Explainer: What is front-running, how does it impact MF or its investors

With Quant Mutual Fund coming under regulatory scanner for alleged front-running activities, Business Standard provides an explainer on what such activities mean, with past instances and the impact they had…

What is front-running?

Front-running in executing trades happens when one is in possession of sensitive information about a fund’s buying or selling activity. Whenever a mutual fund or other large investor executes trades, it tends to have an impact on a stock price, more so if the stock is relatively less liquid. Typically, a fund house official or a broker who executes the trade on behalf of the fund leaks the information about an impending trade. This information is used by an individual or an entity to build prior positions with an objective of booking profit when the stock moves after the actual trade by the fund house takes place. This is an illegal practice and one of the most serious stock market violations.

How does it work?

Cases of front-running mostly happen when large asset managers and intermediaries are involved in bulk trades as their transaction size is generally big enough to impact the stock price. For example, say a person employed with a mutual fund (MF) invests Rs 1 crore in shares of a company after knowing that the MF is set to buy Rs 100 crore worth of stocks of the company with Rs 20,000 crore market capitalisation. If the stocks move up 2 per cent due to the bulk buying, the person will make gains of Rs 1 lakh.

How is front-running detected?

The Securities and Exchange Board of India (Sebi) uses various algorithms, data analytics, and supervision technology to track instances of front-running and insider trading. As most of the trades these days are done on an electronic platform, it is easy to establish instances of front-running. Also, insiders use mule accounts to carry out trades. Sebi in the past has established links between fund house officials and conduits by tracking emails, phone calls and WhatsApp messages.

How does it impact the MF or its investors?

While investors of asset managers are not directly affected by front-running in most cases, the credibility of the asset managers takes a hit, giving a poor perception of management practices at such institutions.

Recent instances of front-running?

In April, Sebi had barred eight people and directed them to disgorge Rs 1.3 crore for indulging in front-running activities. These players, including employees of several stock brokers, were found to be front-running trades of a portfolio management services firm. In April 2023, Sebi had cracked the whip on five entities and individuals for front-running trades of Life Insurance Corporation of India (LIC). They included an employee of the investment department of the insurer. They made unlawful gains of Rs 2.44 crore. In the Axis Mutual Fund matter, Sebi findings revealed ill-gotten gains of over Rs 30 crore through front-running by former chief dealer Viresh Joshi and 20 others. In recent times, Sebi has also taken action on research analysts and experts appearing on television channels for front-running trades before making recommendations to the viewers.

How have regulations changed to curb such misconduct?

Following concerns of front-running, Sebi has announced implementation of an institutional mechanism to step up surveillance and internal control procedures to identify instances of misconduct and misuse of sensitive information. The regulator has also suggested stringent action on key officials of MFs. The Association of Mutual Funds in India (Amfi) is also in the process of formulating a standard operating procedure (SOP) to prevent front-running.