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| Main Authors: | , , |
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| Format: | Preprint |
| Published: |
2023
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| Subjects: | |
| Online Access: | https://arxiv.org/abs/2306.05756 |
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| _version_ | 1866917770017374208 |
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| author | Heimbach, Lioba Schertenleib, Eric Wattenhofer, Roger |
| author_facet | Heimbach, Lioba Schertenleib, Eric Wattenhofer, Roger |
| contents | 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. |
| format | Preprint |
| id |
arxiv_https___arxiv_org_abs_2306_05756 |
| institution | arXiv |
| publishDate | 2023 |
| record_format | arxiv |
| spellingShingle | The Potential of Self-Regulation for Front-Running Prevention on DEXes Heimbach, Lioba Schertenleib, Eric Wattenhofer, Roger Computer Science and Game Theory 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. |
| title | The Potential of Self-Regulation for Front-Running Prevention on DEXes |
| topic | Computer Science and Game Theory |
| url | https://arxiv.org/abs/2306.05756 |