Purdue News
Purdue News
April 1995
That's because crooked traders aren't as active in those contracts, says Sugato Chakravarty, assistant professor of consumer sciences and retailing. Front running occurs when a trader, suspecting his client's trade may cause price fluctuations, makes a trade on his own behalf before placing his client's order. This allows the trader to gain personal profits using privileged client information.
In a recent study published in the Journal of Futures Markets, Chakravarty concludes that competition for actively traded contracts is too intense for front-running to pose a significant threat. Instead, he says, the ban should be implemented in the less active contracts -- contracts where the chance of detection is minimal and the opportunity for profit is high.
"If you think about it, it only makes sense that you wouldn't see the most illegal activity in the most visible areas," Chakravarty says. "If you were going to steal a car, you probably wouldn't steal it from a parking lot at a police station."
In May 1991, the Chicago Mercantile Exchange suspended dual-trading privileges in top contracts -- contracts with an average trading volume of 10,000 or more over the previous six months. The move was meant to discourage front-running by unethical traders, Chakravarty says. The ban has been questioned by dual-trading proponents who say dual trading fosters market liquidity.
To make a trade, clients contact traders with a seat on the exchange. Traders can be dealers or brokers. A dealer buys and sells contracts on his own account. A broker acts strictly as a matchmaker, pairing up buyers with sellers. A broker is paid on commission. Dual trading means a trader can be a dealer one minute and a broker the next, but never both in the same transaction.
According to Chakravarty, the Chicago Mercantile implemented the ban with the idea that because top contracts are traded in such high volumes, and because traders with dual-trading privileges make many more transactions in top contracts than they do in less active contracts, such traders would be more tempted to front run.
Because of the ban, traders planning to trade top contracts must declare themselves either dealers or brokers permanently with regard to those contracts. In all other contracts, traders still may make dual trades.
Front running can occur with or without the dual-trading privilege, but is easier to do with dual-trading privileges because the trader doesn't have to involve a third party, Chakravarty says. Here's how it works: A client contacts a trader and wants to buy a significant amount of a specified commodity. The trader, knowing that the client's purchase will cause prices to increase, places a smaller purchase order for himself, before placing his client's order. The trader's order may cause a small price increase in the commodity. When the trader places the client's order, however, its size is large enough to cause a significant further increase in price. The trader then sells his shares at the higher price.
"This is unethical and illegal, although it appears like the smart thing to do," Chakravarty says. "As a trader, I have used you to gain profits for myself. I have abused the fiduciary responsibility I have to you. That responsibility is equal to the lawyer/client privilege in law. It's even worse if you are paying me a commission. In that case, I've double dipped, so to speak."
If traders always placed orders ahead of their clients, they would easily be caught. To avoid detection, traders have a few other ways to front run on their clients. A trader may ask a colleague to act as his broker and place an order for him. An even more difficult-to-detect arrangement occurs when a trader asks a colleague to buy on the colleague's personal account and the two split the profits.
To test his theory that front running isn't a problem in the most actively traded contracts, Chakravarty developed a mathematical model that showed that intense competition for those contracts drove dual-trading profits down to almost zero. He says it's supply and demand that makes front running unprofitable in the most active contracts.
"There are only so many pieces in the pie, and there are lots of traders wanting a slice," Chakravarty says. "The more traders there are, the thinner the slices become, so nobody gets too big a piece. In these contracts, front running poses great risks for low return. Simply put, there's a lot to lose and very little to gain."
Chakravarty says that isn't the case in less active contracts.
"In less active contracts there is less scrutiny, price fluctuations tend to be much greater and competition is minimal," he says. "This gives unethical dual traders more incentive to front run to add to their commission.
"Many experts say the ban should be abolished. I don't think the ban is a bad idea. I do think it needs to be re-examined and placed in contracts where front running is doing the most damage and where the ban will be most effective -- in less active contracts."
Source: Sugato Chakravarty, (765) 494-6427
Writer: Victor B. Herr, (765) 494-2077; Internet, victor_herr@purdue.edu
Purdue News Service: (765) 494-2096; e-mail, purduenews@purdue.edu
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