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

Liyan Yang and Haoxiang Zhu

The Review of Financial Studies, 2020, vol. 33, issue 4, 1484-1533

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.Received July 4, 2017; editorial decision February 12, 2019 by Editor Andrew Karolyi.

Date: 2020
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