Working Paper: CEPR ID: DP1528
Authors: Jean-Pierre Danthine; Serge Moresi
Abstract: This paper evaluates the welfare implications of front-running by mutual fund managers. It extends the model of Kyle (1985) to a situation in which the insider with fundamentals-information competes against an insider with trade-information and in which noise trading is endogenized. Noise traders are small investors trading through mutual funds to hedge non-tradable or illiquid assets. The insider with trade-information is one of the fund managers. We find that front-running activity reduces their customers? liquidity costs, but it also reduces their hedging benefits. As a result, the customers of the front-running manager may be worse off and place smaller orders. The opposite is true, for those investors who are not subject to front-running, however. In aggregate, front-running will either have no effect, or have a positive effect on welfare.
Keywords: frontrunning; insider trading; noise trading
JEL Codes: G14; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| frontrunning (G14) | welfare of uninformed small investors (G23) |
| frontrunning (G14) | liquidity costs for small investors (G19) |
| frontrunning (G14) | market efficiency (G14) |
| trade information (F10) | market liquidity (G10) |
| insiders with trade information (G14) | market performance (G14) |
| frontrunning fund clients (G23) | welfare outcomes (I38) |