ESMA Consults on Pre-Hedging; FX Firmly in the Spotlight

The European Securities and Markets Authority (ESMA) has published a consultation paper looking at the issue of pre-hedging and while it does not highlight FX as being a market under the microscope, throughout the paper the regulator asks for feedback over the approach of both the FX Global Code and the FMSB’s Standard on the execution of large trades.

ESMA says that during the course of its MAR (Market Abuse Regulation) review, it became aware that regional European regulators had received STORs (suspicious transactions and order reports) resulting from pre-hedging behaviour, a practice that is not defined in European Union law. It adds that while the practice has a risk management aspect to it, the practice “may fall within the scope of insider trading”.

ESMA adds that “several” market participants asked it to issue guidance on what should be considered as MAR-compliant in terms of pre-hedging and what behaviour might constitute front- running. Guidance was also requested on procedural aspects of pre-hedging, such as the documentation required, transparency regarding pre-hedging arrangements by brokers to their clients, and internal policies of market makers.

Appropriately enough for what remains a controversial subject, ESMA also notes that there are “fundamentally different views” on pre-hedging, hence why it is undertaking a review, part of which is the latest consultation.

The paper describes the practice of pre-hedging, with examples, and also lays out the arguments of both critics and supporters of the practice. It also, intriguingly for market makers, ask whether an RFQ could be qualified as inside information, as well as look at market participants’ obligations under MiFID II.

Respondents are asked to answer a series of questions to ascertain their view on the aforementioned subjects, perhaps of particular interest to FX market participants are question 4; Do you have any specific concerns with respect to the practice of pre hedging being undertaken by liquidity providers when the trading protocol allows for a ‘last look’? Equally, question 9 asks; Does the GFXC Guidance describe all the possible cases of risk management rationale that could justify legitimate pre-hedging?

The full paper and the response form can be accessed here, and ESMA’s closing date for responses is 30 September 2022.