Front-running in crypto trading is becoming a huge nuisance, as more and more traders are turning a victim of it. To understand it properly, imagine a scenario where a trader spots a large buy order about to be executed.
They can quickly place their own buy order just before it, driving the price up slightly. Once the large order fills at the inflated price, the front-runner can immediately sell their holdings for a quick profit, leaving the original trader with a less favourable execution price.
Front-running isn’t new, and it isn’t unique to crypto. However, it has the ability to prey upon the way crypto works, and because so much of crypto uses advanced trading tools, it gives scams like front-running a higher success rate.
So the question is, what can we do about it? Let’s dive in to see exactly how front-running hurts everyday traders, why it’s a scourge in both the TradFi and Web3 markets, and what can be done to fight and perhaps even end front-running for good. We will look at specific encryption protocols and architectures, such as Enclave’s Fully Encrypted Exchange (FEX).
Front-Running: The Cheater’s “One Weird Trick”
So what exactly is front-running? Interestingly, it’s not just a straightforward scam, and it takes different forms even within TradFi and Web3. For TradFi, the simplest form of front-running is when a broker takes in orders from its customers, then cheats by putting in trades of its own before it processes customer orders. Its own trades are calculated to take advantage of the pending trades from customers.
If customer trades are about to cause a particular security to jump up, a broker might buy some just before that happens. If there is about to be a selloff, the broker can cheat and be the first one to sell, ensuring they do so at a higher price.
Obviously, the introduction of high volume trading using automated algorithms causes the entire process to move faster, but can also create an even bigger benefit for front-runners.
Whether it’s a broker or even an exchange, by setting up algorithms that use pending trades as a calculated input, they can automatically benefit from this knowledge and make money. This by definition is a type of insider trading because they gain non-public information used to inform their trade, and is very illegal.
For Web3, unfortunately, the problem is even more complex. Like TradFi exchanges, CEX and even DEX models can allow for front-running if the exchanges are willing to abuse their customers’ trust. However, node providers can potentially front-run if they have fast enough algorithms, as they are able to see pending transactions that haven’t been verified by the network. They can jump in front of these trades and make money as a result.
One of the most obvious Web3-only front-running strategies would be on Ethereum, where bots can potentially view pending trades and offer a higher gas fee for their own trade, cutting in line and taking advantage of the information they have gained on pending transactions.
The fact that all of this activity can be programmed into bots and other algorithms means it can take advantage of activities and pending transactions that happen in fractions of a second. Even if this gives front-runners a slight advantage, those slightly better trades add up to benefit front-runners and take real money away from their victims.
Easy Answer, Difficult Execution
Based on all of the above (both TradFi and Web3), the answer to the front-running problem is pretty straightforward: Don’t let people (or bots) see pending trades! Think about it: If brokers couldn’t see pending trades, they couldn’t take advantage. Same for exchanges. Same for fully connected nodes. And same for bots/algorithms.
The challenge is also pretty obvious: If no one can see the pending transactions, how will they be processed? This highlights the issue to date: If a system has encryption that protects information part of the way through the process, but not all the way through the process, then it really isn’t protected, is it?
Fortunately, there is progress being made with encrypted execution platforms. The furthest along is currently Enclave, whose evolutions of this “fully encrypted exchange” (FEX) allow transactions to be processed privately without involving brokers, the exchange, nodes, and eliminates the points at which bots can intercept information. EnclaveX is the newest iteration with secure enclave technology.
Like any platform that can fully encrypt the process, this protects all pending transactions from abuse. While this type of service has been created for a handful of professional, high volume trading customers, the ability to provide this to all users can not only protect high volumes but can prevent front-runners from identifying fast moving trends that hit the market (surges on a particular token, selloffs, etc).
Protecting both professional and casual traders alike makes more sense because doing so ensures that front-runners can’t spoil natural market movements.
Does this solution help in the TradFi world? Unlikely. Not because it wouldn’t work, but because TradFi tends to lag in these types of advanced technologies.
While Web3 is perfectly willing to innovate and develop things like fully encrypted exchanges, you don’t see the same level of technology in TradFi, and especially not in ways that favor a more decentralized, trustless operating environment.
For TradFi, the exchange and the broker are key functions, and there is little to no motivation to make those roles trustless. To do so might almost remove their perceived value, and there is no interest in allowing for that. This is where Web3 shines, and will continue to shine.
The entire business model is built around the volume and success of the members, not setting up gatekeepers. In this way, Web3 is taking the longer view with less of an ego, focusing on the value of technology itself and ensuring the network benefits when it builds up satisfied users.
Looking Ahead
Thanks to advances in technology, and encryption architecture in particular, the capabilities of front-runners are becoming more and more limited, and will soon be isolated to those lower quality exchanges where front-running is one of many sketchy risks that affect users.
For high quality exchanges, the ability to encrypt trading through the entire process is absolutely necessary to not only prevent front-running, but to build confidence in the process and the market.
After all, markets are emotional creatures, and act on fear, doubt, and suspicion just as much as encouragement, hope, and trust. Ensuring that everyone is playing fairly and your trades are yours alone is a big step in the right direction.
Also Read: Top 5 Free DeFi Tools to Level Up your Crypto Trading Game
