Front-running is a cancer that erodes faith in the market and therefore needs stronger punishment
It is disturbing that allegations of front-running should surface against one of India’s leading fund houses just as mutual funds were cementing their position as a favoured vehicle for retail investors. In the last five years, retail investors have powered the near-doubling of mutual fund accounts from seven crore to almost 13 crore and scorching asset growth from ₹23 lakh crore to ₹38 lakh crore. Mutual funds have marketed themselves as the ‘ sahi’ option for small investors mainly on the premise that they are more tightly regulated and transparently managed than other financial products. Episodes such as the Franklin Templeton crisis in 2020 and allegations against fund managers of Axis Mutual Fund now, shake this faith.
Though over a week has elapsed since suspicions were flagged against two fund managers of Axis Mutual Fund and it replaced them, Axis investors are still groping in the dark about the exact nature of ‘irregularities’ that led to these exits. Axis says that it has been conducting a ‘ suo motu’ investigation into this issue since February. But it is unclear why it allowed these fund managers — one of whom was also the Chief Dealer and probably had access to trade information across schemes — to continue in their roles until the suspicions became public. Given that internal investigations by institutions accused of wrongdoing seldom yield concrete results, the Securities and Exchange Board of India (SEBI) must order an external investigation into the affair. When allegations of irregularities surface against mutual funds, it is critical for the fund’s Board of Trustees and SEBI to act promptly. In the open-end structure, retail investors are left holding the baby, should big investors jump ship at the first whiff of trouble.
But front-running is by no means a crime unique to mutual funds. Going by the frequency with which SEBI has passed front-running orders against employees of brokerages, alternative investment funds and even Foreign Portfolio Investors in recent years, tipping off friends and relatives to orders from their big clients seems to be a pervasive market practice. In fact, after a HDFC Mutual Fund dealer was found guilty of front-running in 2009-10, SEBI had stipulated stringent rules that restricted dealing room access, barred mobile phone use and required all fund manager-dealer conversations to be recorded, at mutual funds. As leaks can occur anywhere, such restrictions must be extended to other intermediaries such as brokerages. Automated surveillance mechanisms at stock exchanges and SEBI’s powers to demand call records have made front-running investigations easier, allowing SEBI to take up more suo motu investigations. But its enforcement actions still seem to suffer from inordinate delays, with several years often elapsing between the act of front-running and the denouement. Instituting official whistleblower mechanisms at all market institutions can perhaps help SEBI gain early tipoffs to commence investigations. The regulator’s current penal actions against market players found to be guilty of front-running also appear too soft to act as a deterrent. It usually bars the guilty individual from markets for a period or levies a low-brow fine. Imprisonment of the culprit trader and disgorgement orders that force such firms to compensate investors for losses, may prove stronger deterrents.
Published on May 13, 2022