Nearly everyone in the western world has heard of the US$65 billion Madoff fraud. Many would have heard that the fraud was being investigated by a team lead by Harry Markopolos for many years before Mr Madoff turned himself into authorities. The story of how Mr Markopolos tried to get the SEC interested in investigating the case is interesting in its own right, but not the topic of this article.
When his team started investigating Madoff, Markopolos was undecided whether Madoff was running the world’s largest Ponzi Scheme, or was Front Running through his (legitimate) brokerage firm to make the profits that he was declaring to his ‘investors’ in the securities firm. Everyone now knows that it was a Ponzi Scheme, but what is front running and could it have made the profits declared?
Front running is generally defined as:
Entering into a securities trade while taking advantage of advance knowledge of pending orders from other investors
Front running is a practice usually committed by people working for a stock broker, or (as was suspected in the Madoff case) by the stock broking firm itself. It is a practice where a stock broker executes orders on their own account with the advance knowledge of orders from its customers and the effects that the client’s order will have on the market.
Front running is possible when orders placed by a client will probably affect the price of the security, which generally means that the client’s order must be very large. Most trades by share trading individuals will not affect the price, so the opportunity to front run may be limited to instances where institutions place large buy or sell orders and their brokers (or the staff at the institution) are aware of these pending trades. Madoff’s brokerage firm handled many large ‘block’ orders.
There are a few ways of profiting from this advance knowledge. The broker may purchase the share on his own account first and try to profit from rise in share price once the client’s order is processed – or sell to profit from or avoid a drop in the price. They may also speculate on a rising share knowing that the client’s order will cover any potential loss if the share price drops.
To give an example, a broker receives an order from a client to buy 500,000 shares for a price up to $10. This gives the broker a number of opportunities to make a quick profit.
The broker may buy shares at a lesser price and resell to his client at $10.00 profiting by the difference.
Large limit orders can be front-run by order matching (what the Americans sometimes term “penny jumping”). If a client issues a buy order for 500,000 shares for $10.00, the broker may try to buy the same share for $10.01 and beat his client to the shares. If the market price increases above $10.01 because of this order, they sell and get the full amount of the price increase. However, if the market price drops, they will be able to sell the shares to their client under the $10.00 buy order, and only suffer a one cent loss.
By front-running, the broker has put his or her own interest above (or in front of) the customer’s interest and is thus committing fraud. They might also be breaking securities laws on market manipulation or insider trading. As Madoff ran one of the largest brokerage firms on Wall Street and processed many very large orders for clients, Markopolos and his team initially suspected that Madoff was using monies invested in his investment firm to front run orders made by client of his brokerage firm to make the ‘profits’ that he declared in his investment firm.
In the end the investigators of the Madoff fraud determined that, even though large ‘profits’ could have been made if Madoff had front run his client’s orders, they would not have been any near large enough to cover the alleged profits that the securities firm was declaring.