Pre-hedging - We know it’s a global issue…
At a recent ISDA/AFMA Forum, ASIC Chair Joseph Longo foreshadowed greater regulatory interest in the elusive subject of pre-hedging.
There can be little doubt that clear and consistent regulatory guidance on the topic would be well received, but this may actually be unrealistic.
In this blog I focus on why global clarity around pre-hedging has proven so difficult and share some thoughts on what regulators may be missing.
ASIC Chair
At the recent ISDA/AFMA Forum in Sydney, ASIC Chair Longo made the following comment in relation to pre-hedging:
We know it’s a global issue, so we’ve been engaging with ESMA on its call for evidence in Europe, as well as the FMSB and IOSCO, which is considering work in this area.
It is hard not to read this as an acknowledgment that the subject has multiple layers of complexity and that a globally consistent approach has, to date at least, proven elusive.
In separate news, Risk.Net reports that IOSCO is examining the question of “how dealers place hedges before executing trades,” and is expected to release its findings in Q3 2024. This is welcome, but some way off.
Pre-hedging?
So, what exactly is pre-hedging?
Here I submit standard industry and regulatory definitions, which are similarly framed but subtly different.
According to the European Securities and Market Authority, ESMA, pre-hedging is a practice in which a:
“…liquidity provider undertakes one or several transactions to hedge an order before it is received.”
The keyword being “before.”
While noting that pre-hedging is not defined under EU law, the authority concludes that:
“…pre-hedging is a voluntary market practice which entails a risk of conflicts of interest between the investment firm and the client/counterparty.”
The Financial Markets Standards Board, FMSB, has described the practice with a subtly different definition it its “Standard for the execution of Large Trades in FICC markets”:
“Pre-hedging is the management of the risk associated with one or more anticipated client trades. Pre-hedging is undertaken where a dealer legitimately expects to take on market risk in circumstances where such dealer does not have an irrevocable instruction from the client.”
The keyword here being “anticipated.”
The Global FX Committee, GFXC, provides a definition that describes pre-hedging in strictly legitimate terms:
“Pre‐hedging is the management of the risk associated with one or more anticipated Client orders, designed to benefit the Client in connection with such orders and any resulting transactions.”
While adding the highly important rider that:
“Pre‐hedging done with no intent to benefit the liquidity consumer, or market functioning, is not in line with the FX Global Code (Code) and may constitute illegal front‐running, depending on the laws of the relevant jurisdictions.”
These all provide useful individual points of guidance, but they cannot mitigate some fundamental problems that confront liquidity providers the moment information about a large or sensitive transaction first crosses an information barrier.
A number of very reasonable questions arise for liquidity providers (ESMA’s descriptor for sell-side firms) when a potential risk-transfer situation is first revealed:
Is there a clear, unambiguous, and enforceable pre-hedging agreement?
Can I trust the client (liquidity consumer)?
Who else is aware of the impending transaction?
What do these others know relative to my information?
Is my existing book at risk of loss given the potential transaction flows?
Could natural market factors move the market against the client if and when I execute pre-hedges?
Such questions could be thought of as the tip of an endless catalogue of questions in an endless range of potential dealing settings. Which may explain why a comprehensive and readily enforceable global standard has proven elusive.
Why so elusive?
It is not as if the conflict risk surounding pre-hedging is new.
The potential for large trades to convey sensitive market information is well understood and could be argued to be a problem as old as markets themselves. What is odd is that regulatory efforts to guide market participants with respect to dealing conduct are only relatively new.
Consider the following timeline:
2016 – FMSB, Reference Price Transactions standard for FICC markets,;
2017 – GFXC, FX Global Code;
2019 – ESMA, Market Abuse Regulation review;
2020 – FMSB, Standard for the execution of Large Trades in FICC markets;
2021 – GFXC, Commentary on the role of pre‐hedging; and
2024 – IOSCO’s pending pre-hedging investigation.
Which is all quite recent work, particularly considering that the US Insider Trading Sanctions Act was first enacted in 1984.
And these more recent efforts, though excellent initiatives, are tellingly somewhat different and come in the form of general industry codes or guidance. Which makes ASIC Chair Longo’s hint of possible ASIC engagement with ESMA, the FMSB, and IOSCO look all the more reasonable.
Some comments
Here I leverage the impressive work completed by the GFXC in 2017.
Firstly, it is clear from the GFXC FX Global Code that pre‐hedging conducted without the intent to “benefit the liquidity consumer, or market functioning” may “constitute illegal front‐running, depending on the laws of the relevant jurisdictions.”
“The intent of any pre‐hedging by the liquidity provider should always be to benefit the liquidity consumer and help facilitate the transaction.
Any pre‐hedging should be done in a manner so that it is not meant to disadvantage the client nor cause market disruption.”
What is unclear is how one proves “intent,” regardless of jurisdiction. As the GFXC concedes, intent “exists in the mind of a liquidity provider.”
Regardless of intent, what if circumstances arise that suggest pre-hedging contributed to an observable market move against the interests of the liquidity consumer? Or to an observable market disruption?
This problem of “intent” may therefore be intractable, a kind of wicked problem in financial markets and one bearing the unfortunate potential to mire relatively common market activities in protracted dispute.
Which suggests the existing jurisdictional mix of insider legislation, which leaves clear conduct risk hanging, may remain a kind of natural limit to governing pre-hedging in practice.
What about obligations for liquidity consumers?
One area that regulators appear to have paid little attention to is that of conduct obligations for liquidity consumers.
While it has made sense for regulator and industry attention to focus squarely on the actions and incentives of providers it seems odd that those who generate, carry, and/or convey potentially market-sensitive information have not been subject to much closer scrutiny.
It should be clear for those handling large transactions that when deal information is conveyed onto a dealing floor it can restrict the freedom of portfolio manoeuvre of the liquidity provider to an unknowable extent. Hence, generally agreed protocols for observance by liquidity consumers should be assembled with a view to restricting information slippage and miscommunication. These could be developed with industry input to limit the ways and extent to which misconduct on both sides of large deal settings may arise.
Here I pose some technical arrangements that regulators might consider, perhaps forming the basis for wider industry consultation(s):
Define a common and well understood threshold for deals that constitute “market sensitive transactions,” perhaps labelled MSTs. There are a range of possible approaches to defining such a threshold which would be related to market liquidity.
Define a suite of conduct obligations for those carrying market sensitive information related to deals above the MST threshold, not limited to:
o information security and communication protocols;
o formation and extent of information barriers;
o dealing panel formation and extent;
o request for indicative quote (RFI) protocols;
o RFQ protocols;
o pre-hedging communication and agreements; and
o clear markets and risk transfers.
Consider alignment of subsequent guidance with the well-received FMSB Reference Price Transactions (RPT’s) standard for the Fixed Income markets and their Standard for the execution of Large Trades in FICC markets. RPT’s may have particular advantages in removing conflicts and improving dealing price formation – for parties on either side of large deals.
This is a clearly non-exhaustive list, but I pose it as a possible starting point for the development of buy side protocols that might level the large deal playing field – and lead to more balanced outcomes for all parties.
Buy-side considerations
Whatever paths regulators eventually take, large deal strategy, frameworks and well-established dealing/execution protocols can be shown to meaningfully improve outcomes for those whom ESMA refers to as liquidity consumers.
Some important considerations:
No large transaction should ever be contemplated without a comprehensive transaction and associated deal communications strategy.
A deal situation-assessment should be used to inform and develop the transaction strategy.
Transaction strategy should include consideration of ultimate deal execution approach and path-to-execution, with proper assessment of:
o product suitability;
o hedge cost and risk assessment, including versus doing nothing; and
o counterparty evaluation and ranking – with reasonable consideration given to determining which party may provide the right home for the associated deal risk and/or product.
Communication strategy – crucial to minimising the risk of conflicts – should be more robust than the simplistic “needs to know” principle, covering:
o communication milestones;
o internal and external communication and controls;
o timing and establishment of robust information barriers;
o timing of RFI/RFQs and any deal rehearsals if appropriate; and
o panel bank composition and engagement timings.
It can be useful to imply a best-interests test to help inform and guide decision-makers, and to evidence best practice.
The unloved task of maintaining suitable records should be adopted.
Conclusions
With increasing regulatory attention, the observance of the approaches outlined here can help ensure firms exceed what we might term the implied industry obligations. Observance can be shown to reduce hedging costs and risks and reduce the chance that large deals result in disrupted markets.
For market participants of all types, global comprehensive standards for these sensitive market risk transfers really cannot come soon enough. In the absence of clear guidance great care in the approach to large dealings is warranted.