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Front-Running, Trading Ahead and the Best Execution Obligation

Background

Under the Government Securities Act Amendments of 1993 (PL 103-202), bank and non-bank securities regulators were authorized to write sales practice rules to govern the activities of those entities under their respective jurisdictions that trade in government securities. The focus of the initial rulemaking has been on suitability. Regulators and industry analysis have indicated that there are other sales practices that should receive consideration as well, including front-running, trading ahead and best execution.

Front-running is a practice in which a dealer executes a trade for itself based upon impending nonpublic information about a pending customer order. Brokers or dealers that have advance knowledge of a block transaction in a particular security may improperly benefit from that knowledge by predicting the effect of the transaction on the price of the security.

Limit orders are orders placed with a broker-dealer on which the customer has placed price restrictions. Trading ahead of customer limit orders is the practice of having received an order and then trading at prices equal to or better than the limit order without executing that order. It is closely related to the practice of front-running.

Trading ahead of research reports is a variation on the use of nonpublic information for the benefit of the broker-dealer's own account, whereby the knowledge that the content of an unreleased report will have an effect on the price of a security is used to undertake a favorable transaction.

The best execution obligation requires that a broker-dealer attempt to obtain the most favorable prevailing market price on a security for a customer when executing a trade. It requires a broker-dealer to use reasonable diligence to ascertain the best deal in the security and buy or sell in such a market.

The prohibitions on front-running, trading ahead of customer limit orders, trading ahead of research reports and the best execution obligation already apply in the equities market, and are generally considered to be obligations under rules of fair practice. Regulators are considering whether and how to specifically apply these same rules, or appropriate modifications of each, to transactions in the government securities market.

Recommendation

The Government Finance Officers Association (GFOA) views such regulation as necessary to assure just and equitable trading in order to preserve the integrity of the marketplace and to reduce the costs of investing for all investors, including state and local governments and their taxpayers. The Association urges regulators to carry out the intent of Congress and supports efforts to write appropriately crafted sales practice rules to curb front-running, trading ahead of customer limit orders, trading ahead of research reports and best execution abuses when they occur.

Adopted: May 21, 1996