockets a quick incentive from that.

In another example, assume that a firm is about to release a very negative report on a company. An analyst at the firm short-sells the currency pair in anticipation that the negative report will cause the price to drop. The report is released and the currency pair drops. The analyst covers their position and reaps a quick profit. This is illegal. Shorting after the news is released is not illegal since the information is now public.

The trader or broker doesn’t necessarily need to make money for the transaction to be considered illegal. Even if they lost money because the market did not react as expected, the activity is still illegal. Front-running another person’s or entity’s order is legal if the order is made public.

Impact Of Front Running

1. Risk-averse dealers have a strong incentive to unilaterally front-run their own customer orders, even when the execution of those orders has no impact on prices.

2. In an equilibrium where dealers have the opportunity to front-run their own customer orders, trading ahead of those orders creates an information externality that has significant effects on trading flows and prices. The externality slows down the process by which inter-dealer trading aggregates the information that is ultimately embedded into the prices, which in turn affects the trading decisions of both dealers and investors.

3. Front-running reduces the  costs dealers incur from providing liquidity to It raises the price hedgers pay when they are net purchasers of Forex, and reduces the price they receive they are net sellers of Forex. These effects are substantial. They reduce dealers’ costs of providing liquidity by more than 90 percent.

4. Front-running also affects the welfare of dealers and investors. The information externality makes risk-averse investors less willing to speculate on their private information when trading with dealers, so they make smaller trading profits when that information becomes embedded in future prices. This indirect effect of front-running can reduce investors’ expected returns by as much as 10 percent. The reduction in investors’ trading profits also benefits dealers, accounting for approximately half of the reduction in the total costs of providing liquidity across the market.

5. Collusive front-running has larger effects on aggregate inter-dealer order flows than unilateral front-running because information-sharing reduces the risks dealers face when trading ahead of customer orders. In other respects, the effects of collusive and unilateral front-running are quite similar. Greater collusion lowers the costs of providing liquidity to customers, and it reduces investors trading profits, but the effects are small.

Summary

Front-running is an unethical and illegal practice in which a broker with advance knowledge of a client’s large order for a currency or security earns a profit by placing orders for their own account in advance of the client’s larger order, at the expense of the client. It is worth emphasizing that these results address the impact of information-sharing and front- running across the entire market. It is also empirically important because even though dealer information-sharing and front-running appear to have been widespread, it is unlikely to have directly involved more than a small fraction of all trades in the market. In my analysis, dealers do not front-run investors’ trades or share information about those trades, so the impact of information-sharing and front-running on investors occurs indirectly via changes in the behavior of equilibrium prices. In this sense, the fall in investors’ returns represents collateral damage from dealer front-running.