*****Regulating from the front | Business Standard Editorials

Clipped from: https://www.business-standard.com/article/opinion/regulating-from-the-front-122051001642_1.html

Focus on deterrence against front-running

The market regulator, the Securities and Exchange Board of India (Sebi), has investigated various instances of front-running over the past several years, but the issue came to a head again last week when Axis Mutual Fund suspended two individuals, reportedly for this offence. One of them was the manager of five funds, and the other was an analyst-cum-assistant fund manager, handling three funds. Sebi has to undertake a speedy investigation of this case, and hand out fast, exemplary punishment in case the allegations are correct to help stamp out this malpractice. As the term indicates, front-running occurs when somebody utilises insider knowledge of planned future institutional transactions to take a position on their individual account before the institutional orders are placed. If the institutional orders are substantial enough to move the market prices of stocks, the front-runner will profit from being an early bird. In effect, however, the financial institution (and its investors) is being cheated when front-running occurs, since the front-running trades influence prices in themselves.

Axis Mutual Fund has over Rs 2.5 trillion in assets under management, and a fund manager at a large financial institution is well-placed to do this, since he or she formulates the fund’s strategy in the case of an active fund, and does the balancing transactions for an exchange-traded fund in a passive fund. An analyst with such an institution is also well-placed since that person would be making key recommendations about buys and sells. This practice is, of course, illegal. It is based on non-public information and allows the front-runner, or -runners, to make unlawful, extraordinary profits. The punishment for this can involve fines of up to Rs 25 crore, or three times the profits from the transactions. According to news reports, individuals in question may have profited to the tune of Rs 170 crore by front-running in at least nine stocks. In addition to fines, the individuals may also be banned from accessing the market.

On several previous occasions, Sebi has taken action against front-running. In 2021, it banned three individuals working for Reliance Capital Mutual Fund from participating in capital markets for six months for this. In December 2020, the regulator barred 16 individuals and entities for periods ranging up to seven years and they were ordered to disgorge illegal gains of Rs 20 crore. As the examples given indicate, however, the practice seems to be common, especially in large mutual funds. They are among the biggest players in the domestic capital markets and, collectively, manage over Rs 37.5 trillion in equity assets. Most of that consists of household savings invested by retail investors. Every instance of front-running leads to some erosion in trust and the illegal profits can reduce the returns that could otherwise accrue to the funds themselves.

Axis Mutual Fund has released a statement that it conducted a “suo motu investigation” from February 2020 with external consultants before suspending the two employees. It will continue its investigation into potential irregularities. However, while this is commendable, it may not be enough. The temptation to make a quick buck by acting upon such information will always be there and the issue may not be limited to a particular fund house. The regulator thus needs to crack down quickly to demonstrate that such actions will not be tolerated. It could also consider putting in place fresh measures in terms of monitoring employees with access to confidential information and fiduciary responsibility in asset management companies and other financial institutions.

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