All the guidance in the world…
In February, ASIC released their Dear CEO Guidance for market intermediaries on pre-hedging setting out the Commission’s expectations in relation to a market practice that’s increasingly in the spotlight.
This was making good on a promise of ASIC Chair Joseph Longo, who back in 2023 noted industry’s “calls for guidance” on this thorniest of topics.
In this blog I ask a simple question: when it comes to pre-hedging, does ASIC’s (or anyone else’s) guidance matter?
‘Principles and guidance are great but they’re not enforceable. ‘
With these word’s the US-based Managing Director of a major global market association neatly summed up the rather uniquely Australian pre-hedging conundrum. Faithfully abiding by industry and regulatory guidance might be helpful, but it is only partially helpful if your trading patterns and deal outcomes appear to put you on the wrong side of the Corporations Act.
And what happens if you are on the wrong side of the Corporations Act, inadvertently or otherwise?
What we know is that it is the Corporations Act that matters. While pre-hedging situations may be rare, any ASIC investigative and/or enforcement action carries risk and almost certain business disruption (that can carry for many years).
ASIC’s Guidance
We‘ve blogged on this topic a lot in the past year, with John Feeney’s February post arguably the best of available summaries and one that helpfully provides a kind of guidance on the guidance.
Here I plagiarise in order to recap John’s points of what constitutes best practice in ASIC’s view:
Document and implement pre-hedging policies and procedures to ensure compliance with the law.
Provide effective disclosure to clients of the intermediary’s execution and pre-hedging practices in a clear and transparent manner – before any pre-hedging is conducted.
Obtain explicit and informed client consent prior to each transaction.
Monitor trade execution and client outcomes and seek to minimise market impact from pre-hedging.
Appropriately restrict access to and prohibit misuse of confidential client information and adequately manage conflicts of interest.
Have robust risk and compliance controls, including trade and communications monitoring and surveillance arrangements, to provide effective governance and supervisory oversight of pre-hedging activity.
Record key details of pre-hedging undertaken for each transaction (including the process taken).
Undertake post-trade review to determine the quality of execution for complex and/or large transactions.
ASIC went on to reminded CEO’s that:
‘failure to live up to these standards can be unfair and unconscionable.’
The market response?
It’s fair to say that the Dear CEO letter generated a lot of market interest and discussion among domestic and international firms alike. Some feel that ASIC has inserted a new higher standard with point seven.
For others, the insertion of point seven signalled the creation of what amounts to a uniquely Australian arrangement.
To recap ASIC’s pre-hedging guidance, point seven:
7. Record key details of pre-hedging undertaken for each transaction (including the process taken).
This is a definite extension of the guidance provided by both the FMSB and within the FX Global Code.
FMSB - Standard for the execution of Large Trades in FICC markets
Global Foreign Exchange Committee - Commentary on Principle 11 and the role of pre‐hedging in today’s FX landscape
And it doesn’t matter how large the underlying transactions are, the Corporations Act is in force down to the cent. The key point here is that the legislation does not appear to only refer to ‘large transactions’.
What are some of the practical risks and difficulties this creates?
It’s important to remember that when dealers are engaging in pre-hedging, they’re doing so as principals – i.e., as principal risk takers. They are also operating in risk-transfer settings, typically with multiple stakeholder interests to consider as they go about serving customers, managing an order book, and their firm’s own risks.
We also note that the dealing environment can vary between quiet periods of relative inactivity and periods of high turnover and volatility. In the latter the exercise of dealer discretion and split-second decision making are very normal, for example when market data is released or there is significant news flow.
We ask:
How do firms treat trades conducted in proximate time and price around the level of those that are recorded as pre-hedges for a specific transaction?
Is there a risk that by specifying a who-gets-what requirement for individual fills that a situation evolves where there is (real or perceived) ‘good-trades for us bad-trades for the client’ event ?
Which makes us think pre-hedge transactions should probably be recorded contemporaneously with a compliance operative present? But gosh, that adds a whole new layer of dealing oversight, complexity, and potential disruption.
We also ask, what if after all of the best compliance with ASIC guidelines, the market moves adversely against the client’s interests regardless?
There appears to be no easy answer to these questions.
So, does ASIC’s (or anyone else’s) guidance matter?
We’ve mentioned previously that we believe market intermediaries now bear a disproportionate responsibility for conflict-free, non-disruptive risk transfers in financial markets.
The latest ASIC guidance appears to add further to that burden.
We are also on the record as encouraging the development of guidelines for those who bring deals on the buy-side. But such guidance seems unlikely to emerge, at least any time soon.
In the absence of some new move to amend the Corporations Act, we therefore encourage firms to follow the guidelines with clarity, and think particularly carefully about:
documenting pre-hedging policies and procedures
recording the details of pre-hedging undertaken for each transaction
Our own mantra is worth remembering:
‘If it’s not written down it doesn’t exist.’
If it doesn’t exist, you probably have a risk you don’t need.
So yes, the guidance matters, and it matters a lot since a failure to demonstrate compliance will surely count against firms that become exposed to post-deal investigations.
The ability to demonstrably show compliance with the ASIC guidance may be all that actually protects a firm