The Potential of Self-Regulation for Front-Running Prevention on DEXes

TL;DR

This paper models how self-regulation through market design and participant incentives can reduce front-running on decentralized exchanges, highlighting the importance of trader education and incentives for effective adoption.

Contribution

It introduces a game-theoretic model analyzing trader and liquidity provider behavior, revealing conditions under which front-running can be mitigated without external regulation.

Findings

Less than 1% retail order flow aligns incentives to eliminate front-running.

Around 10% retail order flow causes liquidity providers to avoid protective pools.

Market self-regulation requires trader education and additional incentives.

Abstract

The transaction ordering dependency of the smart contracts building decentralized exchanges (DEXes) allow for predatory trading strategies. In particular, front-running attacks present a constant risk for traders on DEXes. Whereas legal regulation outlaws most front-running practices in traditional finance, such measures are ineffective in preventing front-running on DEXes. While novel market designs hindering front-running may emerge, it remains unclear whether the market's participants, in particular, liquidity providers, would be willing to adopt these new designs. A misalignment of the participant's private incentives and the market's social incentives can hinder the market from adopting an effective prevention mechanism. We present a game-theoretic model to study the behavior of sophisticated traders, retail traders, and liquidity providers in DEXes. Sophisticated traders adjust for front-running attacks, while retail traders do not, likely due to lack of knowledge or irrationality. Our findings show that with less than 1% of order flow from retail traders, traders' and liquidity providers' interests align with the market's social incentives - eliminating front-running attacks. However, the benefit from embracing this novel market is often small and may not suffice to entice them. With retail traders making up a larger proportion (around 10%) of the order flow, liquidity providers tend to stay in pools that do not protect against front-running. This suggests both educating traders and providing additional incentives for liquidity providers are necessary for market self-regulation.