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arXiv · 2306.05756

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

Lioba Heimbach·Eric Schertenleib·Roger Wattenhofer
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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.

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Lioba Heimbach, Eric Schertenleib, Roger Wattenhofer. 2023-06-09. The Potential of Self-Regulation for Front-Running Prevention on DEXes. https://arxiv.org/abs/2306.05756

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