The Financial Industry Regulatory Authority (FINRA), has proposed to codify its front-running policy that seeks to prohibit member firms and their associates from participating in a broader range of front-running transactions, preceding a customer block order in securities. According to Robert Buckholz, in an article, published on theHarvard Law School blog, the proposed policy, which was originally adopted by NASD (National Association of Securities Dealers) in 1987 will now be codified as a new FINRA rule 5270.

The rule will affect many derivatives, going beyond futures and options. It will apply to block transactions that involve the underlying security, as well as to transactions in the block security itself. Furthermore, the block orders subjected to the rule include those in most derivatives, contrary to the current rule that focuses only on futures and options.

FINRA believes that the new package, if violated, would also break other FINRA rules and, or federal securities laws. The  proposed rule changes were first coined in the year 2008, and upon approval by the SEC, FINRA expects to  implement within 90 days.

Originally, the front-running policy was adopted as a supplement to to Article III, Section 1 of the NASD’s Rules of Fair Practice in 1987; it is currently set forth as IM-2110-3 under Section 2100 (General Standards) of the NASD Conduct Rules. The current rule states that:

“It is considered conduct inconsistent with just and equitable  principles of trade for a member or an associated person of a member to buy or sell  security futures or certain options for accounts in which the member or associated person have an interest when the member or associated person have material, non-public market information concerning an imminent block transaction in the underlying security.”

This is seen as an unfair advantage over the other market participants, and with its expected impact on the activity of the underlying asset in the market, it is only fair to delay such a transaction until market parity is achieved in the public domain.

“Additionally, this prohibition applies in the underlying security when the material, non-public market information regarding a block transaction concerns an option or security future on that underlying security.”

This policy also takes into consideration the futures and options transaction, by whose calculation, the economic value of the transactions in such markets would cause a similar or further impact, on the underlying asset’s activity as outlined in the rule.

“Furthermore, the Front Running Policy prohibits the provision  of material, non-public market information concerning an imminent block transaction to customers who then trade  on the basis of the information.”

This means that the information is not unfairly disseminated to a certain group of customers, who could then take advantage of the impending block transaction to profit at the expense of others.

The Front Running Policy is limited to transactions in equity securities and options that are required to be reported on a last sale reporting system and to any transaction involving a security  future, regardless of whether the transaction is reported.

This is the point where the proposed changes will be concentrated. The current policy does not cover a majority of derivatives transactions; something FINRA feels should be amended, to include a wider cover.

The prohibitions apply until the information  concerning the block transaction has been made publicly available, and in this case,  publicly available information is seen as information which is or has been “disseminated via the tape or high speed communications line of one of those systems, a similar system of a national securities exchange under Section 6 of the Act, an alternative trading system under Regulation ATS, or by a third-party news wire service”.

The Policy also includes exceptions from the general prohibitions in the rule for “transactions executed by member participants in automatic execution systems, in those instances, where participants must accept automatic executions.” This means that, participants are exempted to execute transaction orders made via the ATS, without violating the front-running policy. This clause is also revised in the proposed new rule, to give specific guidelines on the above exceptions.

The proposed new rule seeks to maintain a majority of the front running policy rules, albeit with the following changes:

FINRA is proposing to extend the prohibitions in the rule to apply explicitly to all securities and other financial instruments and contracts that overlay the security that is the subject of  imminent block transaction and that have a value that is materially related to, or otherwise acts as a substitute for, the underlying security. This means that the rule will cover all derivatives transactions including stock options and futures, options futures, other derivatives, and security-based swaps, rather than be limited to equity securities, security futures, and some options.

Furthermore, the proposed changes would also prevent trading the underlying security when the imminent block transaction  itself involves a related financial instrument. The proposed rule change also extends the trading  provisions in the rule to explicitly include trading in the same security or related financial instrument  that is the subject of an imminent block transaction.