Front‐Running and Market Quality: An Evolutionary Perspective on High Frequency Trading

• Author: Thorsten Hens,Klaus Reiner Schenk‐Hoppé,Terje Lensberg
• Published date: 01 December 2018
• Date: 01 December 2018
• DOI: http://doi.org/10.1111/irfi.12159

Front-Running and Market Quality:

An Evolutionary Perspective on

High Frequency Trading*

THORSTEN HENS

†,‡

,TERJE LENSBERG

‡

AND KLAUS REINER SCHENK-HOPPÉ

‡,§

†

Department of Banking and Finance, University of Zurich, Zurich, Switzerland

‡

Department of Finance, Norges Handelshoyskole, Bergen, Norway and

§

Department of Economics, University of Manchester, Manchester, UK

ABSTRACT

We study front-running by high-frequency traders (HFTs) in a limit order

model with continuous trading. The model describes an evolutionary equi-

librium of low-frequency traders who compete in portfolio management ser-

vices by offering investment styles. The introduction of front-runners inflicts

heavy losses on speculators, while leaving passive investors relatively

unscathed. This encourages investment in the market portfolio and markedly

reduces overall turnover. Speculative trading persists despite its lower profit-

ability. By most measures, market quality is not affected to any significant

extent by front-running HFTs.

JEL Codes: D53; D47; C63; C73

Accepted: 8 September 2017

I. INTRODUCTION

Financial markets are complex ecologies of interdependent market participants.

Investors differ with respect to styles that focus on value, news, momentum,

sectors, factors, and so on. Moreover, markets rely on market makers to provide

liquidity; price discovery by informed traders; speculators to correct temporary

mispricings, as well as gamblers who are willing to lose enough money to pay

for these services. In addition, there are predatory traders who make money by

front-running or bluffing other traders. This diversity poses a challenge to

financial research because (i) regulations and innovations can affect different

types of market participants in widely different ways, and (ii) the interdepen-

dence between them renders partial analyses ineffective.

* We thank LGT AlphaGenerix for having initiated thisresearch paper during their workshop “Rule-

Based Cash Equity Strategies,”April 27, 2016.The work was conducted during a research stay at iFM in

Vitznau, Switzerland. Financial support from P&K-foundation and from the Swiss National Science

Foundationgrant 149856 “Behavioural FinancialMarkets”(2014–2016)is gratefully acknowledged.

© 2017 International Review of Finance Ltd. 2017

International Review of Finance, 18:4, 2018: pp. 727–741

DOI: 10.1111/irfi.12159