Anatomy of a Front Run

Last Tuesday evening, while the global head of FX trading for a certain bank was boarding his flight from New York to London, federal agents arrested him. The next morning, representatives of the Justice Department, the FDIC, and the FBI charged him and a colleague with “conspiring to defraud a client through a scheme commonly referred to as front running.”

The charges stemmed from a 2011 transaction, wherein the client sold a subsidiary for USD proceeds, planning to convert them immediately into GBP 2.25 billion proceeds for distribution to its shareholders. Prior to the asset sale, the client ran an RFP process with about ten financial institutions, selecting this one for its commitment to provide the lowest risk, best possible execution.

However, the two traders allegedly did nothing of the sort. As soon as the client authorized the full GBP 2.25 billion purchase prior to the 3 pm fix, one trader said to the other on a recorded line – “You’re kidding!” and when the other confirmed, the first replied, “Ohhhh, f***ing Christmas!” On a subsequent call, the two discussed how high they could “ramp” the GBP-USD rate before the client would “squeal.”

Ramp it they purportedly did! Here’s a graph of the GBP-USD exchange rate on the specific day, highlighting the movement from the time of the final authorization call at 2:28 pm until the 3 pm fix (the screenshot shows New York time, so the x-axis labels display five hours earlier):

chart

The rate jumped 103 pips in just 30 minutes, as the traders allegedly sold dollars and bought sterling heavily ahead of the fixing, driving the market spot rate upward. Troublingly, when the client called to express concern about the rapid climb, the traders claimed that the jump was caused by a fictitious “Russian name.” In all, the complaint asserts that the trading activities associated with this single transaction generated $8 million in profits, including those “profits generated from the front running conduct.”

Given the significant financial costs of getting front-run – in this case, seven figures – how can it be avoided?

(1) Don’t leave orders to be filled at a fixing rate. Trading at a fixing rate permits forward manipulation of that fixing. Unless a trade is too small to be economically sensitive, it should be traded real-time at market rates.

(2) Establish readiness to trade, but not detailed trade timing, in advance. In the present regulatory environment, it can take days or weeks to establish counterparty trading relationships. While it’s important to solidify those before trading, including ensuring sufficient lines for credit-intensive transactions, communicating detailed trade timing in advance makes getting front-run far more likely.

(3) Avoid times of peak volatility. Specifically requesting to trade at a certain fixing time can expose a company to higher volatility, as can trading around a major event or economic announcement. Consequently, trading at hours with solid liquidity but without significant exogenous activity can permit greater trading stability, particularly with larger trades.

(4) Develop a practice of regular transaction cost analysis. If your firm has measurable financial exposure to currency trading – either through a high volume of trades or through large-notional trades – there may be significant embedded trading costs that can be saved. Hourly fixes are rife with manipulation, so best-in-class transaction cost analysis will benchmark against actual transactions done at market rates by sophisticated trading counterparties, rather than against published fixings.

(5) Understand how much rate slippage is appropriate. It’s not possible to buy 2 billion pounds without some slippage from the screen rate. On any substantial trade, market-makers will need to charge a liquidity premium to ensure that they are able to transfer the currency risk, and that liquidity premium will vary based on exact size, time of day, and numerous other factors. It’s critical to quantify and bring full transparency to the fair liquidity premium for a given trade, without which overpayment is much more likely.

At Chatham, we’ve traded everything from thousands of pounds to billions of euros – our expertise includes managing each transaction for optimal execution timing and quality, with a variety of flexible techniques at our disposal to facilitate that. Please give us a call if you have economically sensitive trades to do, or if you would like to see just how efficiently you are currently trading.

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