'Front-Running' - Insider Trading Under the Commodity Exchange Act
60 Pages Posted: 3 Nov 2010
Date Written: Fall 1988
On ‘Black Monday,’ October 19, 1987, ‘perhaps the worst day in the history of U.S. equity markets,’ the Dow Jones Industrial Average fell by 508 points, representing a loss of approximately $1 trillion in the value of all outstanding United States stocks. In the wake of the crash, numerous studies were conducted and reports published in which a host of regulatory issues were considered, including a disturbing phenomenon called ‘front-running.’ Simply stated, the practice of front-running involves a transaction in a commodity futures contract or a stock option contract by a trader with ‘material’ nonpublic information concerning a ‘block’ transaction in the commodity or security underlying the futures or options contract. To be material, the block transaction must be of such a size that it will cause a price change in the futures or options contract and thereby allow the front-runner to profit from the offsetting options or futures position.
In actuality, front-running is more complex than this definition suggests. It encompasses at least three forms of conduct, each of which raises different regulatory and policy issues. They are: (1) trading by third parties who are tipped on an impending block trade (tippee' trading); (2) transactions in which the owner or purchaser of the block trade itself engages in the offsetting futures or options transaction as a means of ‘hedging’ against price fluctuations caused by the block transaction (‘self-front-running’); and (3) transactions where a broker with knowledge of an impending customer block order trades ahead of that order for the broker's own profit (‘trading ahead’).
This Article will explore the background of front-running, and its regulation in the securities industry. The Article will then focus on the spread of the practice to the commodity futures industry and the regulatory and policy issues raised by various forms of front-running. It will then address whether the present statutory framework is adequate to prohibit undesirable front-running practices. The Article proposes legislation to restrict such practices, and identifies surveillance methods that are needed to detect violations of necessary restrictions.
Keywords: Front-running, insider trading, Commodity Exchange Act (CEA), commodity futures contract, stock option contract, securities options, market, fraud on the market theory, manipulation, prices.
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