Navigating Front-Running: Unpacking its Definition, Legal Boundaries, and Detection Techniques
In May’s Regulatory Roundup, I covered a highly complex case involving a combination of spoofing and front-running behaviors in digital assets. In that case, the people performing the front-running-like behavior (“sandwich attack”) were the victims, not the perpetrators of the fraud, and I briefly contrasted it to a more standard front-running case that was going through the same court at the same time. This case sparked some interesting discussions on the nature of front-running, when front-running is illegal and how to detect it, which I will cover in this month’s analysis.
Front-running involves using non-public information to trade ahead of and benefit from an order that has anticipated market impact. The simplest example would be a broker receiving a very large buy order from their client, large enough to increase the stock price. Before executing the client’s order, they buy some using their own personal account. They then execute the client’s order pushing the market up and selling at the higher price soon after, profiting off the difference. This activity is unethical and illegal in most jurisdictions. The front-runner is profiting off inside information entrusted to them and the price impact of their trading activity could have worsened the price they could have gotten for their client.
The United Kingdom’s Financial Conduct Authority (FCA) handbook provides a good definition and summary of how front-running is treated under the U.K. and EU Market Abuse Regulations, where it is considered a form of insider dealing. The handbook covers additional considerations that also need to be taken into account, pre-hedging being a particularly interesting one. Pre-hedging describes the practice of liquidity providers taking a hedge position to mitigate inventory risk in anticipation of an incoming transaction. Pre-hedging and how it is different to front-running is a complex topic, which is deserving of its own deeper analysis. For those interested, ESMA produced a report on pre-hedging in 2023 after collating industry feedback on the practice.
Another thing to consider when looking at the regulations concerning front-running is that the cases often involve a broker-client, fund manager-fund style relationship. This means that it would often also be covered under rules that control conflicts of interest, such as United States Rule17j of the Investment Company Act.
Front-running scenario in-depth
Now, let’s look closer at the case mentioned in the May analysis where a trader was sentenced to just under six years. Lawrence Billimek was a trader at a major asset management firm that routinely traded in amounts large enough to move the price of the securities they were active in. To avoid detection, Billimek coordinated with an accomplice, Alan Williams. Billimek would tell Williams the large trades that he was going to do for the asset manager as part of his job, and just prior to those trades, Williams would make his own in the same direction, front-running Billimek’s activity on behalf of the asset manager. Once Billimek’s trades moved the market, Williams would close out that position and take the profit, of which there was a lot. Williams made a profit of at least $47.3 million over a six-year period from the trading.
Front-Runners Unusual Patterns
Williams traded through two separate brokers, and the filing covers the behavioral factors that marked Williams’ activity as unusual. Firstly, his trading accounts were incredibly profitable, unrealistically so. The U.S. Securities and Exchange Commission (SEC) calculated what it referred to as a “dollar-weighted win rate,” which is the proportion of the trader’s investment dollars associated with profited outcomes. For example, if a trader invested $1 million, and $900,000 of the investments were associated with profited outcomes, the dollar-weighted win rate would be 90%. Over the front-running period, the dollar-weighted win-rate was over 90% every month.
Secondly, Williams’ trading had a large amount of “roundtrip stock trades.” That is, trades where the position was opened and closed that day. This makes sense for a front-runner as they are profiting from the expected market impact of the front-ran trades — the longer they hold their position, the more likely other market activity or news will move the price the other way. The SEC was also able to line up 1,697 of Williams’ trades against activity by Billimek on the same stock, on the same day, in the same direction. The chance of this happening was less than one-in-a-trillion.
A data-driven approach to detecting the behavior is also mentioned in the SEC press release, which states that, “The SEC staff analyzed trading using the Consolidated Audit Trail (CAT) database to uncover William’s allegedly fraudulent trading and to identify how he profited by repeatedly front-running large trades by Billimek’s employer.”
Though relatively simple in nature, the case gives a good overview of many of the characteristics of a front-running scheme: The material non-public information possessed by Williams and the mechanics of the front-running activity, as well as the breach of the code of ethics. It also hints at the behavioral data markers used to find the scheme, such as the unusual profitability and paired trading.
The Sandwich Attack
Circling back to the sandwich attack case involving Ethereum, it becomes clear that the perpetrators of the sandwich attack did not possess material non-public information. On the Ethereum block chain, the pending orders are publicly available on the mempool. Separately, the sandwich attack perpetrators didn’t have any legal fiduciary or similar style obligation to the victims of the attack. However, the behavior is similar enough to front-running that U.S. Department of Justice (DOJ) referred to their trading as the “front-run trades.” The financial impact on the victim is also similar; someone has traded ahead of them, potentially causing them a worse price for no benefit. As we develop new market models, as well as evolve our current one, the concept of fairness also needs to be a consideration.
Regulatory Updates
19 July: The SEC’s Division of Enforcement initiated the Interagency Securities Council (ISC), promoting collaboration among federal, state and local agencies to combat financial fraud through shared insights, unified efforts and quarterly discussions.
18 July: The Securities Commission Malaysia (SC) updated its Guidance Note on the Provision of Investment Advice to regulate financial influencers’ activities on social media, emphasizing the need for a license for promoting capital market products under certain circumstances.
17 July: The European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA), and the European Securities and Markets Authority (ESMA) released the second set of policy products under the Digital Operational Resilience Act (DORA), including regulatory and implementing technical standards to enhance digital operational resilience in the EU’s financial sector. These standards focus on incident reporting, threat-led penetration testing, oversight framework design and guidelines for estimating costs due to incidents, aiming to ensure continuous financial service provision and data safety.
10 July: The Abu Dhabi Global Market (ADGM) introduced a whistleblowing framework to enhance transparency and accountability within its financial center. The initiative requires ADGM entities to establish written whistleblowing policies by May 31, 2025.
1 July: The Securities and Exchange Board of India (SEBI) instructed Indian market entities to stop providing volume-based discounts to brokers and others in a bid to ensure fairness, transparency and equal costs for all participants, with a potential aim of regulating the soaring growth of derivatives trading; these changes must be implemented by October.
30 June: The South Korean Financial Services Commission (FSC) announced the Act on the Protection of Virtual Asset Users, enforcing rules for virtual asset service providers (VASPs) to safeguard user assets and prevent unfair transaction activities in the virtual asset market. The legislation confers oversight and sanction authority to the FSC, with provisions including separate management of customer assets, restrictions on improper market practices and penalties for unfair transaction activities, aiming to enhance user protection and transparency in virtual asset transactions, set to go into effect in July 2024.
Enforcement Actions & Fines
The Office of the Comptroller of the Currency (OCC) amended its October 2020 Cease-and-Desist Order against Citibank, N.A. due to the bank’s failure to meet remediation milestones regarding enterprise-wide risk management and compliance, issuing a $75 million civil money penalty for violations.
The Federal Reserve Board fined Citigroup $60.6 million for breaching its 2020 enforcement action, citing inadequate progress in addressing data quality management issues and implementing necessary risk controls.
The Ontario Court of Justice in Toronto sentenced an individual to four years in jail and ordered them to pay restitution of more than $3.9 million for charges related to trading securities without registration and fraud, fabricating returns as a trader for a hedge fund.
The Sydney District Court convicted the Australian promoter of BitConnect for providing unlicensed financial advice about the cryptocurrency platform, including through seminars and social media.
Following legal proceedings brought by the Securities and Futures Commission (SFC), the Market Misconduct Tribunal ordered a former responsible officer of Tarascon Capital Management to disgorge over $5.6 million from false trading and barred him from directorial roles for four years due to matched trades causing gains in his mother’s account at the expense of the hedge fund he managed.
The Securities and Futures Commission (SFC) oversaw the sentencing of three individuals for conspiracy to carry out false trading in shares, leading to the heaviest jail term imposed under the Securities and Futures Ordinance since 2003.
The Monetary Authority of Singapore (MAS) imposed a civil penalty of S$70,000 on an individual for insider trading in GS Holdings Limited shares after a joint investigation by CAD and MAS. The individual was the sole shareholder and director of GSG Capital and purchased 515,000 GHL shares over 13 days while possessing non-public information about GHL’s intended sale of its loss-making subsidiary.
A U.S. District judge sentenced a former Goldman Sachs and Blackstone analyst to 28 months in prison for insider trading. The former analyst was accused of passing tips on eight planned corporate mergers and partnerships between 2021 and 2023, resulting in more than $400,000 in illegal profits.
A U.S. District Judge in Trenton federal court arraigned a former partner at a New Jersey broker-dealer firm on charges related to an insider trading scheme that yielded around $3.4 million in illegal profits. The scheme, which involved leveraging confidential information from a contact at a Canadian asset management firm, led to securities fraud charges with a potential prison sentence of up to 25 years and significant fines.
The Seoul Southern District prosecutors’ office is reviewing a warrant request to arrest the billionaire founder of tech giant Kakao Corp over allegations of stock manipulation during a 2023 acquisition.
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