Heavy lobbying by the sell-side appears to have worked on the International Organisation of Securities Commissions (IOSCO), which published its final report on pre-hedging. Brushing aside calls for the practice to be banned, IOSCO insists that pre-hedging is a legitimate risk tool that benefits stakeholders if proper disclosures and documentation are in place.
Pre-hedging, where dealers hedge exposures based on requests for quotes (RFQs) or indications of interest (IOIs), without a firm order in place, is a controversial topic. Boris Molls, head of markets at Brightwell, which manages the £33 billion BT pension scheme, told Global Trading “I believe most execution traders would agree that pre-hedging is in most instances just another word for front-running. It’s a plausible way to explain behaviour and market moves that look like front-running as something that was done to benefit the client.”
Pre-hedging is popular among bank-owned market makers that can use their large balance sheets to fund over-the-counter derivatives trades, a luxury denied to newer electronic liquidity providers with comparatively small balance sheets.
Read more: Editor’s Opinion: Lies, Damn Lies and Pre-hedging – Global Trading
“Pre-hedging is unacceptable and should be banned”, said Emma Lokko, head of market structure at market maker Susquehanna International Group, which sponsored a survey of buyside firms that largely echoed this view. In its submission to IOSCO, Susquehanna said that pre-hedging should be restricted to bilateral transactions, a view also expressed by Jane Street in a 2022 submission to ESMA. “Pre-hedging in the competitive RFQ context should not be permitted”, Jane Street said.
It was in the bilateral context that pre-hedging could be pinned down, Brightwell’s Molls explained. “Only in scenarios where the precise nature and purpose of the broker’s activity was transparently agreed in advance, could the practice be accepted”, he said.
However, after a long consultation, IOSCO’s final recommendations on pre-hedging dashes hopes that regulators will crack down. IOSCO defines pre-hedging as principal trading by a dealer, after receiving information about an anticipated client transaction but before the client has accepted the quote. To be considered pre-hedging, IOSCO says that dealers’ principal trades should aim to mitigate the risk related to the anticipated client transaction(s) with the intention of benefiting the client.
In its recommendation, IOSCO sets out principles that pre-hedging should be done fairly and minimise market impact. To that intent, IOSCO recommends that dealers provide clear disclosure of their pre-hedging practices to their clients and seek prior consent as well as limit the numbers of traders allowed to pre-hedge to facilitate monitoring.
IOSCO has been under pressure from banks that seek to use pre-hedging as a defence against hedge funds and other sophisticated buyside firms that game the RFQ process, a practice known as ‘drive bys’ amongst traders.
In its response to IOSCO, German bank Commerzbank said. “In reality, clients tend to trade in multiple clips without indicating the final size and banks often anticipate additional lots. With RFQs you also have the problem that customers may send “test RFQs” in sizes not identical to the final request to compare prices. Additionally, there is uncertainty if a client already traded or just asks multiple RFQs”.
France’s Natixis also complained about buyside abuse of RFQs in its IOSCO submission, “Many clients are not transparent on their Full size and split their amount in many slices in a very close period of time (which can create market impact and unfair losses to the makers which are not aware of the parent size order) to try circumvent the Spread they should pay for their genuine full size. No taker should use techniques to slice risk without the maker being able to be aware of it”.
Another trader at a large UK buyside firm agreed that IOSCO was right not to recommend an outright ban on pre-hedging by its member supervisors: “We believe that any pre-hedging should only be undertaken by a bank where it is discussed with the client beforehand and it is agreed that it is in the best interests of the client that pre-hedging should be expected to achieve a better outcome for the client”, the trader said. “We think those circumstances are extremely limited, but they do exist and hence they shouldn’t be banned under UK market conduct regulation.”
In the Susquehanna–Acuiti survey from 27 October where Acuiti polled an undisclosed number of European asset managers, Acuiti says: “92% of respondents said that pre-hedging has the potential to move the price away from their trade and provide a disadvantageous price.” The consultancy also adds that: “Over 80% of respondents believe dealers should only hedge their positions after the trade has been awarded.”
In a response to Global Trading, IOSCO said, “The Final Report on Pre-Hedging takes into account all views and extensive feedback from all market participants. A ban of the practice was never part of the discussion nor proposed by the majority of the buy-side, with very few individual exceptions”.
“Moreover, IOSCO is an international standard setting body, not a supranational regulator – financial regulation remains a matter of national sovereignty and IOSCO does not have the ability to ban any practice.”
Additional reporting by Etienne Mercuriali
