What Is Trading Ahead?
Trading ahead refers to a scenario in which a market maker prioritizes their firm’s interests above the interests of other investors. This refers to transactions conducted by brokers utilizing the accounts of their businesses rather than matching available bids and offers from other market players. Trading ahead is prohibited under FINRA standards, which implies that market makers may not trade ahead of other client or broker-dealer orders.
- Trading ahead happens when a market maker trades using their firm’s account rather than matching available bids and offers from other market participants.
- It happens when a market maker intentionally prioritizes their firm’s interests above the interests of other market players.
- Trading ahead offers market makers an unfair edge in terms of information, to the prejudice of individual investors and traders.
- The behavior is prohibited by FINRA and most major exchanges, and it often results in severe fines, penalties, and even censure.
- Certain exceptions to the trading ahead restrictions are permitted by regulations, including those for big orders, institutional orders, and ISO exceptions.
Understanding Trading Ahead
Market makers, also known as market experts, are an important element of the secondary market trading infrastructure. Many market makers are companies (and people who work for them) that offer trading services to individual investors. They use a bid-ask trading mechanism to connect buyers and sellers in the open market. They may benefit from the bid-ask spreads produced by each transaction using this strategy.
Specialists may conduct any deals from their own accounts as long as just one leg of the transaction is available. However, the trade becomes unlawful when a market maker decides to trade with their own account to complete a transaction while there are unexecuted orders from investors available that may be filled at the same or better price.
For example, if a client places an order to sell 100 shares at $10.00 and a bid for $10.05 is received, a market maker cannot sell the bid ahead of the customer’s request. Similarly, if the best offer was $10.00, the market maker could only sell at that price when the client had completed all 100 shares at that price.
Trading ahead is against market trading rules. Trading ahead is violated by a market maker who employs securities from their own account ahead of other orders on the open market. The conduct may generate a greater trading price for the market maker while restricting the fair market price for the open market. Trading ahead may also result in an unjustified profit for the market expert.
As previously stated, FINRA and individual exchanges have implemented regulations to monitor and discipline market trading professionals who breach trading ahead restrictions. Firms that violate the law may face fines, penalties, and even condemnation.
Trading ahead may be accomplished via the creation of common market procedures.
Initially, trading ahead was forbidden under NYSE Rule 92. In order to decrease regulatory redundancy and simplify compliance, the New York Stock Exchange (NYSE) and other exchanges, notably the American Stock Exchange (AMEX), replaced Rule 92 with FINRA Rule 5320. This took effect on September 12, 2011.
FINRA Rule 5320 gives specific guidance on trading ahead as well as its limitations. It is also known colloquially as the Manning rule. The judgement compels market makers to have documented trading rules policies and processes, as well as to follow the documentation standards established in FINRA Rule 5310. Rule 5320 also allows for a number of exceptions to the restriction on trading ahead.
However, some exclusions are permitted under the rules. Among these exclusions are:
- Large orders
- Institutional orders
- No-knowledge exceptions
- Riskless principal exceptions
- ISO exceptions
A market maker may also satisfy an exception by instantly executing a customer’s order that is the same size and price (or better) than what they executed for their own book.
Trading ahead, regardless of purpose, is seen as a disturbance to the orderly and efficient market trading norms that authorities want to maintain for all investment participants. Unless, of course, the trading forward is done without knowledge of the current orders.
Real-World Example of Trading Ahead
Citadel Securities, located in Chicago, was penalized by FINRA in July 2020 for breaching trading ahead restrictions. Citadel’s over-the-counter (OTC) trading systems were determined to be configured to follow trading ahead guidelines, according to the government. Despite this, restrictions and other settings were in place to eliminate “hundreds of thousands” of bigger purchases from that net.
Among other findings, FINRA ruled that the business lacked supervisory procedures to verify that orders were compliance with current standards.
Citadel was fined $700,000 by FINRA as a consequence of its inquiry. The business was also censured and ordered to pay compensation to impacted customers, as well as interest on any orders placed at prices lower than those traded on its own account. In addition, the business was required to attest that it had inspected its systems to ensure that client orders were correctly displayed and that the firm was in compliance with FINRA laws and regulations.
Citadel never admitted nor rejected the claims, although it did comply to the FINRA fines.
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