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Key Takeaways
Front running is the act of placing trades based on insider knowledge to profit from market movements before a large transaction is executed.
In crypto markets, front running is common in decentralized exchanges (DEXs), where traders or bots exploit transaction visibility and slippage tolerance.
To prevent front running, DeFi traders can lower slippage tolerance, use private transaction methods, and leverage MEV protection tools like MEV blockers.
Introduction
Front running is a term used in the financial world to describe an illegal and unethical trading practice. It involves taking advantage of non-public information about a trader’s impending transaction to make personal gains. This article will explain what front running is, how it works, its impact on markets, and how it applies to cryptocurrency trading.
What Is Front Running?
Front running occurs when a broker, trader, or financial professional acts on insider knowledge. The goal of the front runner is to place their own trades ahead of an impending large order, expecting the market to move in their favor once the larger transaction is executed. This behavior is considered a violation of trust and integrity in financial markets because it exploits confidential client information for personal benefit.
In traditional markets, front running typically occurs in anticipation of a large trade. However, it may also occur in crypto markets, especially low-liquidity ones (for example, when trading meme coins in decentralized exchanges).
How Front Running Works
To understand how front running operates, let’s start with the typical front running scenario that may occur in traditional markets.
1. Access to insider information
Front running typically involves a broker or trader who has access to information about a large transaction. For example, a client might place an order to buy or sell a large number of stocks, bonds, or other assets.
2. Preemptive personal trade
The broker, knowing the transaction will likely affect the asset’s price, buys or sells the same asset for their own account before executing the client’s order. If the client plans to purchase a large number of shares, the broker might buy shares at the current price, anticipating that the large buy order from the client will drive up the price.
3. Profit from market movement
Once the client’s transaction is executed and the price moves as expected, the broker sells their shares (or closes their position) at a profit. The client’s order causes the market to react, benefiting the broker who acted on the information before the other market participants.
Example of Front Running in Traditional Markets
Let’s consider a hypothetical example to illustrate how front running works:
A large institutional investor decides to buy 1 million shares of Company X.
The investor places this order through their broker.
The broker, aware that this large purchase will likely drive up the stock price, buys 10,000 shares of Company X for themselves before executing the client’s order.
Once the client’s order is completed, the stock price rises as expected. The broker then sells their 10,000 shares at a higher price, making a quick profit.
Why Is Front Running Illegal?
Front running is considered illegal in many countries because it:
Exploits confidential information: Financial professionals are trusted to act in the best interest of their clients. Using confidential information for personal gain violates that trust.
Undermines market integrity: Front running distorts market fairness, giving an unfair advantage to those with privileged access to information.
Harms investors: Clients and other market participants may suffer financial losses due to price manipulation caused by front running.
To prevent front running, regulatory bodies such as the Securities and Exchange Commission (SEC) in the United States enforce strict rules and penalties.
Types of Front Running
Front running can occur in various contexts, including:
1. Stock markets
In stock trading, brokers might use knowledge of large buy or sell orders to make personal trades. This is one of the most common forms of front running.
2. Commodities and forex markets
Traders in commodity or foreign exchange (forex) markets may engage in front running if they have access to information about large pending transactions.
3. Cryptocurrency markets
As cryptocurrency trading grows, front running has emerged as a concern in this sector. It’s particularly common in decentralized trading platforms. We’ll explore this in detail in the next section.
Front Running in Cryptocurrency Markets
How Front Running works in crypto
In the context of cryptocurrency, front running typically involves blockchain transactions on a decentralized finance (DeFi) platform. It is particularly common in decentralized exchanges (DEX) and automated market maker (AMM) protocols, where transactions are processed by smart contracts and are visible on the blockchain before confirmation.
Here’s how it typically works:
Observing pending transactions. In public blockchain networks like Ethereum, Solana, and BNB Chain, transactions are visible before they are confirmed. Malicious traders or bots can monitor the network for large pending transactions.
Submitting a priority transaction. On Ethereum and BNB Chain, bots can pay higher gas fees to get their transactions processed first. On Solana, front-running is usually done using priority fees or by validators with privileged access to transaction data.
By paying a higher gas fee, the malicious trader can ensure their transaction is processed before the target transaction. This allows them to benefit from price changes caused by the original transaction when it’s finally confirmed.
Profiting from price movement. For example, if the pending transaction involves buying a large amount of a token, the front-runner buys the token first at the current price. Once the original transaction drives up the price, the front-runner sells the token at a profit.
Besides targeting large trades, front runners also exploit low-liquidity markets and traders who set high slippage tolerance on DEXs like Uniswap, PancakeSwap, or Raydium.
Exploiting slippage in low-liquidity markets
Slippage tolerance defines how much price variation a trader is willing to accept to prevent their transaction from failing. In low-liquidity markets, setting high slippage can make traders vulnerable to front running.
For example, if Bob wants to buy a low-liquidity meme coin on a DEX, he might set high a slippage tolerance to make sure his trade goes through. A front-running bot can detect this, pay higher fees to buy up existing liquidity first, and resell the token to Bob at a much higher price.
Since Bob’s slippage tolerance allows for a price increase, he unknowingly pays more than expected, benefiting the front-runner. The bigger Bob’s order and slippage tolerance, the bigger the price impact.
This form of front running can happen even in high-liquidity markets when slippage settings are too high, allowing bots to manipulate prices and extract profits unfairly.
MEV and front running on Solana
Solana, a fast and scalable blockchain, has its own issues with front running, mainly due to Maximal Extractable Value (MEV). MEV refers to the profit that validators or bots can gain by manipulating the order of transactions within a block. On Solana, MEV-driven front running happens because transactions are visible before they are finalized, allowing traders to exploit this information.
Unlike Ethereum, where transactions are prioritized based on gas fees, Solana allows traders to use priority fees to have their transactions processed first. This means bots and validators can pay a higher fee to push their transactions ahead of others, just like traditional front running. When a large buy or sell order is detected, an MEV bot can quickly submit its own order to profit from the expected price change.
To tackle MEV-related front running, developers are working on solutions such as private mempools, fair transaction ordering systems, and MEV auctions that redistribute profits fairly. While Solana’s fast processing speeds reduce some risks, MEV remains an ongoing challenge.
Preventing front running in crypto
A great portion of cryptocurrency trading occurs in decentralized platforms. This makes it harder to prevent and penalize front running. However, some measures are being implemented.
To avoid being front-run in crypto, traders can:
Lower slippage tolerance to reduce vulnerability.
Use private transaction methods to hide their orders from bots.
Break large trades into smaller ones to avoid attracting attention.
Use MEV protection tools like MEV blockers, Flashbots (Ethereum), or private mempools (Solana).
By understanding how front running works in crypto, traders can better protect their investments and avoid unnecessary losses.
Closing Thoughts
Front running is a serious violation of market ethics and trust. Whether in traditional financial markets or emerging sectors like cryptocurrency, this practice undermines fairness and integrity. By understanding how front running works and taking preventive measures, traders, investors, and regulators can work together to create a more transparent and equitable trading environment.
Further Reading
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