ESMA Review Finds a Divided Market On Pre-Hedging – Again
Posted by Colin Lambert. Last updated: August 9, 2023
With The Full FX View
The issue of pre-hedging continues to split opinion in financial markets, and in its latest review on the subject the European Securities and Markets Authority (ESMA) says a recent consultation received “opposing views about the legitimacy of pre-hedging and on whether it is necessary for the market as a whole”.
This is not a new finding from the European regulator, it originally addressed the issue in 2019 and 2020 and was in receipt of a similar divide of views. In the latest Call for Evidence (CFE), ESMA says it received 32 responses and that the majority of responses believe there are specific instances when pre-hedging is beneficial for markets, namely when trading very illiquid markets in an OTC environment. “However, due to the diverging positions regarding the practice and its legitimacy, the scenarios presented were often different,” ESMA observes in the report.
ESMA offers two scenarios as base cases in the latest consultation, one where the hedging is ahead of an anticipated acceptance of an RFQ, and the other, an LP trading ahead of a pending order. Unsurprisingly, few found the second instance to be pre-hedging, although there were still voices of dissent it appears, ESMA also included the practice of last look in the review, but has concluded that “if needed”, these practices should be addressed separately.
Although largely a repeat of previous reviews, ESMA does note what to it at least is a “new element”, with one stakeholder arguing that “free-optionality” should be considered because LPs pre-hedging incoming transactions might benefit from price movement and might not pass on this benefit to the client. Alternatively, the stakeholder argues, they might amend their initial quote in instances where pre-hedging moves prices against them.
“In both cases, the end result would be that the liquidity provider shifts their market risk to the client,” the feedback notes shows that market participants support a case-by-case assessment of the different practices. “This choice is motivated by the divergences in the functioning of the different markets, which impedes the adoption of detailed rules applicable to all markets in the same way,” ESMA says.
In respect of the consent of the client, ESMA notes that respondents share the view that it is important to determine whether the transaction is in the interest of the client and legitimate, although there is no real attempt by respondents to quantify this. Furthermore, ESMA says there was support for express consent on a trade-by-trade basis.
At the same time, ESMA also notes that there is also general agreement on considering that consent alone does not prevent illegitimate behaviour from occurring. Thus, ESMA concludes that consent could be used as an indicator in any future guidance, but only as a rebuttable presumption of legitimacy. Thus, the debate has not moved on. ESMA adds this approach ‘should always concur with other indicators and/or elements to be considered”.
Respondents agree that the capacity to obtain the consent of the client for each transaction depends on the type of market considered. Unsurprisingly, the review finds that obtaining consent for each transaction seems to be difficult in electronic trading.
“On this point, ESMA is of the view that further evaluations need to be made, as on the one hand there seems to be support for requiring the client consent for each transaction, and on the other hand the measure seems difficult to adopt in some instances, in particular when the RFQ takes place in an electronic context or not,” the review states.
The Full FX View
The overriding argument of those in favour of pre-hedging in the ESMA review is that the practice is a “necessary tool” for LPs to manage their risk. This view could be questioned, not least by pointing out that another, less controversial method, could be to quote wider to the client or offer them an algo execution channel. Of course, this does require the client to accept this and that is probably the key aspect of this whole debate that ESMA needs to get to – what is the view of the buy side?
Unfortunately in this case, the identities of the respondents is not revealed, this may occur at a later date, but for now we are left with the overriding impression that the latest review provided yet another platform for entrenched views to be expressed – none of which moved the debate forward.
It is notable that “some” respondents considered that the consent of the client is important, therefore it should be taken on a case-by-case basis, however others observed that consent is not a barrier to illegitimate behaviour. That said, “very few” respondents were openly against a presumption of legitimacy based on consent.
Sadly, there will always be instances where someone tries to take advantage of pre-hedging to their own benefit, and this will often involve being too aggressive – equally there will be times when reasonable pre-hedging goes wrong, although probably the number one identifier of ‘wrong’ is when the LP loses money on the pre-hedge – I suspect that rarely, if ever, happens.
The bottom line is, financial markets generally, have still to come up with a method of actually judging whether the pre-hedging is to the benefit of the client, although a paper published recently, could be a big step in the right direction.
It’s a concern that ESMA seems no closer to defining guidelines or rules around the practice, but then kicking the can down the street has become a feature of European regulation when it comes to tricky issues, so it may continue for some time yet.
My biggest concern is how, over the past 15 years since the GFC, too often the authorities and law firms have applied current standards to historical conduct. Importantly, ESMA says it agrees with the views expressed by some stakeholders, requesting international coordination of any future action on pre-hedging to ensure a level playing field across EU and non-EU jurisdictions.
This is crucial, for the longer we go on without a clear definition of whether or not pre-hedging is an acceptable practice from global regulators, the higher the future risk for anyone indulging in the practice now…because as we have seen, management endorsement of a current practice is little protection against dismissal in the future when that same management is on the receiving end of a disciplinary notice.
On the question of last look, very much an FX issue, the feedback is a little enlightening, suggesting that the work of the Global FX Committee may have finally borne fruit in terms of clarifying what is, and is not, best practice. ESMA observes there remain “diverse opinions” on last look, however the “large majority” of respondents “seem to believe that last look should not be included in the analysis of pre-hedging”.
This could be because these respondents trade little in FX, or it could be that everyone is content with the guidance in the FX Global Code, specifically that pre-hedging in the last look window is poor practice.
In conclusion – and this might be seen as deferring the issue for later appraisal, ESMA states that pre-hedging is “a voluntary market practice which might give rise to conflicts of interest or abusive behaviours”.
