ASIC’s guidance on pre-hedging February 2024
ASIC recently (1 February 2024) released some guidance for market intermediaries on the difficult subject of ‘pre-hedging’ While not specifically mentioned, this was in the aftermath of Federal Court findings in a high-profile case of relevance.
This blog focusses on the content and provides some comments on the meaning of that guidance. Our next blog will build on the guidance and look more closely at the practical implications for both buy and sell-side firms.
ASIC also released a ‘Dear CEO’ letter which has some more detail on the obligations for intermediaries when considering and/or engaging in pre-hedging of transactions.
While ASIC acknowledge the role of pre-hedging in managing liquidity and price risks associated with client trades, there are considerable concerns about conflicts of interest. Specifically:
‘ASIC acknowledges that pre-hedging has a role in markets, including in the management of market intermediaries’ risk associated with anticipated client orders and may assist in liquidity provision and execution for clients. However, it can also create significant conflicts of interest between a client and the market intermediary which actively trades in possession of confidential information about the client’s anticipated order or trade.’
ASIC state that they have observed ‘a wide range of pre-hedging practices in the Australian market, with some falling significantly short of its expectations. Differences in pre-hedging practices can disrupt fair competition and the effective functioning of markets’.
International regulators including IOSCO, ESMA, FMSB and FX Global Code have all provided some commentary and limited guidance on pre-hedging. ASIC does point out that their guidance is in addition to and consistent with both the international practice and the Australian legal and regulatory requirements.
Our interpretation of the ‘Dear CEO” letter
The letter starts with some principles where the guidance aims to:
raise and harmonise minimum standards of conduct related to pre-hedging;
improve transparency so that clients are better informed when making investment decisions;
promote informed markets and a level playing field between market intermediaries; and
uphold integrity and investor confidence in Australian financial markets.
These principles are very clear, but the real guidance is in the section headed ‘ASIC’s Guidance’. The reference to the Corporations Act (section 912A) reminds CEOs of their obligations to act efficiently, honestly and fairly.
Eight separate points follow which make up the guidance. The ASIC extracts are in italics and our views are in normal script.
1. ‘document and implement policies and procedures on pre-hedging to ensure compliance with the law. They should ideally be informed by consideration of the circumstances when pre-hedging may help to achieve the best overall outcome for clients.’
This requirement is common to many ASIC better practices for trading financial products. The important point is to show documentation and ongoing training that supports the relevant policies and procedures.
It is imperative to ensure that the policies and procedures give clear direction on how firms decide whether pre-hedging will benefit the client.
2. ‘provide effective disclosure to clients of the intermediary’s execution and pre-hedging practices in a clear and transparent manner. Better practice includes:
upfront disclosure, such as listing out the types of transactions where the intermediary may seek to pre-hedge; and
post-trade disclosure, such as reporting to the client how the pre-hedging was executed and how it benefitted (or otherwise impacted) the client;’
Point 2 is quite clear that intermediaries need to be very specific where pre-hedging is beneficial to the client before the trading commences.
Detailed records will also be essential to support a post-trade report to the client as to how this was actually executed and how the client derived some benefit.
3. ‘obtain explicit and informed client consent prior to each transaction, where practical, by setting out clear expectations for what pre-hedging is intended to achieve and potential risks such as adverse price impact. For complex and/or large transactions, the intermediary should take additional steps to educate the client about the pre-hedging rationale and strategy;’
This point uses ‘explicit and informed’ when describing client consent and appears to preclude general comments about pre-hedging often included as footnotes to term sheets. It puts in place a requirement to obtain explicit consent, i.e., specific acknowledgement of the pre-hedging for that transaction.
There is also a need for sell-side firms to make certain the client is ‘informed’, particularly for larger or complex transactions.
We expect a ‘sophisticated client’ designation may not be sufficient to demonstrate the client is informed and aware of the detailed use of pre-hedging for a specific transaction.
4. ‘monitor execution and client outcomes and seek to minimise market impact from pre-hedging’
Proper record-keeping will be essential. Firms will need to show how they monitored the trade execution and what explicit steps for each transaction they took to minimise market disruption.
Note, markets may move as a result of firms’ pre-hedging. However, it will be up to the intermediary to demonstrate that this is for the overall benefit of the client and exercised with due diligence to not unfairly disadvantage other firms involved in relevant markets at that time.
5. ‘appropriately restrict access to, and prohibit misuse of confidential client information and adequately manage conflicts of interest arising in relation to pre-hedging. It is critical that appropriate physical and electronic controls are established, monitored, and regularly reviewed to keep pace with changes to the business risk profile’
This point is self-explanatory and follows current regulation. However, note the additional requirement to keep aligned with changes to technology and presumably monitor many channels of communication to maintain confidential material.
6. ‘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’
This requirement is not new but the application to pre-hedging could be difficult to implement. We expect intermediaries will need to:
identify pre-hedging activity before commencing any trading
monitor the trading of both the teams pre-hedging and anyone else who may have knowledge of the transaction
perhaps provide oversight during and after the pre-hedging activity
7. ‘record key details of pre-hedging undertaken for each transaction (including the process taken, the team members involved, and the client outcome) to enhance supervisory oversight and monitoring and surveillance’
This point reinforces the requirements for record-keeping in the normal oversight and surveillance of trading. The focus is on the accuracy and completeness of the record-keeping after identifying pre-hedging activity.
8. ‘undertake post-trade reviews of the quality of execution for complex and/or large transactions. This should be performed by independent and appropriately experienced supervisory team members.’
The post-trade review appears to be above the requirements for other trading activity. This will likely involve all the items in point 7 above and a thorough review and report of the decisions and outcomes relevant to the pre-hedging activity.
Also note that the review is independent so Risk and Compliance teams will need to be appropriately skilled and informed.
Summary
The February 2024 ASIC guidance for pre-hedging is timely.
While consistent with global equivalents, the 8 points provide intermediaries with clear reference to the relevant Australian legislation and regulatory guidance.
It is very important to note that this is Australian guidance, and it may not be identical to other jurisdictions .
The challenge for many firms is the practical implementation of the contents of the letter.
How do you define which transactions will require explicit client consent to pre-hedge?
Who is an informed client and who may need additional assistance to fully appreciate the implications of pre-hedging?
How do you define and measure market impact when markets can vary in both the liquidity and the participants in each product?
How do managers oversee the pre-hedging and ensure it is consistent with regulation and guidance?
Since the guidance is a ‘Dear CEO’ letter, how does a CEO ensure compliance?
There are many other questions which we will address in our next blog. The focus will be on practical approaches to the guidance for both buy and sell-side firms.