Pre-hedging and the use of electronic execution platforms
Recently we published a podcast on the Martialis website where I discussed the development and use of electronic execution platforms with Anthony Robson. Anthony was CEO of Yieldbroker where they created the electronic trading infrastructure over 20 years and serviced the fixed income markets in Australia.
One of the topics we explored was the role of electronic execution platforms for pre-hedging of client trades by market participants. This has been a very important subject recently.
FMSB published ‘Pre-hedging: case studies’ in July 2024 which looked at the role of execution platforms in pre-hedging.
This blog looks at the FMSB case studies and relates the relevant example to my conversation with Anthony.
Recap on recent guidance on pre-hedging
Several industry and regulatory groups globally have provided guidance on pre-hedging in financial markets. We have reviewed them in previous blogs which can be found here, here, here, and also here. As you can tell, we have been busy in this subject!
One of the earliest examples of global guidance was within the FX Global Code first published in 2017. Principle 11 specifically addressed pre-hedging and was updated in 2021.
The FMSB has also updated their guidance in 2021. This has been recently supported by some case studies which are designed to assist market participants identify and manage pre-hedging activities.
The Australian regulator, ASIC, has also weighed in with a ‘Dear CEO’ letter published in February 2024. ASIC proposed 8 points which sell-side firms may use in any pre-hedging activity.
However, any advice or guidance can only assist market participants and will be subject to local regulatory and legal requirements. In other words, all market participants should pay close attention to the specific situation and their involvement in pre-hedging.
Most guidance emphasises any pre-hedging should be designed to:
Benefit the client or, at least, not adversely impact that client.
Be done with reasonable expectation of winning the trade. Note that a trader knowing they will win the trade in the very near future may not be consistent with ‘reasonable expectation’ and may constitute front running.
The role of electronic execution platforms
Returning to the FMSB, the 2024 case studies include 4 different examples of pre-hedging.
Case studies 1a, 1b and 1d all include using an electronic platform as the execution method. In all cases the client order is sent as a ‘RFQ’ (Request for Quote) in a liquid or illiquid market or product. The banks receiving the RFQ react in different ways based on whether it is a 1 or 2-way price request and/or by either pre-hedging or not. The trade is awarded to a single bank in each case.
The challenges for the banks receiving the RFQs on electronic platforms include:
Potential for the information to leak from the pricing desk to other traders thereby providing them with non-public information.
Pre-hedging may be permissible as long as it follows points 1 and 2 in the previous section.
While the time to respond to a RFQ may be very short (seconds typically) manual pre-hedging is impractical but algorithmic trading can quickly access electronic platforms. This needs to be carefully considered by banks and clients.
Illiquid markets and products present special challenges. While attempting to manage the possible position from winning the RFQ, a bank may impact the market price substantially.
I also note that the FMSB case studies include some client responsibilities to communicate clearly and honestly and be very clear about whether they accept any pre-hedging activity.
It is important to note that obligations and responsibilities impact both the intermediary (bank) and the clients.
The benefits of electronic platforms
The podcast with Anthony really highlighted using electronic platforms can have major benefits in managing risks as well as compliance with market obligations.
In the example of Yieldbroker (and I assume most platforms I have used), the electronic records of all activity are collected as a matter of routine.
There is a complete audit trail of activity that can be used for checks and analysis.
Platforms are generally required to conduct some form of surveillance to identify unusual behaviors or potential market abuse.
Orders and RFQs can be explicit about whether pre-hedging is permitted and record that agreement.
While it is possible to use another platform for pre-hedging apart from the one with the RFQ, it is possible to collect data from many platforms, check the time and activity and cross reference the pricing and trading.
Is pre-hedging permitted?
The simple answer is yes, provided it follows the rules and is agreed to by both parties.
Electronic trade execution platforms are often the dominant form of RFQ and trade execution especially in FX and fixed income markets. As such they have an important role and have functionality and characteristics which differ from voice markets.
How much is traded on electronic platforms?
The market data on turnover is difficult to gather accurately because it is spread across a number of different reporting entities including CFTC, ESMA, BIS, industry bodies such as ISDA as well as the platform providers.
However, it is generally understood that:
US and European markets trade approximately 70 – 90% of interest rate derivatives electronically due to regulatory requirements.
Around 30 – 50% of non-spot FX is traded electronically.
75 – 85% of spot FX is traded electronically.
I do note that these percentages can vary widely across regions and currencies but represent a significant proportion of the traded risk.
With relatively high percentages traded on electronic platforms, perhaps the FMSB focus on pre-hedging cases on those platforms is timely and relevant.
Summary
Electronic platforms for executing derivative and FX trades are well established and commonly used by market participants.
FMSB has recognised this and has recently provided a number of case studies of pre-hedging which related directly to the use of such platforms.
My discussion with Anthony Robson was very useful in understanding how the platforms are used and how they can provide great data for analysis of trading patterns. The complete audit trail including orders and trades can help identify when participants are trading and in what manner.
Electronic platforms are commonly used for trade execution and are very amenable to algorithmic trading: this aspect can create additional risks for market participants and may require additional controls.
In the case of pre-hedging, this could be detected by platform analytics and particular care needs to be exercised by all market participants to align their obligations to clients and markets with their trading patterns.