Study finds evidence of widespread front-running

Investor anxiety may be largely focused on swings in commodity prices or sluggish economic growth, but there may be another problem to add to the list: illicit trading practices.

According to a new study co-authored by a Toronto-based professor, there is evidence that front-running is a common practice on Wall Street.

Front-running is the term used to refer to an investor with insider knowledge of an impending large sale of a security using that information to trade in the security before the sale. It’s a type of insider trading, and it’s illegal.

According to the article “Do Short Sellers Front-Run Insider Sales” by professors Mozaffar Khan of MIT’s Sloan School of Management and Hai Lu of the University of Toronto’s Rotman School of Management, front-running on Wall Street persists through the use of short sales, which are not required to be disclosed in real time.

Using intraday short sale data compiled by the NYSE — which only recently has become publicly available — Khan and Lu tracked short sales between January 2005 and May 2007, and found that short sales intensified seven days prior to a large insider sale of stocks, peaking right before the sale.

Lu suggests this data points toward front-running because insider sales of stocks, such as the liquidation of a large position by a company CEO, must be reported under U.S. Securities Exchange Commission (SEC) regulations, but they are usually reported 48 hours after the sale. The spike in short sales well before the sale is publicly disclosed would suggest insider information leakage.

“Today, they can sell the stock, but they don’t have to file with the SEC until the day after tomorrow. That means the general public doesn’t know about the sale [for 48 hours],” Lu explains. “However, the peak in short sales are the two days prior to the sale.”

Front-running has long been suspected of being an ongoing practice on Wall Street. The most basic example would be a broker getting wind of a large sale happening by a mutual fund or a company executive who does business with the brokerage, and then trading on that information. Since that’s a pretty straightforward case of insider trading, it’s more common that accusations concern brokerage employees’ tipping off favoured clients, like hedge funds, that impending sales are coming, and those investors then acting on the information.

The latter scenario is more difficult to prove, and the study points out that using short sales rather than long positions further obscures what’s going on, since the general public doesn’t have intraday access to the short trading activity of certain securities.

The study also notes that many of the short trades usually happened to stocks in which the cumulative abnormal stock returns are positive and increasing until the first day after large insider sales and then become constant, neither increasing nor decreasing.

The authors say this means the short sales are contrary to the general market outlook, which suggests the traders have access to information not widely disseminated. However, since there is no discernibly large drop in price after the sale, it might be assumed that the trades are not profitable.

Khan and Lu believe they are.

“We argue against this interpretation because we do not observe when the short sales are covered. In particular, it is unclear what holding period to examine (i.e., it is unclear how many days these short sellers maintain their position). Further, holding period returns are typically calculated using closing prices, but the short sales may be covered at an unknown intraday price if the price pressure generated by the large sale is very short-lived or intraday,” they write. “We find that intraday stock price volatility in the pre- insider sale window is higher for large insider sales, and peaks on the day of the insider sale. Higher price volatility affords greater opportunity to cover shorts profitably, and is consistent with short-lived or intraday price pressure.”

Lu hopes the research motivates the SEC to introduce new policies that increase transparency and reporting requirements for short sales. Currently, exchanges are required to disclose the level of short selling once a month. Lu says disclosure of daily short sales activity could increase transparency and deter abuse.

“The results of this study have some policy implications,” he says. “We hope they [SEC] will change to daily disclosure so that investors and all market participants have the same information.”

In Canada, the Investment Industry Regulatory Organization of Canada (IIROC) monitors trading practices and has specific rules regarding front-running, through section 4.1 of the Universal Market Integrity Rules (UMIR).

Khan and Lu’s study is available through the Rotman School of Management’s website.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(07/31/08)

Mark Noble