Pre-Hedging Fixing Orders Can Benefit Clients: Study

For large fixing orders, it benefits both the client and the dealer carrying out the transaction to hedge in the pre-fix window, as long as certain liquidity conditions are satisfied, according to a new study examining behaviours around the 4pm benchmark. Eva Szalay takes a look.

The paper, dubbed Hedging of Fixing Exposure, was written by Deutsche Bank’s global head of FIC quantitative trading, Roel Oomen, alongside Imperial College’s Johannes Muhle-Karbe and Benjamin Weber from Carnegie Mellon University.

The tension between client and dealer interests that arises when banks hedge fixing orders before the calculation window opens was the central focus of the paper, as the authors sought to study the price outcomes for clients. The authors looked at how dealer’s behaviour around the fix influenced client outcomes while taking into account available liquidity and the size of the fixing orders.

They found that for small orders relative to available liquidity it made no sense for dealers to hedge before the fixing window. However, hedging before the window can benefit both dealer and client in the case of outsize orders as long as liquidity conditions are appropriate. “We show that smaller fix exposures are fully hedged over the calculation window, but that larger fix transactions are optimally hedged over a longer horizon that includes the pre-fix window,” the paper states.

It adds that this is true only under certain liquidity conditions, such as “when the transient price impact dominates permanent impact and decays sufficiently quickly”. In other words, the benefits only arise if the price impact of the pre-window hedging doesn’t filter into the calculation window, driving it against the client’s interests. “Hedging ahead of the window reduces the dealer’s exposure while any associated market impact that persists into the calculation window drives the fixing rate against the client,” the study notes.

The 4pm fixing came under regulatory scrutiny 10 years ago that resulted in billions of dollars of fines across the largest banks and subsequent reforms to the fixing window which was lengthened to five minutes from one previously. A key issue in the debate is how best dealers can manage the conflict of interest that arises between them and clients as a result of the price impact of their hedging activity feeding into the fixing.

As soon as dealers start to hedge before the fixing window this conflict of interest becomes an issue because they suddenly have a vested interest in the level at which the fix settles. Last year Oomen co-authored a study that examined pre-hedging as a broader practice and found that pre-hedging can benefit both clients and dealers, under certain conditions.

The latest paper is at pains to stress the differences between the two practices and it notes that the two should be treated separately. “While there is a tendency to conflate “pre-fix hedging” with “pre-hedging”, these are fundamentally different concepts that deserve a separate treatment,” the report argues.

A key difference is that with pre-fix hedging dealers have to handle a known amount at a known point in time and benchmark. Pre-hedging, meanwhile, is inventory management in anticipation of a potential trade from clients at an unknown time and probably in competition with other banks. “A feature shared by both, however, is a potential conflict of interest between the dealer’s hedging activity and the client’s effective transaction costs,” the authors note.

In recent years, pre-hedging has also attracted controversy, regulatory attention and settlements. It has also attracted lively debate in the context of the FX Global Code – in the last refresh of the Code, a guidance paper on pre-hedging was published, however it does not, at the moment, form part of the formal Code.

Global standard setter IOSCO concluded a consultation about pre-hedging in March and it’s set to report on the feedback in the second quarter of this year. It will issue a final report in the fourth quarter, in which it will lay out its assessment on the vulnerabilities in pre-hedging practices by dealers and its guidance on how these issues can be mitigated. European regulator ESMA said last year that it might issue further guidance on the practice once IOSCO’s work on the topic is concluded.

Oomen and his fellow authors found in July last year that pre-hedging can benefit both parties because better risk management over a longer horizon allows dealers to tighten spreads, which “more than offset” any possible adverse impact that their pre-hedging had on the execution price. They noted that this is only true if dealers don’t engage in pre-hedging “too aggressively.”