Unethical activities

Unethical activities come in many shapes and forms. The prohibited activities discussed in this section range from mildly unethical to detrimental. Generally speaking, you’ll need to understand what these unethical activities are and how to avoid them. These are the unethical actions we’ll cover in this section:

• Interpositioning
• Backing away
• Frontrunning
• Trading ahead of research

Interpositioning

Interpositioning is the act of creating an unnecessary middleman. Most of the time, customers have no idea what happens behind the scenes when they request to purchase or sell a security. For example, let’s say a financial firm takes an order to buy 100 shares of ABC stock from a customer and sends it to an associated broker-dealer. The broker-dealer then sends the trade to a market maker, who fills the trade at $50 per share. The shares come back to the broker-dealer, who then marks up the trade by another $1 per share (now up to $51 per share) and sends it to the original financial firm. The financial firm then charges a $1 per share commission on top. The customer pays $52 per share but only should have paid $51 per share. The broker-dealer in the middle was completely unnecessary as the financial firm should have sent the trade directly to the market maker.

Backing away

Backing away is the act of providing a firm quote on a security, but then failing to fulfill a trade request. A firm quote is a legitimate quote provided by a market maker for a security. Assume XYZ Market Maker provides a quote for a stock at $20 per share. If an investor requests a purchase at $20, the market maker “backs away” if they refuse to fill the customer’s order.

Frontrunning

Frontrunning involves a financial professional placing an order for themselves prior to a customer’s order. When a large order is placed, it has the potential to “move the market.” For example, a large hedge fund requests a purchase of 100,000 shares of a thinly traded stock. Due to the size of the order, the price of the stock rises. To personally benefit from the transaction, the financial professional places a smaller buy order for themselves, then places the hedge fund’s order. After the price of the stock rises due to the hedge fund order, the professional sells their shares for a quick profit.

Trading ahead of research

Trading ahead of research* is similar to frontrunning, but involves a research report release. There are many security analysts in the industry, some of which are very popular and closely followed. When a prominent research analyst releases a report, the market tends to react. For example, assume Charmaine is a well-respected research analyst that plans on publishing a negative report on XYZ stock. Knowing that many investors will sell their investment in XYZ stock (which will drive down the price of the stock), Charmaine short sells XYZ stock prior to the report being released to make a profit.

*There are two prohibited actions involving the term 'trading ahead." In the secondary market chapter, we discussed how the DMM may not step ahead of public orders. If it occurs, the DMM is trading ahead. In most test questions involving this topic, there should be enough context in the question (or answers) to determine what version of trading ahead is being covered.

All of these actions are unethical and prohibited. If you recognize any of these activities in the real world, it’s your responsibility to report it to your principal (supervisor).