Front-running, the unethical practice of trading on non-public information about upcoming large trades, has long cast a shadow over the mutual fund industry. Front-running typically occurs when individuals with access to sensitive information about impending substantial trades, such as those executed by mutual funds, exploit this knowledge for personal gain.
For example, if an Asset Management Company (AMC) plans to buy a large quantity of a particular stock, an employee or associate might purchase the same stock in advance, anticipating its price to rise following the AMC’s purchase. This unfair practice undermines investor confidence and distorts market prices.
Recognising the need to safeguard investor interests and uphold market integrity, the Association of Mutual Funds in India (AMFI) recently introduced a set of stringent measures to curb front-running within AMCs, in accordance with directives from the Securities and Exchange Board of India.
A closer look
These guidelines will be implemented in stages, beginning November 2024, initially focusing on equity schemes with an AUM exceeding ₹10,000 crore. AMCs must institute comprehensive standard operating procedures (SOPs) to monitor suspicious activity.
This includes a three-tier alert mechanism. AMCs must generate three levels of alerts weekly to detect any potential front-running or market abuse. Tier 1 alerts are based on participation volume and volume-weighted average price across large, mid, and small-cap stocks.
Tier 2 alerts focus on price movements during deal execution, block trades, and scrip volumes traded within an hour before the AMC’s trade. Finally, any other suspicious activity that doesn’t fall into the first two categories will be flagged under tier 3. Further, AMCs are required to examine suspicious alerts through various measures like reviewing recorded communications of key employees, inspecting entry logs of AMC premises, and checking CCTV footage.
The restricted trading windows will significantly reduce information asymmetry, ensuring that all market participants have a level playing field. This will promote fairer price discovery and prevent undue advantages for insiders. By demonstrating a strong commitment to combating front-running, the mutual fund industry will instil greater confidence among investors.
The perception of a transparent and fair market will encourage more individuals to participate in mutual funds, leading to increased inflows. The new rules will enhance regulatory oversight of the mutual fund industry.
Stricter surveillance and monitoring will deter potential wrongdoers and facilitate prompt action against any violations.
AMCs will need to invest in upgrading their systems and processes to comply with the new requirements. While this might entail additional costs, it will ultimately benefit them by fostering a culture of integrity and bolstering their reputation. Distributors will play a crucial role in educating investors about the new rules and ensuring that they understand the importance of ethical practices.
They will also need to adhere to the stricter code of conduct and avoid any actions that could compromise market integrity. Finally, investors will be the primary beneficiaries of these regulations. They can be assured that their investments are protected from unethical practices and that market prices reflect genuine supply and demand dynamics.
The success of these measures will depend on effective implementation and vigilant enforcement. AMFI, along with market regulators, will need to monitor compliance closely and take swift action against any violations.
By working together, the industry can create an environment where front-running is eradicated.
The writer is the Head of India at Sernova Financial