Anonymous trades no evidence of

(April 1, 2005) Front-running — the bane of a portfolio manager putting on a large order, only to have someone in the know step in front of it to profit — is not occurring in systematic fashion on Canadian securities markets. But Market Regulation Services (RS), which supervises trading on Canada’s stock exchanges, has found a number of other areas where tighter controls are required to prevent sensitive order information leaking out before a trade.

Concerns about front-running have roiled the New York Stock Exchange in recent months, as both specialist firms who make markets and floor clerks who facilitate third-party trades have been accused of stepping ahead of a large trade to profit for their own account, or leaking information so others could front run. Large Canadian investors are suspicious too that their brokers are taking advantage of pre-trade information.

In a statement released on Thursday, RS said it had conducted a review of the Canadian marketplace “in response to investor concerns that there could be significant front-running activities that are not visible to clients.” Indeed, after RS started the project, another survey indicated that many market participants are convinced front-running is prevalent, particularly through the use of trades identified as anonymous or jitney trades, where one dealer executes a trade for another.

However, RS eastern region vice-president Maureen Jensen said “this detailed study found no evidence of systematic front-running or substantive client priority violations in the Canadian marketplace.” The study examined policies and procedures of buy and sell-side firms as well as a sample of one week’s trading activity.

RS acknowledges “there is a perception by both buy-side and sell-side firms that there is a serious information leakage about pending transactions and larger orders as well as inappropriate disclosure of confidential information.”

But the existing audit trail requirements do not give regulators “reliable” access to what transpired between clients and traders before placing an order, RS said. Moreover, it does not have the means to police “tipping” by traders to other traders, whether by phone, e-mail or instant messaging.

The RS report recommends giving regulators access to pre-order information, improving existing regulatory tools and better education of traders of the universal market integrity rules that, for example, preclude blanket trading alongside or before a client order, although such trading is permitted on a case-by-case basis with the permission of the client.

As for the review itself, RS says that the one-week period examined was limited but the findings were consistent with its trade desk compliance program, which has resulted in the prosecution of five front-running cases over the past three years, one of which resulted in a dealer returning $120,000 to clients while the trader disgorged $30,000 in profits.

Buy-side leaks

One of the weaknesses the study commented on was the gap in information about how buy-side firms managed their internal and external communications before placing an order. While pension funds and mutual funds generally have internal controls, hedge funds may not, the report noted. In addition, while trading on an investor’s “expression of interest” is inappropriate, it is not illegal, and is impossible to detect without a specific client complaint.

Another weakness is that, although “tipping” violates the market integrity rules, it is not covered under the mandatory audit trail requirements. RS acknowledges, however, that audit trail requirements do not allow it to determine how trade information is communicated to other employees of a dealer, its other clients, or other people. How sell-side firms record communications is inconsistent. Some firms, for example, may keep phone records for 10 days, some for 24 months. However, taping trade-desk conversations is not required. Consistent rules for participants, the study recommends, would have to include other forms of communication including e-mail and instant messaging.

Although there is a perception that there is widespread leaking of trade information, buy-side firms frequently point the finger at other buy-side traders for carelessly letting information out, rather than their dealers. RS recommends issuing a notice that reiterates a participant’s obligation of protect the confidentiality of client information, and another that stresses the importance of buy-side firms protecting the integrity of their own information.

Expressions of interest

Buy-side firms also urged that the front-running prohibition be broadened to include expressions of interest as well as firm orders and apply to all client trades, not just ones that “could reasonably be expected to affect the market price.” On the one hand, RS recommends training sessions for buy-side traders on what is covered under the front-running and client priority rules. On the other, RS recommends examining whether to amend the front-running rule to include expressions of interest, with a clear definition of expression of interest and whether to develop a means to monitor market participants’ receipt of expressions of interest. It also recommends looking at whether the rules should cover all client trades, and not just potentially market-moving ones.

Expressions of interest are knotty. Some buy-side firms believe dealers should stop trading for their own account once they receive an expression of interest, while others believe principal trades are okay even after a firm order has been made.

RS admits that the universal market integrity rules foster confusion. While it is permitted to trade on an expression of interest, the rules say there may be instances of participants who repeatedly trade on expressions of interests in specific securities. Those who do are violating “just and equitable principles of trade.”

In another area of concern, dealers can trade alongside or ahead of the client to reduce the market impact of a block trade, with the client’s permission. But many firms believe they have blanket permission to do so, and don’t seek out permission for each trade. RS recommends a notice that explains how client consent should be recorded and examine whether blanket authorization should be allowed.

Anonymous trades

Buy-side firms have argued that trades marked as anonymous hinder the monitoring of their order’s progress as well as their monitoring of the dealer. Although the names of firms involved in anonymous trades are available to RS in real time, they are not broadcast to the marketplace. The share of trades marked anonymous on the TSX has climbed from 3.56% in 2002 to 10.93% by April 2004.

Still, no buy-side manager complained that dealers were using anonymous trades to front- run. On the other hand, there is deep suspicion of jitney trades. However, RS found that they constitute a tiny fraction of trading, and would constitute even less if non-clearing brokers were not required to execute trades through clearing dealers.

All the same, RS recommended that buy-side concerns be communicated to the TSX and the venture exchange, and that jitney trade markers, which are sometimes precluded by computer system limitations, be added to the trade record as required.

Filed by Scot Blythe, Advisor.ca, scot.blythe@advisor.rogers.com.

04/01/05

Scot Blythe