The terms originate from the era when stock market trades were executed via paper carried by hand between trading desks. The routine business of hand-carrying client orders between desks would normally proceed at a walking pace, but a broker could literally run in front of the walking traffic to reach the desk and execute his own personal account order immediately before a large client order. [1]
Front running is where you get information about a trade before the trade happens, illegally, and get your own trade in first with advance knowledge that you should not have. That's still 100% against the law whether a computer is involved or not. Do it and you will go to jail. If you got your information from the public market because it is a thing that already happened, then ok. That is really just fine. Other laws might be being broken somehow in other ways or they might not but seriously that's the whole point of a public market and using public information. Everyone has the chance to react as fast as they can.
In the case of this sort of information-speed arbitrage you're not making any stock analysis decisions, you just know an index has to respond a precise way to the stocks within it, and you're able to beat this information to the exchange and buy it ahead of the change.
An analogy would be to redefine all killings (lawful or otherwise) as "murder". It's not helpful. Words have specific meanings in specific contexts, so lets stop overloading them so much when we don't have to.
I hope this clears things up.
Eg https://arstechnica.com/information-technology/2016/11/priva...
I've worked for an options market maker, chasing nanoseconds of latency improvements. If you want racks in the exchange data center, you have to pay more to be on one side of the room vs. the other, because the latency improvement for being a couple hundred feet closer actually matters.
https://sniperinmahwah.wordpress.com/ (Many people who work in HFT are quite familiar with it.)
It's an entertaining and fascinating "view of the inside."
https://hackaday.com/2018/05/12/hft-on-hf-you-cant-beat-it-f...
i imagine this will be true for a while (i.e. the practical throughput of sneakernet in many cases will keep outpacing the practical throughput of wired and wireless networks, probably for a long time).
It's interesting, but I don't think it stands out as "comical" from the finance realm, given that programmers unironically talk about "race" conditions during the "handshakes" from "tunneling" with a "certificate" in order to to "serve" up "pages".
On a far-more-obscure note, the etymology of "computer" itself can be traced back towards "something which counts using small pebbles of limestone."
It is a violation of being put in a position of confidence with respect to privileged information. Front-running clients is always bad. But one need not have a fiduciary relationship with a counterparty to front run them. Practically speaking, however, when non-client relationships involve front-running, we usually go after them as insider trading. (For example, suppose I trade for a hedge fund. I hear my PM is going to buy X. So I buy X. One, I front ran my own shop's order. But two, I also violated their confidence.)
It's of course worth mentioning that in the US, "insider trading" is itself defined largely in terms of fiduciary duty. There's nothing wrong with developing and exploiting proprietary sources of tradable information; in fact, as Matt Levine points out, that's kind of the point of a market (to aggregate information and discover prices). What's really problematic is when you're given access to private information in confidence and then use that information to trade against the owners of that information.
(I imagine this is not new to you; just for the thread).
Basically, a front runner looks for orders which will move the price on an exchange. So if an exchange has the following sell orders:
0.1 BTC @ $5100
0.1 BTC @ $5110
0.1 BTC @ $5120
And someone places either a market buy for 0.3 BTC, or a limit buy for 5120+, then they would expect to get 0.3 BTC @ 5110 average price.
However, the front runner, if they can see this order is about to be placed, could theoretically buy 0.2 BTC @ $5105 average, and instantly relist them for 5120, knowing they will be immediately sold to the $5120 limit / 0.3 BTC market buy order about to be placed, in this case pocketing $15/BTC
minus fees and commissions (trading being negative sum is always worth highlighting)
There are a few different points here. Firstly, there are plenty of unambiguous definitions of frontrunning that are accepted by the scientific community that this blatantly does fall under; see the Clark SoK we cite in our paper for this in the blockchain space, or the definition Wikipedia uses, which was from an economics article by Khan & Lu (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1140694): "trading by some parties in advance of large trades by other parties, in anticipation of profiting from the price movement that follows the large trade."
The second point here is even if you want to restrict the definition to require privileged information, privilege in p2p networks is not binary: there are some nodes that are better peered on the topology, have better mining equipment, etc. who can use these privileges to extract market rent, harming the security of a blockchain.
This is a complex and dense paper that took 8 people 18 months to produce, and I recommend you read it with an open mind, rather than having a gut reaction to whether we use your preferred definition of "frontrunning". I also recommend reading the primary source material directly, or at least my summary on Twitter - https://twitter.com/phildaian/status/1116155236433956865
Happy to answer any questions!
But if 51% of Wikipedians believe otherwise, who am I to argue?
I read the whole paper before I commented, but really wasn't remarking on the paper so much as this subthread. If I was going to pick nits, it'd be with the title of the paper and the allusion to _Flash Boys_, which is just a terrible book.
Late edit:
If you want to bring this back to computer science, I think it's helpful to think about this stuff in terms of the CAP theorem; according to our science, the opportunity to arbitrage latency in a continuous market basically has to exist.
edit: > But that's basically the fundamental challenge of shopping a large block; it implies that essentially all of institutional trading is "about" frontrunning. That can't be right.
That doesn't make the Khan & Lu definition wrong, just that there is a lot of "front running" that occurs. Larry Harris even explicitly mentions this point:
"When large traders recognize that they cannot trade as well as a professional trader can, they commonly hire a professional to help them trade. They may hire a block broker to act as their agent, or they may ask a block dealer to facilitate their trades. Block dealers who facilitate their customers' trade trade their blocks at uniform prices. The dealers then try to profit by trading the block in the market at a better average price. In a sense, block traders are front runners whom large traders hire to help them solve their trading problems"
This is related to the idea of sunshine trader discussed earlier in the chapter before that blockquote.
Front Running: Front running occurs when a broker improperly allows one order to trade ahead of another. The order that goes first usually profits from the price impact of the following order. Front runners hurt the traders whose orders they front-run because they take liquidity that the front-running traders otherwise would have taken. These orders then fill at worse prices than those tat which they would have filled.
Front running is most common when a broker holds a large order that will likely move the market. The broker then trades for his own account first, or he tips off a confederate who does the front running.
Front running also hurts the brokers who represent the orders that are front-run. Broker clients who pay close attention to how well their brokers perform will discover that their brokers who knowingly or unknowingly allow others to trade in front of their orders do not trade effectively on their behalf. When their poor performance becomes apparent, the clients often direct their orders to other brokers. Firms that employ brokers must therefore be vigilant to ensure that their brokers do not cheat their clients and thereby lose business for the firm.
This seems pretty cut-and dried.
But, a little later in the book, there's a whole little subsection on "Legal Front-Running By An Observant Trader", ending with "[the front-runner's] trading is legal. Her profits come from recognizing [the broker's] shortcomings as a broker, and from noting that [the broker's] clients tend to split their orders. She is a profitable trader because she is observant and because she acts quickly on her information."
I fully concede this point.
It's of course important to retain the distinction between legitimate front-running and FINRA-style illegal front-running.
FWIIW Michael Lewis is considered to be a serial fabulist by most people on Wall Street; his "flash boys" was a particularly egregious example of this, being a marketing effort for IEX, which was funded by friends of Michael Lewis.
Yes, it's very surprising, no, shocking, that people on Wall St. are reluctant to have behaviors like this called out publicly....
I am not Michael Lewis and cannot speak to the accuracy of his facts; our work is a scientific paper backed by a lot of data currently undergoing peer review. The views on HFT and market design in the paper are similarly informed by cited work that is quite extensive in its data analysis, and peer reviewed. I recommend you read it!
I'll add: on Twitter you noted that virtually every HFT trader, lawyer, and quant pushed back (either to your definition or to your allusion to Lewis's unfortunate book). You seem to think that's added credibility for your argument. Isn't a near-universal rejection of that argument from subject matter experts sort of damning for the position you're trying to take?
FWIIW I'm not on Wall Street; I work in tech. Wrong again.
Your results are both trivial and basically linkbait. Everyone who knows what a time priority order book is knows there are stale orders on DEX exchanges. The fact that people are arbing them is markets doing what they're supposed to do; creating one price across disconnected markets. Anyone who knows what they're doing and uses a DEX knows this; DEXes are for people who for whatever reason can't use central exchanges, or for smart contracts that are less concerned with getting the best price marked to the millisecond. In fact I pointed out the stale order issue to people who created the one of the more popular DEX protocols over lunch. They pointed out what DEXes are for. I guess nobody sent you the memo. It's OK to not know this; I didn't know. Personally I think they're bloody stupid, but you making their use out to be something sinister or poorly understood is ... well, a lot like Michael Lewis paranoid lunacy.
I realize you're not Michael Lewis, but you're taking on the title of his execrable book to sell ... something much less science fictiony and exploitative than his tall tales, but still fairly off the mark.
To claim this is what they were designing for is just ignorance of the space though. None of them knew about or even anticipated this issue; just because it is obvious to you does not mean it was obvious to them.
Just because DEXes are only for regulatory arbitrage (your words, not mine) doesn't mean that we should stand up crappy market designs.
The majority of the paper is about the formalization of and data on PGAs and miner OO, which was also not known in the blockchain community until now. If you point me to a reference to the contrary, or that contains the same results as e.g. Sections 5-7 of our paper, I'll gladly cite this and reduce my claims of novelty. Otherwise, this is something I've been working on for years, I'm going to stick with it, and it's up to peer review in the scientific community to decide :).
I hear what you are saying, but your preconceptions about Flash Boys being a bad book seem to be severely coloring your understanding of the work!
The paper is good! The surrounding context you're trying to provide about how real-money markets work, perhaps not so much.
The paper doesn't comment on money markets much at all, and cites pretty unambiguous peer reviewed work which is highly substantiated when it does.
I didn't think you made the case in your sections 5-7. 7 in particular looked like speculation to the point of paranoia (which, admittedly, is justifiable in blockchain, but for the kinds of dollar amounts you're quoting -rather unlikely). I'll read it again to make sure.
> Virtually all existing market designs are crappy. Maybe CBOT is an exception. Michael Lewis' book is a big giant marketing document for a shitty market design, FWIIW: not a preconception; I read and panned his ridiculous book.
I'm not saying anything promoted by Lewis is a good market design, nor that existing continuous limit order books are. Merely that from the PoV of the efficient markets hypothesis, blockchain markets are worse (and have the potential to be better, e.g. by exploring batched designs).
Your statement in section 7 seems to not understand how blockchains work. I could be wrong; it don't pass the sniff test. Since I actually have a day job, I may not have time to look into this in enough detail to thoroughly pull it apart, but hey, maybe they'll catch it in "peer review."
That being said, I've been studying blockchains for years, and this paper has been reviewed by some very high caliber designers of blockchain protocols in both academia and industry. It also uses very simple models as in http://randomwalker.info/publications/mining_CCS.pdf which in my view are extremely unlikely to be incorrect (of course, anything is possible).
That said, I think you're off a bit on the nomenclature, too. Market makers can indeed have clients. For example, [1] is a list of the Chicago Mercantile Exchange's market makers for equity options. Citigroup, which has clients out the wazoo, is on the list. It's (presumably) just that the market making operations themselves are not done on behalf of a client.
You're maybe conflating the concept of a market maker with that of a proprietary trading firm. It's very common for market makers to be prop shops.
Prop shops, by virtue of not having clients of their own, are perhaps some of the least-well-positioned firms to engage in frontrunning. But a player like Citigroup or Goldman Sachs (which does a fair bit of currency and interest options market making) could have a relatively easy time of it.
[1]: https://www.cmegroup.com/trading/equity-index/e-mini-equity-...
Market makers generally don't have clients.
Once upon a time, I was a big-bank algorithmic equity derivatives market maker. We only had counterparties. Sometimes, those counterparties were our own bank's sales-trading desks. We were isolated from them, in terms of supervision and information access. (The sales-traders had clients.)
Not only are there very stringent access controls in place to prevent cross-contamination, but there are physical boundaries as well. When the guy who runs the business side of our team started collaborating on a project with a team that did client trading, he had to move off our trading floor and into an office, and we had to revoke this access to, well, pretty much everything. He wasn’t allowed to go near our traders’ desks. It stayed that way until the project ended.
People at a distance from organisations see them as monolithic. People closer to them see them as coalitions of distinct entities.
A parent company could operate both a market maker and agency/broker businesses side by side. Leaking information from the agency/broker to the market maker operation is illegal.
Perhaps you think I am nitpicking here, but the point is the bad guys in OPs example are the broker/agency which illegally sell/give away their clients information. Their illegal behavior is not predicated on the existence of the market maker. The market maker is simply an easy bogeyman for people who don't know what the hell theyre talking about.
Wikipedia states, for instance: >Front running, also known as tailgating, is the prohibited practice of entering into an equity (stock) trade, option, futures contract, derivative, or security-based swap to capitalize on advance, nonpublic knowledge of a large pending transaction that will influence the price of the underlying security.
No client needed.
A nice neutral primer on the HFT frontrunning debate can be found here, which contains a note regarding the HFT industry's attempt to advance the 'fiduciary' requirement. https://fas.org/sgp/crs/misc/R43608.pdf
Matt Levine, for instance, is very firmly on the 'keep frontrunning to only mean brokers interceeding before client orders' side of the semantic battle. Charlie Munger, by contrast, had no issues calling out the entire HFT industry as 'evil' and 'legalized front-running'. All this to say, there's clearly a lot of fight over the semantics here.
If you want to look at the official industry position, look at the communication between SIFMA and FINRA during the relevant time period wrt frontrunning regulations. You'll see SIFMA makes repeated reference to recognizing they have a duty in respect of customer orders, while the FINRA rules (5270, for instance) do not track this language. SIFMA attempted to conflate Rule 5270 (Front Running of Block Transactions) with Rule 5320 (Prohibition Against Trading Ahead of Customer Orders). I know a few people who have admitted in private that this strategy was not a mistake.
Rule 5270 notably has no exclusionary requirement that the non-public knowledge is in respect of a client trade. Rule 5270 also contains a definition of Publicly Available Information, which requires that the trade be COMPLETED prior to it being public.
To note how much of a gong show this situation was, note that in requests from SIFMA to delay the implementation of Rule 5270, FINRA said they'd grant the extension because firms needed time to train staff and retool systems - but FINRA explicitly noted that the activities prohibited under 5270 were almost all already illegal and covered by other FINRA rules.
So insider trading on non-public information is illegal and that's not news. Unless everyone does it with computers for a while. The regulator would look like an idiot for charging practically the entire industry, so instead they tell people they have a few years to knock off all that silly business while giving them a stern finger wagging.
But they only 'fixed' it for large orders, and then only in an official sense. The SEC hasn't done much in the way of enforcement on this point.
This is a frustratingly common misconception, but it is still incorrect. If you ascertain material nonpublic information without breaking a confidentiality agreement or fiduciary duty, you are fully allowed to trade on that research.
Price discovery is a core function of a financial market. Without information asymmetry, there exists no meaningful way to signal new prices to a market. In the abstract, the only way to achieve alpha is to have an informational advantage over the market consensus.
This is why the SEC is generally very careful in its terminology; to wit, you will usually see the terms "insider trading" and "illegal insider trading" distinguished. The "illegal" prefix is significant. Insider trading also refers more generally to the mundane, non-criminal trading activity of any corporate insiders. Legally trading with material nonpublic data is not insider trading by definition, because you can't legally trade on that kind of information as an insider.
Take a look at the SEC's spotlight of insider trading cases[1]. Note the commonalities - a confidentiality or agreement or fiduciary duty was broken directly (e.g. by an employee of the firm involved) or indirectly (e.g. by friends or family of the employee). Likewise, consider the SEC's definition of illegal insider trading[2].
As for what Munger has said about HFT - it frustrates me to hear that he's said those things, because of the coherent criticisms you can levy against the practice, frontrunning is not one of them. It's extraordinarily frustrating to me that you're characterizing this as something debatable - it isn't! "Frontrunning" has an established, precise definition which the SEC will happily and aggressively use for litigation - HFT or otherwise. Whatever Munger's problems with HFT are, his argument would be strictly better if he dropped the inaccurate jargon and simply criticized the practice directly.
In fact, I can't find a single citation in which Munger actually provides an argument for why HFT is bad or frontrunning. There are legitimate reasons you can be concerned about HFT, but Munger doesn't seem to mention them. Instead, every source I can find has him claiming HFT is wasteful or unproductive because he doesn't like the idea of people competing on nanoseconds. His overall dislike for the practice is extremely underspecified.
In contrast, Levine is actually far more neutral about the activity than you've given him credit for. He has written extensively about HFT, Flash Boys, IEX, the various players involved and the peripheral industries and incentives. He might not be as personally successful or wealthy as Munger, but his take on the subject is - objectively speaking - much more well-constructed and coherent.
___________________
That said, your response is half accurate. You're right that not all trading on non-public information is illegal, because price discovery is important (note, however, that in common parlance, 'insider trading' refers to illegal insider trading, not trading on non-public information). Anyways, regardless that's not the case here. First off, frontrunning does not help with price discovery. Second, trading ahead of a trade that's imminent and non-public is not legal. The opening subsection of rule 5270 is fairly straightforward:
"(a) No member or person associated with a member shall cause to be executed an order to buy or sell a security or a related financial instrument when such member or person associated with a member causing such order to be executed has material, non-public market information concerning an imminent block transaction in that security, a related financial instrument or a security underlying the related financial instrument prior to the time information concerning the block transaction has been made publicly available or has otherwise become stale or obsolete."
Recall, FINRA went to lengths to point out that this was ALREADY illegal by the time this section was put into force after the flash crash.
As for Munger, his views are fairly straightforward.
https://www.cnbc.com/video/2013/05/03/why-charlie-munger-thi...
https://www.cnbc.com/video/2014/05/05/hft-equivalent-of-rats...
"It does civilization no good at all. It's the equivalent of letting rats into a granary. I don't like it."
I think your note regarding Levine shows a point you've missed. I'm not saying Levine is for or against HFT activity. I'm saying he prefers a narrow interpretation of the term front-running like you do. However, even he capitulated, because both usages are acceptable. Hence my original note at the start of this chain where I note there's a dispute regarding the use of the term.
"In Money Stuff yesterday I said that "I seem to be losing the fight against semantic drift in the term 'front-running,'" which (I thought) used to mean a broker's breach of fiduciary duty by trading ahead of his customers, but which now seems to mean anyone's trading ahead of anyone else. Reader Bill Bremse pointed out by e-mail that some form of the second sense has been in respectable use for quite a long time, including by Larry Harris in the 1990s. I am not sure there is any higher authority on market-structure usage than Larry Harris, so I will cheerfully confess error on this one. "Front-running" can indeed mean something other than an illegal fiduciary violation, though at least Harris seems to have used it to mean trading ahead of exposed limit orders, not racing to trade on one exchange after seeing executions on the other. Though I don't know how much that was a thing in the 1990s."
A bit of an explanatory note: Prof. Larry Harris literally wrote the book on exchanges. He was also the Chief Economist for the SEC in the early 2000s, and later the head of their economic analysis unit.
Here's Order Exposure and Parasitic Traders, which he authored in 1997, well before HFT really took off. He refers to the activity we're discussing as front running, and explains systemic issues with the trading strategy before the HFT industry even existed: http://www-bcf.usc.edu/~lharris/ACROBAT/Exposure.pdf
Edit: And that version claimed tailgating is legal. Looks like it was in this version: https://en.wikipedia.org/w/index.php?title=Front_running&old...
The prototypical example is a large investment bank hearing about a large client buy order, then putting in a buy order first on their own book, knowing it will go up due to the client order. It is a violation of your fiduciary duty to the client.