FMSB Publishes Pre-Hedging Case Studies

In an effort to bring some clarity to a perpetual grey – as well as controversial – area in markets, the Financial Markets Standards Board (FMSB) has published a Spotlight Review containing a series of case studies on the practice of pre-hedging.

Observing that a founding objective of the body was to “address areas of uncertainty in specific trading practices”, FMSB observes there remains uncertainty in FX, fixed income and ETF markets as to how and when pre-hedging may take place, as well as the rationale and client benefits deriving from the activity. It also highlights uncertainty between inventory management, pre-hedging and front running.

The Review starts by setting four fundamental questions that need addressing: what constitutes pre-hedging, in what circumstances is it appropriate, how should the activity be disclosed to clients, and what policies should the LP have in place when it does pre-hedge? FMSB stresses that the paper “is intended to advance the industry debate on pre-hedging but not codify standards of behaviour”. It adds it will determine if standard-setting work would be beneficial in this area in due course taking into account international regulatory developments – most likely ongoing work by IOSCO into the practice, although the Review notes that pre-hedging is not defined under EU or UK law.

The review studies the treatment of pre-hedging by the EU and UK authorities, subject to it not being defined of course, and reiterates the idea that it only constitutes activity between the quote and the trade being executed – after which any activity becomes straight hedging as the risk transfer has taken place.

The Review leans heavily on FMSB’s own Standard for the execution of large trades, as well as the FX Global Code, specifically Principle 11, however it acknowledges that the former is limited to out-sized trades and the latter to FX markets. Four case studies have been published, although the first has four different scenarios of its own – the focus of the first three is RFQs, and the last new issuance.

The case studies lay out considerations for any participant considering pre-hedging, as well as areas of focus that could help determine its appropriateness. It also includes ongoing considerations for LPs across the trade cycle.

The Review was developed by an industry-led FMSB Working Group chaired by David Morris, head of Rates for Europe at BlackRock, under FMSB’s Market Practices Committee, chaired by Kieran Higgins, head of flow Rates trading, EMEA and co-head of global finance & Rates SM at Citi. “A lot of time and effort has gone into the case studies given the broad range of expert views and I think the final paper is a valuable contribution on a complex topic,” observes Morris.

Higgins adds, “These case studies are a helpful practical contribution to the broader industry debate around pre-hedging. This is precisely the type of topic where FMSB, in bringing together a diverse set of market experts, can play a valuable role.”

Finally, Myles McGuinness, FMSB CEO, says, “When FMSB was established, it was tasked with addressing gaps between regulation and actual market practices. Pre-hedging sits squarely in this space. This Spotlight Review will inform further debate on the practice, improve transparency and understanding of when and how pre-hedging occurs and the impact it may have on client execution through practical case studies.

“We await further work on the topic, including from the international regulatory community, with interest and will consider how this may inform our next steps,” he adds. ”I would like to thank our members for their contribution and to Blackrock’s David Morris, for chairing the Working Group.”

The full paper can be accessed here.