Back-Running: Seeking and Hiding Fundamental Information in Order Flows

Abstract

We model the strategic interaction between fundamental investors and "back-runners,'' whose only information is about the past order flow of fundamental investors. Back-runners partly infer fundamental investors' information from their order flow and exploit it in subsequent trading. Fundamental investors counteract back-runners by randomizing their orders, unless back-runners' signals are too imprecise. Surprisingly, a higher accuracy of back-runners' order flow information can harm back-runners and benefit fundamental investors. As an application of the model, the common practice of payment for (retail) order flow reveals information about institutional order flow and enables back-runners to earn large profits.

Keywords: back-running, order flow, order anticipation, high-frequency trading, price discovery, market liquidity, payment for order flow

JEL Classification: G14, G18