Relevance: GS-3: Indian Economy and issues relating to planning, mobilization of resources, growth, and development.

Key Phrases: Front-Running, Reverse Strategy, Shri Anandkumar Baldevbhai Patel v. Sebi, SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003, Insider Trading, Unpublished Price Sensitive Information, Surveillance mechanisms.

Context:

• Last Friday, Axis Mutual Fund issued a public notice removing and replacing two of its fund managers, Viresh Joshi and Deepak Agarwal, from seven of its schemes — its Banking, Technology, Consumption, and Nifty ETFs and Axis Value, Quant, and Arbitrage Funds. This move was accompanied by speculation that the managers were suspended on front-running charges. Axis Mutual Fund hasn’t explicitly mentioned front-running charges, but it has confirmed that it has been investigating “potential irregularities” with the help of external advisors.

What is Front-running?

• Front-running is a dubious market practice in which a dealer, trader or employee gets wind of a big order for buying or selling shares that will be placed by a fund or big investor and get ‘in front of the trade. Large orders usually move a stock’s price. By buying shares just before the big order hits the market and selling them once the price moves up, the front-runner pockets illegal gains from his advance knowledge. A reverse strategy is used with sell trades. Front-running by insiders can adversely impact investors in a fund by bidding up the prices they get to buy stocks or hammering down the prices at which they get to sell.
• Usually, there are two parties to a front-running operation. An information carrier gets advance information about the big investor’s orders because he/she is an employee, dealer or trader for it, and the front-runner is usually a friend, acquaintance, or relative who puts through the actual trades.

Types of Front-Running:

• The Supreme Court of India, in the case of Shri Anandkumar Baldevbhai Patel v. SEBI (2019), highlighted three types of front-running present. i.e.
  • Trading by third parties who gets a tip about any future transaction which is about to take place.
  • Owner or purchaser of trade himself engaged in the future trade in the offsetting of future transactions.
  • Transactions where an intermediary knows some trades ahead of that order for the intermediary’s gain.

Effects of Front-Running:

• The practice of Front-running not only gives an extra profit to the insiders of the company but also affects the market price of the shares, like
  • Front running increases the chances of inter-dealer orders.
  • Dealers of stocks who practise front-running have chances of making a high profit.
  • Front-running eventually slows down the process of the company, which later affects the decisions of investors and dealers of the company.
  • Front-running also reduces the costs of the liquidity of the company.
  • Front-running also affects the welfare of the company, its dealers, and investors. The investors earn fewer profits because their profits are affected by front-running, and this eventually affects the company as its investors are reduced.
  • Front-running reduces the risks dealers face when trading ahead of customers.

Regulations to Prevent Front-Running Practices In India:

• SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003 clearly define front-running as a fraudulent and unfair practice. SEBI has invoked this section many times to pass orders against front-runners. SEBI has categorised front running as a form of market manipulation and insider trading because a person who commits a front running activity expects security’s price movements based on non-public information. SEBI has investigated and penalised several fund houses and fund managers in the past for front-running.

Way Forward:

• Surveillance mechanisms of stock exchanges are most useful to uncover instances of front-running. Surveillance software that tracks real-time trades in the market is well-equipped to spot similar trading patterns between big investors and individuals, which forms the basis for front-running investigations by the regulator.
• Therefore, rooting out such cases calls for a stringent examination of surveillance data by the exchanges and the quick escalation of any suspicious trades to SEBI. Putting in place clear whistle-blower policies with anonymity for the informer at the exchanges, big institutions, and brokers trading in the markets can help flag a nexus between market players at an early stage.
• SEBI will also need to consider more stringent punishments for information carriers and front-runners when investigations find hard evidence of wrongdoing. Soft measures such as barring the entities from securities markets for a temporary period, levying a low-key fine or settling with the accused without admitting to the offence, may not suffice.

Source: The Hindu BL

Mains Question:

Q. Differentiate between Front Running and Insider Trading? What are the provisions related to the prevent Front Running in India? Examine.