Is Front-Running Considered Insider Trading?

BY Hari Sreenivasan  February 23, 2010 at 10:37 AM EDT

Question: I’ve been a Paul Solman groupie for some years now, but I think your recent piece on front-running was the best ever. Why, under the law, is front-running not considered insider trading?

Paul Solman: There IS a law against front-running. Here’s former Goldman trading strategist Nomi Prins, explaining in somewhat more complicated form how firms like Goldman don’t technically “front-run.”

NOMI PRINS: The idea of front running, which is technically not legal, is the idea of knowing, for example, there’s going to be a lot of [buying of] in oil. But instead of [buying] oil, you [buy] natural gas, which has some correlation or some connection to oil.

PAUL SOLMAN: So I know, because I’m Goldman Sachs that, let’s say, there’s going to be a lot of buying of oil in the next few days…

NP: Or I know I’m going to buy a lot of oil in the next few days [for a client]….I have a strong sense, given the information I have and that I’m a part of it, that there’s going to be a large directional move.

And that’s just one kind of trading. I might go out and buy myself some sort of a future or derivative in oil or I might do it in another type of related commodity. I might do it in natural gas instead of in oil. Same thing if I was [buying] gold, I might not really [buy] gold per se, I might have a position in gold, but I might back it up with trading silver or something that’s connected and correlated, but not necessarily the same exact commodity.

PS: Wait. You mean so if I’m Goldman Sachs and I know that I’m going to be buying gold in the next few days for clients …

NP: Or because it’s undervalued or because of any type of knowledge or analytical model or some combination of that together, you might decide to go in deeper, to buy more, go long gold. Or, you might decide to position a little bit and go long in buying gold but back that up with some other commodity possibly. Or, you can create a derivative of a basket of commodities. You can buy and sell pieces of that derivative.

In short, there are ways to front-run in spirit without actually putting in the exact same trade before one of your clients, to take advantage of the subsequent run-up in price.

But remember, David Stockman said that, with computerized trading, there’s really no way to know if firms like Goldman are front-running, pure and simple. As he said in our story: “When you’re in the customer trading business, and then you’re in the proprietary business, which trade are you making first? I don’t know. And, if it’s in milliseconds, how’s anybody going to figure it out?”

Meanwhile, all groupies warmly welcomed.