Sunday Musings: Front Runner

Reader Jeff submitted an interesting blog post dealing with an old problem that you may have thought had long been resolved. This piece was written by Jake Zamansky, a NY attorney and titled “Front Running and Institutional investors.” Here’s what he had to say:

You would think that institutional money managers, who have a fiduciary responsibility to their clients, would also avoid doing business with any firms that engaged in organized wrongdoing and ripped them off. But that certainly doesn’t appear to be the case. There have been repeated incidents where major Wall Street firms reportedly have traded in advance of major trades they were asked to execute for their institutional clients. This practice, known as front running, gives brokerage firms an unfair advantage because they have insider knowledge that a pending block order will likely cause a significant price swing.

The SEC reportedly is investigating whether Merrill Lynch was front running orders placed by Fidelity Investments, the massive mutual fund operator. If the allegations prove true, it won’t be the first time Merrill Lynch has been nailed for this infraction. In 1995 the firm was fined $10,000 and censured by the American Stock Exchange for “the practice of profiting on advanced knowledge of a planned transaction.” The piddling fine didn’t even cover the losses incurred by Merrill’s client and could hardly be considered a major deterrent. Whoever coined the phrase “crime doesn’t pay,” never worked on Wall Street.

But let’s not just pick on Merrill. Front running has long been suspected as a widespread practice at all the big brokerage firms. Yet institutional money managers continue to route the bulk of their trades through them, rather than support the various independent boutiques that have sprung up in recent years offering very sophisticated algorithmic trading capabilities. One of the reasons is that the big brokerage firms offer their institutional clients equity research, but we know that most of that research is hardly worth the paper it’s printed on. Another major reason is simply fear: In the words of one institutional money manager, “no one is going to get second guessed for routing an order through Goldman Sachs.”

Rest assured, even if the SEC finds that Merrill was front running Fidelity’s orders, nothing much will come of it. The matter will be settled by Merrill agreeing to pay a relatively insignificant penalty without admitting any wrongdoing. It will, of course, get to keep most of its ill-gotten gains. The SEC neither has the resolve, or the resources, to take on a big Wall Street firm.

Additionally, current news reports show that firms like Merrill Lynch continue to be involved in lawsuits alleging improper sales of investments. There seems to be no end in sight as to how brokerage firms repeatedly work for their own gains without having the client’s best interest at heart. In the case of Merrill, I suggest they rename their TV advertising campaign from “Total Merrill” to “Total BS.”

For more on this subject, be sure to read Mish Shedlock’s piece called “Merrill Lynch Opens Legal Hornet’s nest.”

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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