In a move intended to “advance the industry debate on pre-hedging”, the Financial Markets Stability Board (FMSB) has published a Spotlight review on the practice.
The paper cites with approval ESMA’s definition of pre-hedging as any trading activity undertaken by an investment firm:
- where the investment firm is dealing on its own account, and the trading activity is undertaken;
- to mitigate an inventory risk which is foreseen due to a possible incoming transaction;
- before that foreseeable transaction has been executed; and
- at least partially in the interest and benefit of the client or to facilitate the trade.
The paper tries to help firms delineate the difference between inventory management, pre-hedging and front-running, summarizing key distinguishing factors in a helpful table, which has been reproduced in a simplified form here:
| Key characteristic | Front running | Pre-hedging | Inventory management |
|---|---|---|---|
| Uses information provided by customer related to upcoming trades | Yes | Yes | No |
| Requires knowledge on the nature of upcoming trades | Yes | Yes | No |
| Transaction solely benefits the trader taking advantage of the impact of the upcoming trades on the market | Yes | No | No |
| Designed to benefit the client and executed in a manner not meant to disadvantage the client | No | Yes | No |
| Uses client information in the normal exercise of its function | No | Yes | Yes |
| Short-term strategy to manage immediate anticipated risk exposures from expected or potential client trades | No | Yes | No |
| Ongoing activity of position adjustment to respond to market fluctuations and optimise holdings (reasonably expected near-term demand) | No | No | Yes |
It also identifies a range of key factors, organized into three main categories, which may help firms determine whether pre-hedging may be appropriate given the specific circumstances:
| Client considerations | – Client consent / express request not to pre-hedge – How the client may benefit from the activity – Client relationship – How often the client requests RFQs that do not result in a trade |
| Transaction / market considerations | – Liquidity of the instrument – Size of the transaction – Prevailing market conditions and any relevant pending market events – Spread compression and any potential price impact of pre-hedging as well as the degree to which the price impact is expected to decay over the pre-hedge horizon – Method of execution – voice; electronic; algorithmic (this will influence, among other things, the timing and nature of disclosures) – Trading protocol – RFQ (bilateral or competitive; number of liquidity providers in competition; information on direction of RFQ); orders or enquiries; price streaming public transparency regime for instrument |
| Liquidity provider considerations | – The nature of the relationship between the liquidity provider and client/counterparty and the service being provided – Position of the liquidity provider’s book at point of request, taking into account its overall exposure across its trading activity – Likelihood of additional near-term related transactions |
According to the paper, areas of heightened focus for market participants when considering whether pre-hedging is appropriate include:
- liquidity and prevailing market conditions;
- size;
- method of execution;
- trading protocol; and
- post-trade review.
The more detailed discussion of each of these areas illustrates the potential for very different approaches by firms to pre-hedging, leading to a lack of market consensus, which is driven by some of the complexities also highlighted in the case studies that form the backbone of the paper.
The case studies included in the paper are pithy and focus on pre-hedging and risk-management considerations while also considering both firm and client perspectives. The case studies cover the following scenarios:
- RFQ in liquid instrument;
- application of pre-hedging principles to 2-way RFQs;
- risk management and conflicts of interest;
- illiquid RFQ;
- pre-hedging and price discovery;
- fixed income ETFs;
- new issuance swap.
This is a very helpful paper on a particularly thorny topic and one well worth reviewing in detail by operational and compliance teams at firms engaged in pre-hedging activity.
