Pre-hedging is a risk management tool used primarily for larger transactions in order to manage order flow, reduce market impact and improve client outcomes in terms of both liquidity and price.
It does, however, give rise to potential market abuse risk including:
- front running;
- the misuse of information (insider dealing);
- lack of transparency;
- lack of client consent and understanding.
In particular, market participants and regulators often struggle to distinguish pre-hedging, which is considered legitimate, and front-running, which is not. This is unsurprising as both involve access to material non-public information and both involve placing orders on own account utilizing this.
A determination of whether trading constitutes front-running or pre-hedging is usually made on a case-by-case basis and can involve complex analysis of the available evidence.
In its consultation report IOSCO attempts to delineate the difference by putting forward a new definition of pre-hedging:
“Trading undertaken by a dealer, in compliance with applicable laws and rules, including those governing frontrunning, trading on material non-public information/insider dealing, and/or manipulative trading: where:
- the dealer is dealing on its own account in a principal capacity;
- the trades are executed after the receipt of information about an anticipated client transaction and before the client (or an intermediary on the client’s behalf) has agreed on the terms of the transaction and/or irrevocably accepted an executable quote; and
- the trades are executed to manage the risk related to the anticipated client transaction.”
According to IOSCO it is the intent to manage risk in order to protect the client’s interest which distinguishes pre-hedging from other illegal trading practices.
And the report contrasts five key considerations that separate legal from illegal trading:
| Pre-hedging | Front-running, insider dealing or manipulative trading |
| Genuine risk management | No genuine risk management purpose |
| Acting fairly and honestly | No intention to benefit the client |
| To the benefit of the client | Not undertaken to minimize market impact |
| Minimizing market impact | Not acting fairly and honestly |
| Maintaining market integrity | Disrupts market integrity |
The report also suggests six recommended controls arrangements that dealers should have in place to manage conduct risk once a decision to pre-hedge hedge has been made:
- adequate legal and compliance policies and procedures;
- clear disclosure;
- client consent;
- risk and compliance controls including supervision arrangements;
- information and conflict management controls;
- recordkeeping.
Interestingly the document concludes with five suggestions for clients put forward in order to help them manage the potential risks connected with pre-hedging:
- Minimize the potential risk of information leakage.
- Implement internal controls to assess the quality of execution where pre-hedging has been used.
- Enhance the understanding of pre-hedging practices and potential impact.
- Clearly signal to the client where pre-hedging is not to be used.
- Obtain information from the dealer to evidence how pre-hedging benefited the transaction in question.
James Andronis, Chair of IOSCO’s Committee on Regulation of Market Intermediaries, said that the organization had carefully considered existing regulatory approaches and industry codes and that IOSCO believes that its “proposed recommendations will assist to promote greater consistency and good conduct in pre-hedging in the interest of market integrity and market participants.”
Responses to the consultation are to be submitted by 21 February, 2025.
