In the world of finance, front running entails making a move on an asset with prior knowledge of where the price is headed. Generally, front running occurs across various asset classes. In the permissionless world of cryptocurrencies as well, front running is a common tactic for getting ahead of significant shifts in price. Besides high volatility, decentralized networks and open (transparent) ledgers make blockchain-cryptocurrency markets conducive to several methods of front running.
Front Running in Decentralized Systems
To understand what is front running, we first need to know how to make money by getting ahead of the trade. When trading stocks, commodities, and other traditional financial instruments, front running is usually done by acquiring insider information on events that can influence the price. In crypto markets, on the other hand, order flow is king.
Analyzing the order flow and its block sizes can help create a sense of where the price is headed. Crypto front running is all about getting ahead of the right order in the flow.
Mempool Analysis & Crypto Front Running
One of the ways to do crypto front running is by leveraging mempools. Their name derives from a combination of ‘memory’ and ‘pool’, and they refer to data pools of pending transactions. Mempools serve as halfway points by temporarily storing the information being transmitted from one node to another. In other words, they serve as cache memory for data of incomplete transactions. Though their configuration varies across time, mempools contain beneficial information for front runners. For instance, they might identify pending transactions that may significantly influence the market dynamics.
Accessing and analyzing mempools is easier on permissionless, open exchange platforms because of their highly transparent ledgers. Centralized exchanges fare better in this regard, although they are more susceptible to other forms of attacks. Transparency is a coveted feature of decentralized networks, but the risk of front running is a considerable trade-off.
Attempting to gauge the nature of an order before trading is, more or less, a common factor among mempool-based front running practices. Consequently, miners and validator nodes have a vantage point despite their role in securing the network. Consensus mechanisms like Proof-of-Work (PoW), for instance, are indeed necessary evils that harbor the possibility of bad actors gaining an undue advantage by front running. However, innovations in blockchain consensus — such as Pure Proof of Stake (PPoS) — can potentially mitigate these concerns.
Common Front Running Attacks
There isn’t just one way to make money by front running in crypto markets. It all depends on the type of transaction being targeted and the overall objectives. The old-school and straightforward method is to simply get in front of a large order. Then, by placing their order at a price lower than what is coming, one can profit from the difference in price following the execution of big orders.
A ‘displacement attack’ is another possible scenario where the front runner spoofs an order and executes it instead of the user’s original order. Additionally, a common speculative trick is to place an order at a specific price anticipating another transaction. By buying at the first price and selling back to the other party at the price they were quoting, the front runner has profited the difference. This then becomes a sure way of predicting a profitable trade. Holding back an order can work, too, as it gives avenues for the front runner to make their moves.
Although front running seems highly complex, their execution usually occurs in real-time. Specialized bots control the analysis of the data. Crypto front running attacks and the subsequent exiting of positions happen at very high speeds.
Is Front Running Legal?
Front running may be common, but it’s not a great practice. Different types of front running techniques are illegal in traditional markets for a reason. Though competition is welcome, it isn’t always right to take from someone’s gains through unfair means. Even in the permissionless world of cryptocurrencies, it’s possible to have standards and mechanisms restricting such practices.
Decentralized exchanges may disincentivize front running through mutually agreed standards. The global crypto community is currently discussing and innovating ways to deal with these attacks. One way or another, decentralized ecosystems need to overcome front running risks to foster healthy competition and growth in free markets.