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November 2, 2011

New Front-Running Rule Change

By Peter Chapman

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  • New Front-Running Rule Change
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Recent rule changes by the exchanges operated by NYSE Euronext have some on the buyside worried about front-running by their brokers.

In September, the New York Stock Exchange, NYSE Amex, and NYSE Arca all changed their rules that prohibit trading ahead, or front-running, to mirror those of the Financial Industry Regulatory Authority. In so doing, it watered down a key protection for large institutional customers.

The crux of the change is a reversal of the assumptions that underpin the understanding between the sellside and the buyside regarding trading alongside, or ahead.

Rule 92, as both the NYSE and Amex rules were called, barred trading ahead except in the case of block orders. The exception allowed brokers to trade alongside or ahead of their customers, but only if the buyside gave them permission to do so.

The exchanges' new Rule 5320, by contrast, allows brokers to trade alongside their customers without asking for permission. Brokers only need to send out "negative consent" letters to their customers once a year, informing them that they intend to trade alongside, unless instructed otherwise.

In other words, the buyside trader must "opt in" to the protections provided by Rule 5320 by raising the issue with their brokers each time they trade. They no longer have the luxury of "opting out" of the protections of Rule 92 when prompted by the broker.

The change shifts the compliance burden from the sellside to the buyside.

"This is very significant," one buyside trader, who requested anonymity, said. "The broker-dealers are claiming this is just a minor rule change, but it certainly is not. This rule says they can trade beside me or ahead of me anytime they want to."

The concern arises when a buyside trader asks his broker to commit capital for part of an order. If the broker does so, he takes on a position and puts himself in competition with the customer. He must trade stock on behalf of the customer as well as his own account as he seeks to flatten his position.

The fear is that the broker will trade for his own account at prices better than those he obtains for his customer. That's a form of front-running, or trading ahead. Both FINRA and the NYSE have had similar rules prohibiting this for years. In a bid to ease the compliance burden of the sellside, the two organizations have been "harmonizing" their rulebooks in recent years.

FINRA won Securities and Exchange Commission approval for an updated version of its two "Manning" rules earlier this year. It created Rule 5320. NYSE Euronext won SEC approval for its lookalike Rule 5320s in August. The exchange operator received no pushback from money managers or their Washington-based advocate, the Investment Company Institute, at the time. The rules went into effect in September.