IOSCO Publishes Pre-Hedging Consultation

IOSCO has published a much-anticipated consultation document on pre-hedging, following a survey of its own members, seeking wider views on what remains a controversial practice, and while the proposals would provide an globally-implemented framework for dealing with pre-hedging, the more complex, and potentially challenging, aspects of the practice are unlikely to see any real clarification.

The divergence of views can be found early in the IOSCO paper, when, while noting that pre-hedging can offer benefits to clients, it also observes that a range of supervisors, regulators and market participants have raised concerns about the appropriateness of the practice. Indeed throughout the paper, IOSCO highlights a difference of opinion within the industry itself, over not only whether the practice is appropriate, but what framework should exist to monitor and execute pre-hedging strategies.

While the paper looks at financial markets generally, it focuses mainly on OTC markets, at one stage noting that a large number of pre-hedging transactions take place in fixed income markets. Notably, for those used to hedging ahead of the London 4pm Fix, the paper states that transactions agreed that will take place later, will remain as “hedging”.

IOSCO’s proposed definition of pre-hedging very much reflects that in documents like the FX Global Code and FMSB’s Standards. It defines it thus; “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”

In keeping with the general tone of the paper, which effectively leaves a lot of the judgement questions up to the dealer, IOSCO suggests that when deciding if pre-hedging is appropriate, the dealer should do so only for genuine risk management purposes, and, if necessary in low liquid markets, for the purpose of “test” trades.

Again, the paper highlights the lack of clear direction, by stating, “While the net effect of pre-hedging practice on pricing is unclear, a reduction in market risk for dealers may potentially enable them to provide a better quote to the client.”

It adds, “IOSCO believes that pre-hedging should not move prices against the client’s interest and should be used with the intention to benefit a client.”

Panacea or Specifics?

The IOSCO paper spends a lot of time on the conduct risks associated with pre-hedging, although again, it fails to really provide a new, or clearer, direction for market participants. Under the trite, “pre-hedging should only be to the clients’ benefit”, it suggests dealers consider factors such as the client’s instructions regarding pre-hedging, price, speed of execution, expected market impact, trade size and liquidity, and an overriding responsibility to treat the client fairly.

It adds, though, “This recommendation does not mean that every individual pre-hedging trade guarantees the best possible outcome for the client. However, the dealer should be able to demonstrate it reasonably considered these relevant factors in forming its intention to benefit the client before undertaking pre-hedging activity.”

In what might be seen as worrisome by some clients, IOSCO also, perhaps inadvertently, taps into the biggest potential controversy, P&L. “These recommendations do not create an obligation to share all financial benefits derived from pre-hedging with the client,” the paper states.

The paper also, again obviously, stresses that when pre-hedging orders, dealers should minimise market impact and maintain market integrity. It then states, however, “IOSCO acknowledges that it may not always be possible for dealers to ensure pre-hedging does not result in market movements.”

IOSCO also asks the question, within the risk section, what type of disclosure is appropriate? The paper’s recommendations to minimise conduct risk look very like the FX Global Code – document, disclose, prior consent, have the trading appropriately overseen, manage access to the information and conflicts of interest, and maintain adequate records of the pre-hedging for oversight and regulators.

An interesting question for the industry is, should upfront disclosure be required irrespective of the trade size and complexity?

The paper does, however, get into something of a muddle on this question, whilst noting that there is currently no standard practice on how dealers disclose pre-hedging activities, with some using blanket disclosure language, others more specific, trade-by-trade disclosure, and yet others do it post-trade. “We note that dealers may use a combination of disclosure practices or choose not to disclose to their clients their pre-hedging practices at all,” the paper observes drily.

More pertinently, after earlier stating that, “The assessment by the dealer of whether there is a legitimate expectation of a transaction from a client would likely be undertaken on a case-by-case basis,” the paper then observes that some industry survey respondents have “queried the practicality and usefulness of trade-by-trade disclosure”.

An interesting question for the industry is, should upfront disclosure be required irrespective of the trade size and complexity? The paper also asks what should be the minimum content of an upfront disclosure, noting the importance of differentiating between bilateral OTC, competitive RFQ transactions and pre-hedging in the context of electronic transactions?

For the clients, IOSCO recommends they consider using two-way RFQs to muddy the waters for the dealers, and better monitor market prices. They could also consent to a pre-agreed strategy, or tell the dealer they don’t want any pre-hedging. Finally, they can ask, after the trade, how the pre-hedging benefitted them.

One thing for clients to consider that is not mentioned by IOSCO in this part of the consultation, is that of competitive quotes. Elsewhere in the document, however, the consultation makes clear that there are risks associated with this, noting, “A client requesting a quote from multiple dealers who pre-hedge may incur greater price slippage as the pre-hedging impacts the market price. Pre-hedging by one or more of the dealers may impact the price and availability of liquidity for the client, creating slippage costs for the client and potentially resulting in a worse outcome…In a competitive RFQ situation where there is a risk of multiple dealers pre-hedging, any slippage costs may be amplified.”

The full paper can be accessed here, and consultations using this link, can be submitted up to and including 21 February 2025.