What is Front Running?
The meaning of front running in finance refers to the unethical practice of using non-public information to trade securities ahead of a large order or transaction that is likely to affect the price of the security.
Front running is like jumping in line ahead of someone else. Imagine you are in a queue to buy a toy, but someone jumps ahead of you and buys the toy before you even though you were there first. Similarly, in finance, front running is a form of market manipulation where a person uses knowledge of an upcoming trade or order to buy or sell an asset at an advantageous price, before that trade or order is executed by the person who originally intended to make it. The person who "front runs" is essentially taking advantage of the information they have to execute a trade before others, and make a profit from it. It's like jumping in line ahead of someone else, they are taking advantage of the information they have and making a profit from it. It's considered unethical and illegal in many cases.
Front running in crypto is the practice of exploiting privileged information to benefit from a trade before others have access to it. In the crypto space, front running can often be seen when large market orders are placed on an exchange and traders take advantage of this by entering into the same position ahead of time. This gives them the potential for higher returns due to their earlier entry. Front running is considered unethical and illegal in traditional markets, but without proper regulation, it’s difficult to police or control in cryptos. As such, traders must be especially mindful that they are not engaging in front-running practices when trading tokens on decentralized exchanges (DEXes).
Furthermore, traders should be aware that front running is frowned upon by the crypto community and could lead to sanctions in extreme cases. Ultimately, it’s best to use decentralized exchanges responsibly and avoid participating in any front-running activities. Doing so can help maintain a positive reputation within the crypto space as well as keep your trading activity compliant with regulations.
Simplified Example
Front running is like if someone was looking over your shoulder while you were writing a test and then copying the answers. In finance, front running is when a person or group of people use inside information to make trades before the general public gets that information, giving them an unfair advantage. It's like having a cheat sheet before the test, which is not fair to other people taking the test.
The History of Front Running
Front running, originating from early stock trading when orders were physically relayed between brokers, involved gaining an advantage by placing orders ahead of known large orders. This practice, initially involving brokers physically outrunning orders to benefit from impending price movements, now encompasses any trading leveraging non-public information for an unfair edge, extending beyond physical actions to electronic and insider tip-based trading.
The term's legal context emerged in 1921 during a United States Steel stock case, setting a precedent by convicting a broker for insider trading, establishing the illegality of front running.
Examples
Pump and Dumps: This is a form of market manipulation whereby traders will buy up large amounts of a cryptocurrency in order to artificially inflate its price. They then sell their holdings as soon as the price has risen, resulting in huge profits for those who engaged in the front running.
Insider Trading: Traders with insider information will take advantage of this to buy or sell cryptocurrency assets ahead of any public announcement that could affect their prices. This type of front running enables them to make substantial profits before other investors have had an opportunity to act on the news.
High-Frequency Trading (HFT): HFT uses powerful computers to execute trades at lightning speed with millisecond delays, enabling traders to beat out competitors. HFT algorithms are highly sophisticated, and can analyze market data in real-time to identify trade opportunities that others would not be able to capitalize on. This form of front running allows these traders to reap substantial profits with little risk.