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Frontrunning the signals: As arbitrage between sophisticates.
1McCourt School of Public Policy, Georgetown University, Washington, DC 20057; gaa53@georgetown.edu htong@imf.org.
Summary
Sophisticated investors engage in frontrunning, an arbitrage strategy that harms uninformed traders without benefiting themselves or improving market information. This creates financial market inefficiencies.
Area of Science:
- Financial economics
- Market microstructure
- Behavioral finance
Background:
- Sophisticated investors may trade based on anticipated information, not just received signals.
- Existing models often assume information is fully discovered before trading occurs.
Purpose of the Study:
- To model a financial market scenario where sophisticated investors frontrun anticipated information.
- To analyze the impact of this frontrunning on market efficiency and trader outcomes.
Main Methods:
- Development of an arbitrage equation specifically for frontrunning strategies.
- Simulation of trading behavior under conditions of imperfect and anticipated information.
Main Results:
- Frontrunning by sophisticated investors occurs before information receipt.
- The costs of frontrunning are fully borne by unsophisticated traders.
- Sophisticated traders experience no net gain or loss from frontrunning.
- Frontrunning does not lead to faster information discovery in the market.
Conclusions:
- The study identifies a novel financial market anomaly: inefficient transactions where no party gains.
- Frontrunning, as modeled, represents a transfer of wealth from uninformed to informed traders without market improvement.
- This highlights a potential source of market friction and inefficiency not captured by traditional models.
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