NASD May Revive Proposed Ban on Government Bond Market Front Running

Following complaints from the trade association that represents Treasury bond dealers, the National Assn. of Securities Dealers earlier this year quietly dropped a proposal to prohibit dealers from buying or selling government bonds for themselves immediately before filling a large order for a customer.

But faced with strong pressure from the Securities and Exchange Commission, the NASD said Thursday that it had reconsidered its position and would try to submit a revised proposal later this year.

Front running, as the practice is known, has long been banned in the stock markets. But there is no specific ban on front running government securities.

The practice is sometimes considered a form of insider trading because the dealer is buying or selling securities for itself based on nonpublic information--the prospect of a buy or sell order large enough to move the price. The dealer’s profit could be the customer’s loss if the dealer’s purchase or sale of the securities adversely affected the price that the customer could get.

The proposal to ban front running in the government bond markets had been part of a package of rules the NASD submitted to the SEC designed to ensure honorable sales practices in the $3.4-trillion market for Treasury securities.

In 1993, mainly in response to a 1991 Treasury bond scandal involving Salomon Bros., Congress passed a law requiring the NASD to come up with such rules. Previously, the NASD had no authority to regulate the government market.

In the package submitted to the SEC last year, the NASD proposed simply to make its existing ban on front running stocks apply to government securities as well. But in a Nov. 30, 1995, comment letter on the proposal, the Public Securities Assn., the trade organization representing bond dealers, said “it is not clear that, as a matter of policy, the [ban] should apply to the government securities market.”

It contended front running is unlikely to occur in the government bond markets, which are so vast that individual trades are not likely to have an impact on prices. It also noted that the existing ban contained provisions that could only apply to stocks.

The NASD acquiesced. In a filing with the SEC on Jan. 22, the NASD amended its proposal to make the ban on front running “not applicable” to government securities.

That angered some congressional supporters of the 1993 bill, sources said, as well as the SEC. Sources said SEC lawyers put pressure on the NASD to reconsider, and an NASD spokesman confirmed the SEC had been in contact with the NASD on the issue.

In a revised filing submitted to the SEC on Thursday and cleared in advance with the SEC, the NASD said it believed “front running may occur under certain circumstances in the government securities market.” It said it would reexamine the issue.

NASD officials said in interviews that they expected to propose a new rule prohibiting front running in Treasury securities after some additional study later this year. In the new filing with the SEC, they warned that the NASD could invoke existing general regulations against improper business practices if it encountered instances of front running before then.

“It’s naive to suggest that front running hasn’t gone on,” said Michael Basham, a former deputy assistant Treasury secretary for federal finance who also has been in charge of bond trading for a large bank. He said he saw no reason why a simple ban on front running ban could not be extended to the government securities market. He said it is necessary because “there are tons of unsophisticated accounts out there.”

Paul Saltzman, the PSA’s general counsel, said, “I have absolutely no knowledge of any front running in government securities.”

But in interviews, Basham and other experts said it could occur in Treasury bonds, notes and bills that happen to be thinly traded.

Saltzman contended the PSA’s opposition to the ban on front running merely reflected technical problems with the original proposal, not a desire to allow front running.

“We don’t have any objection to rules that ban front running in the government market,” he said, adding that more time was needed to study how such rules should be drawn.

Questions about fair dealing in the government securities market have been raised in recent months, particularly in connection with Wall Street brokerage firms’ transactions with local governments and agencies.

Allegations that firms may have overcharged or defrauded local authorities in connection with the sale of Treasury securities have prompted several pending federal investigations.