New Front-Running Rule Change

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.

NYSE filed the rule with the SEC for "immediate effectiveness," meaning there was no comment period. This is common for non-controversial rule changes. Buysiders who spoke with Traders Magazine were adamant that a comment period should have been part of the process. They also contend they did not receive proper notification of the proposed change. Whether or not some party will petition the SEC to remand the rule remains to be seen, one source said.

Despite the purported surprise by the buyside at the sudden change, NYSE Euronext’s August rule filing was not its first public pronouncement on the subject. In March 2009, the exchange operator sent a memo to its members asking for comment on the possibility of swapping Rule 92 for Manning.

In response, the Securities Industry & Financial Markets Association sent a letter to NYSE declaring its approval for any rule change, noting that compliance with the existing rule was a burden on traders and caused "unnecessary delays in the trading process." Also, at the time, one senior NYSE Regulation official said publicly that it might not be a bad idea for the buyside to do its own policing.

NYSE Euronext declined to comment for this article.

The new NYSE rule does allow the buyside to opt into the protections afforded by the rule. But, in practice, the value of that opt-in may depend on the brokerage.

And at least one broker is taking a hard line. Citi sent a letter to its customers telling them it would only offer share-by-share protection for held orders. "Citi will consider such requests on a case-by-case basis," the letter said. "It will inform the customer whether it is willing to accept such a protected order." Traders Magazine received excerpts of the letter by a recipient.

Citi told its customers it would not offer share-by-share protection for not-held orders. "Because not-held orders require that the firm exercises discretion as to time and price of execution, Citi does not believe it is feasible for these orders to be eligible for share-by-share protection," the letter said. Citi declined to comment.

Not-held orders are those in which the broker has discretion in the handling of the order. Held orders require the broker to follow its customers’ instructions to the letter.

Most institutional trading is done on a not-held basis. Many buyside traders do not use held orders because they involve the display of limit orders on the exchanges. That may signal the trader’s intentions.

A number of brokers have sent out letters to their clients and/or posted their policies on their Web sites. Not all policies are as restrictive as Citi’s. UBS and Goldman Sachs, according to one source, appear more willing to accommodate the buyside.


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