Pre hedging and trading: A practical guide and recent experiences of balancing outcomes
With the recent regulatory interest in pre-hedging, there has been a predictable focus on how this will impact both sides of the market: buy and sell. The ASIC letter to CEOs and the impending IOSCO guidance will add to the existing FMSB and Global FX Code publications.
At Martialis, we have recently worked with intermediaries (i.e., banks) and their clients (corporates and non-bank financials) to look at the practical ways to manage trade execution within the regulatory and market practice guidelines.
This article summarises our recent experiences where the balance between the banks and their clients is managed for derivative transactions.
The buy-side
Buy-side clients are always very much on top of their balance sheet exposures. They really understand the funding and liquidity needs for their businesses and frequently use derivatives and FX to hedge exposures.
They often use derivatives as hedges against liabilities. The derivatives of choice are interest rate and/or cross-currency swaps which can be relatively simple or complex. The swaps can be restructures of existing positions or traded as new swaps.
In restructures, the same counterparty as the original trade must be in the conversation. Our observations have shown repeatedly that some banks do add cost to the trade simply because the client has little choice of counterparty; that is, they are ‘captured’.
New trades are different, they can be shown to a variety of banks and the competitive tension is much more clearly reflected in new deal pricing. The prices tend to be more aggressive, perhaps reflecting the approach that getting the deal allows for restructuring later (see the previous paragraph).
The sell-side
Banks and intermediaries have a tough balance to maintain: what is a realistic price, and does it cover my costs and required returns?
This balance can be difficult to manage and can lead to the typical dilemma: How do banks get to an attractive price while meeting target returns?
How does a trader manage risks in an existing book while not creating an inappropriate market impact that may be (or perceived to be) pre-hedging?
Sales staff are equally challenged to maintain the relationship with their client while only divulging the minimum, appropriate information to traders. Clearly there needs to be some communication, but what is considered ‘appropriate’?
In many cases, the sell-side is considering carefully the management of all trades with clients to balance the regulatory requirements.
What are we seeing?
Pre-trade market moves certainly appear to be happening, and we have seen such price moves in markets just prior to trading.
The price moves may not be associated with any potential counterparties, but it happens often enough that may not be a coincidence.
Is it pre-hedging? We cannot be certain.
Strategy is everything. For the buy-side, agreeing a clear approach before talking to any bank is imperative. As soon as we ‘break cover’ there is a possibility markets move against the client interest and/or we place banks in a position which amplifies the potential conflicts of interest.
Limiting the information provided to the banks and the timing of the release of that information can reduce risks (and costs) for both sides of the trade.
Dry runs are a must. The dry run will help align the pricing especially for restructures and complex trades. This gives us time with the client to identify outliers and negotiate the pricing well before the trade execution time.
Keep the actual execution time confidential for as long as possible. Dry runs help get pricing issues resolved but keeping the actual date and time of trading confidential minimises the potential for market moves related to the trade.
XVAs (CVA, FVA and possibly KVA) need to be priced independently. Banks can layer additional spreads into KVAs. This may be done by individual bank staff or as a corporate policy.
Getting an independent price for the trades and the XVAs before talking to potential counterparties gives our clients the ability to identify any anomalies and confirm the actual spreads they will be paying.
Just comparing prices from different counterparties is not very effective because differences in details which impact prices can go undetected. Getting a full breakdown of the trade mid and spreads means both sides can confirm the details and minimise the chance of miscommunication.
SummarY
Moves in markets just prior to trades for buy-side clients do happen. And it occurs with sufficient regularity to suggest this is not entirely coincidence. Whether this is pre-hedging or not is an open question.
However, if a bank is involved in a trade where the markets moved just prior to the execution of the trade, we recommend they look at whether there was any involvement by their traders. The activity may be unrelated, but it is better to confirm this at the time via an independent review.
A very effective sell-side practice is to look at the trade from the perspective of the client. If they intentionally move a market or pre-hedge, this may be ok if the client benefits overall. But be clear about this before the trade and review after the trade.
We are yet to see any disclosure from banks that they may pre-hedge a trade. At best it appears in the disclaimers (in the small print) but has not been explicitly discussed in our experience.
We continue to work with many market participants on both buy and sell side firms. Our best advice is to get independent and informed advice on the strategy and pricing before executing trades.