Hedge Funds Press for Crackdown on Front-Running Loophole in EU


European regulators are being prodded to close a loophole that some hedge fund groups and trading firms say encourages front-running.

Authorities should tighten curbs on brokers’ trades based on price inquiries from clients, a practice already restricted in the U.S., say critics such as the London Stock Exchange Group Plc and Euronext NV. The concern is that dealers can use knowledge from such a request to buy or sell before an order is even placed, harming the customer.

“We believe it is contrary to the market-abuse regulation in Europe,” said John Keogh, a member of the European management committee at Susquehanna International Group, a global trading firm based near Philadelphia. “We do not engage in the practice and have asked the regulators to ensure it is explicitly prohibited as it negatively impacts customers and undermines confidence in the market.”

The complaints, which the brokerage-industry lobby rejects, highlight one of the oldest issues in financial markets: the limits of confidence that buyers have in the middlemen they count on to get the best prices. While front-running -- the practice of profiting from knowledge gained through clients’ orders -- is illegal, the current issue involves a practice known as “pre-hedging.”

Comments to ESMA

Such trades “can often constitute front-running,” the two largest lobby groups for global hedge funds, the Managed Funds Association and Alternative Investment Management Association, told regulators. “Pre-hedging essentially places the proprietary interest of the broker ahead of the de facto client.”

The exchanges and hedge fund lobby groups declined to comment beyond their letters to the European Securities and Markets Authority, the Paris-based regulator that sets trading standards for the European Union. After mounting criticism of the practice, ESMA launched the review and received comments late last year. Before Covid-19, the plan was to publish its conclusions in spring 2020. But they’re now due as early as September.

In the U.S., the Financial Industry Regulatory Authority’s front-running prohibition includes brokers’ knowledge of an “imminent” trade, such as a request for a quote. Firms aren’t allowed to place their interest ahead of their client’s and if they need to trade to help execute a client’s order they need consent.

FX Crackdown

Most recently, industry officials and regulators have tried to crack down on front-running in the $6.6 trillion-a-day global foreign-exchange market. HSBC Holdings Plc in 2018 agreed to pay $100 million in fines to resolve U.S. Justice Department charges that it defrauded clients by front-running their currency orders.

Big currency dealers around the world have adopted a code of conduct at regulators’ urging after it emerged that they were backing out of trades through “last look” systems that gave them information about clients’ intentions. Barclays Plc paid $150 million in 2015 to settle a case over the practice with New York’s Department of Financial Services.

To be sure, some argue there is a place for hedging trades to help cushion dealing firms’ exposure to price moves when filling orders. They emphasize the need for clear disclosure and sometimes even the client’s explicit consent.

The Association for Financial Markets in Europe, the main lobby group for banks and brokerages, told ESMA that there is no need for new rules and that price requests don’t typically constitute inside information.

At issue in the current ESMA review is trading done primarily through request-for-quote, or RFQ, systems in which an investor typically asks several dealers for the price of an asset, such as stocks or exchange-traded funds.

Brokers anticipating an order will “pre-hedge” by buying or selling the same or similar securities or derivatives. This can happen in split seconds or minutes before the dealer actually needs to fill the position were it to win the order. The market price can move against the client, ESMA said in late 2019 when it solicited industry views on the practice.

“Investors are concerned that market participants may take advantage of their price requests in order to make trading profits and in the process, move prices against the investor,” according to Euronext’s statement to regulators.

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