Some practical approaches to ASIC’s February 2024 letter on pre-hedging - Part 2
We published a blog in February 2024 which looked at the content of the ASIC letter for market intermediaries on ‘pre-hedging’.
That blog was focused on our interpretation of the ‘Dear CEO’ letter which was written to many banks and intermediaries. In most cases, as is normal for ASIC, the firms were required to provide a response.
A significant challenge for intermediaries is the practical application of the contents of the letter. This is further complicated by firm’s obligations under the FX Global Code and the FMSB guidance on handling large trades which offer similar but subtly different guidance to that in the ASIC letter.
It should be noted that many market participants have signed up to the FX Global Code and/or are members of the FMSB so are bound by those publications.
In addition, IOSCO is due to publish the results of a survey on pre-hedging later in 2024. This will likely add to the mix of guidance and will have the backing of many global regulators (including ASIC) who are IOSCO members.
All the codes and guidance have overlaps but also have some differences. This is to be expected because each jurisdiction is bound by their legislation and regulations which can and do differ across regions.
So, what is an intermediary to do? This blog looks specifically at the ASIC guidance and offers some practical alternatives for firms to consider when looking to comply with the Australian requirements.
Our summary of the ‘Dear CEO” letter from the previous blog
We provided this summary in the previous blog. It is a useful starting point for practical ways to address the point in the letter.
‘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 with other jurisdictions due to the local environment.
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?’
The summary poses 5 questions which we believe are important for intermediaries to consider for pre-hedging.
We now look at each question related to the 8 points provided by ASIC and offer some practical ways to address the contents of the letter.
The 8 ASIC points with thoughts on a practical approach to compliance
The 8 separate points follow which make up the guidance. The ASIC extracts are in italics and our views are in normal script.
‘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.’
Update the current policies and procedures with reference to pre-hedging if there is no explicit mention.
This could be assisted by using pre-hedging in the examples.
Provide updated training to impacted staff which specifically includes pre-hedging as a worked example.
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;’
Include an explanation of the pre-hedging practices (that this may occur) in the pre-trade discussion and written material.
Include the specific instruments that may be accessed for pre-hedging.
Explain how this will benefit the client.
Outline any risks that may be present, e.g., price moves against the client.
Make it clear that price moves may not have resulted from pre-hedging and may be a result of unrelated market activity.
We assume somebody has spoken with the client about the trade to get their request and provide a quote. Adding some specific points on pre-hedging should not be too difficult given training and some pro-forma scripts.
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;’
Take additional care when assessing ‘where practical’. For example, if the client calls urgently for a price for immediate execution, then a long conversation may not be practical. In this case, it is difficult to see where any pre-hedging could occur because there is insufficient time for it to be undertaken.
Assume it is ‘practical’ and have specific processes in place to inform the client and get their consent prior to accepting the trade or order.
Have a very wide view of ‘complex and/or large’. This is relative to the client and what each firm may not consider complex and/or large may be just that for the client.
Assess the client and the trade and explain pre-hedging accordingly.
4. ‘monitor execution and client outcomes and seek to minimise market impact from pre-hedging’
Make certain you have accurate records of all trades and times.
‘seek to minimise market impact’ should always be a goal in trading but may not always happen so be aware of the possibility of a large move.
If this does happen, then review the trades and markets to establish the cause of the move.
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’
The nuclear option: completely separate (different rooms) the sales and trading staff and ban electronic communications except on approved channels. Back this with clear instructions of what information can be passed between them.
The other option: physically separate the sales and trading so that discussions cannot be overheard. This may mean a distance of some meters and clear instructions on moving between the 2 areas. This will be supported by clear communication restrictions.
Whichever option a firm takes, make it clear that finding ways to circumvent restrictions is not in anyone’s interest and is strictly forbidden.
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’
Most firms already have oversight of their trading activity.
We suggest checking this includes specific alerts for pre-hedging and add them if they are not included now.
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’
Points 2 and 3 should provide the necessary inputs for the record-keeping.
However, if the pre-hedging is agreed prior to the trade, a post-trade review should be done -and transparency such as this is the kind of sunlight that can prevent downstream dispute of misinterpretation.
This can be relatively automated and done as business as usual.
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.’
Complex and/or large trades (see point 3) should get special attention for the post-trade review.
An independent person or team should be used to remove any suggestion of ‘marking your own homework’.
If there is a client complaint, then an independent review should be conducted.
Intentional or unintentional pre-hedging
Many intermediary firms are looking at how to manage their trading books in a complex environment of actual or potential client trades which may be seen as pre-hedging.
Traders need to engage with the markets to manage existing positions, including the working of orders in a complex book. Such activity could be interpreted as pre-hedging if a client trade is transacted or anticipated. This is the problem: is this activity pre-hedging?
A post-trade review (see point 8 above) could reveal trader activity which is consistent with pre-hedging but, in fact, is just the regular and necessary book management. This is unintentional and should be interpreted as such.
Intentional pre-hedging is completely different. Trading is undertaken with the explicit intention of hedging a specific trade and would clearly need to follow the ASIC letter.
But how does the intermediary firm decide whether the hedging is intentional or unintentional. And how do they review and maintain records showing how this decision was made?
This is a difficult question and will need to be specifically addressed by each firm according to their activities and internal policies. Clear and ongoing communication of intentions seems important here.
Summary
There is no question that banks and other intermediaries have existing positions which need to be managed. But how do they balance their pre-hedging obligations described in the ASIC letter with this normal activity?
We see the only practical approach could include:
· Recognise there can be intentional and unintentional pre-hedging activity and define them as clearly as possible.
· Make sure your policies and processes are supported by clear frameworks which maintain confidentiality and separate traders and sales information (point 5) specific for pre-hedging.
· If all trades are subject to pre-hedging disclosure and explicit agreement (point 3) make sure the scripting for sales staff is very clear and outlines all required information for clients.
· Unless you are very certain the client is ‘sophisticated’ in the product and market of the trade, make very certain the scripts are followed (points 2 and 3).
· Take extra care with large/complex trades, however you define them.
· Check your record-keeping and policies for post-trade reviews.
· Consider adding specific training for pre-hedging for relevant staff to the current requirements (point 1).
There is no correct answer or quick fix.
The approach will need to be dependent on the situation, the client and firm’s existing policies.
We believe all firms should be aware of their responsibilities and make efforts to specifically address the ASIC letter. While it may be tempting to assume pre-hedging is already covered in the current policies, this may not always be the case.
The letter makes the ASIC position very clear and the fact that they have decided to send a letter to CEOs emphasizes the importance ASIC attach to the practice f pre-hedging.
I'd encourage you to expand on these slightly. It seems like an abrupt ending.