The Last Look…

The information released regarding the episode between Westpac and its client that led to the bank being fined for its pre-hedging activity neatly lays out the challenges around pre-hedging as a practice.

The key words are “trust” and “transparency” and frankly neither party seemed that interested in living up to the platitudes of “working together in an open and transparent manner”. The bank was intent on pre-hedging the minute it realised the customer wouldn’t work with it to execute the order, and the customer, by its own admission didn’t trust the banks. As the advisor to the consortium wrote ahead of the M&A when discussing the hedging options, “We must keep the banks in the dark about who is going to be executing. They can’t know for sure they are getting a piece of execution until the very end, otherwise they will all be in the market beforehand moving the price higher.”

This attitude permeated the entire process – Westpac’s trading desk expressed its preference to hedge the transaction over 24-48 hours, but the customer wasn’t interested in giving notice. In fairness it didn’t want the market risk, but it was also concerned about market impact and the execution risk, therefore perhaps it should have worked closer with the bank? As a friend pointed out to me last week, it’s interest rates, it’s not as though they can go nuts like the exchange rate!

All that said, it’s hard to argue, thanks to the detail in the ASIC documents regarding the case, that the customer should have given the bank that much time – it would rightly argue that it did give Westpac a couple of hours’ notice and look what happened! I, naturally, would argue, because of the aforementioned point that rates markets have natural bounds and therefore market impact, while costly, is restricted and 12 yards over a day may well have been a comfortable trade. It certainly seems it would have been so over two days.

What stands out to me from this episode is the aggressiveness of Westpac’s pricing – it was less than half the mark-up of the only other bank to officially price for 100% of the trade, CBA. One has to ask the question, was it, at ASIC asserts, premised upon large pre-hedging? It is clear that Westpac was aware the customer was not going to give it much notice of the trade, therefore should it have priced more defensively? It’s not as though the bank wasn’t alive to the potential cost, four senior managers shared their fears that the other banks would know of the trade being won, and regardless of intentions, the market would move against them.

In the age of improving TCA and increased electronic trading, surely the way forward for deals such as this is for the parties to actually work together in an open and transparent manner?

Another factor in favour of working with the bank is its ability to book build passively. With a day’s notice perhaps, Westpac could have been passively in the market soaking up liquidity to minimise market impact. The big question is, in the absence of proper TCA for these markets at that time, would the customer be confident in their fills?

It does make sense, to a degree, if they know they have the deal coming, for the bank to hold on to certain trades executed on a passive basis – but what actually happened was they went aggressively into the market in the hour or two before the trade was confirmed. Trust? Hard to achieve in such circumstances.

Another challenge around pre-hedging is the sheer size of the deal and keeping it quiet. The sense is that by trading aggressively ahead of the deal confirmation (but after it had been given the word it would win it), Westpac wasn’t sure it could trust the customer to keep the underlying M&A trade quiet for 24-48 hours as requested.

In reality, the news leaked within an hour of the IRS trade being done and it is clear from the transcripts that the customer’s advisor was very angry at events in the market, which he clearly placed at the door of Westpac. In the event, after the news was leaked, the transcripts show the head of fixed income trading at the bank as saying that the desk had almost finished exiting the risk – and the end result was a $20.7 million profit, so it wasn’t badly hurt, but again the expectation of trust – that the M&A would be kept quiet – was again overblown.

Incidentally, there has been some criticism from my network of the customer’s timing, noting that the Australian employment report was due just over 60 minutes after the deal was actually executed, but the reality is the M&A transaction completed that morning at 7am, so it’s hard to know what else it could have done. Westpac asked for the deal to be done after 10am so the EFP market could build liquidity, but it was effectively told it had the deal just after 8am.

Another challenge with pre-hedging is one I have raised before – to a degree it ties the customer’s hands. In most cases the customer, as happened here, is trying to exit the risk as cleanly as possible and that means risk transfer. By pre-hedging, Westpac clearly moved the market against the customer, meaning had it decided to go to another bank, it’s rate would have been a lot worse, and, into the bargain, the winning bank may also have struggled to access sufficient liquidity because it had already been soaked up by the pre-hedger. Imagine if that happened three times over? In this case, ASIC makes it clear that two other banks – CBA and HSBC, explicitly sought the customer’s approval to pre-hedge. The customer can perhaps count itself lucky that they were so honourable.

Hopefully now the adults in the room take control of these situations and these trades are executed in the way they should be – fairly and in the best possible fashion for both sides

The minute pre-hedging starts it alters the balance of the relationship, unless it is disclosed, and, as should be the case where there is an agreed mark-up, the pre-hedging trades should be part of the end price calculation (yes I am looking at you WM Fix!)

The only way to avoid this scenario is one that was raised in an academic paper last year and that is changing the timing or holding onto the risk. This plunges the customer into a game of “chicken” with the pre-hedger over who blinks first – the one with what is intended to be a short-term position that quite possibly breaks normal risk limits, or the one looking nervously at the market with a massive position on board that it doesn’t want?

Ultimately, this case, as so many others that have gone through the law courts have been, is about disclosure and consent. In this case it is clear the bank did not provide disclosure and did not receive consent. Although in hindsight things may have gone differently, the fact is that in spite of a lack of trust on the part of the client, Westpac still won the deal – and this highlights a truism in markets. For all the good you try to do, price will always win. In this case two banks did ask about pre-hedging and didn’t win the deal, which is hardly conducive to getting people to do the right thing next time.

There is one other factor to consider in all this, however, and it is a bigger picture thought – as well as an argument put forward regularly by proponents of pre-hedging. Pre-hedging allows the bank to quote a tighter price. Westpac’s pre-hedging moved the market 1bp, costing the customer, apparently, AUD 4.7 million. Westpac’s price was 7bp better than CBA’s, so saved it at least 6bp, presumably more than $28 million.

So the customer got a better price thanks to the pre-hedging, but the bank didn’t disclose its activity, largely because the customer didn’t want it pre-hedged!

In the age of improving TCA and increased electronic trading, surely the way forward for deals such as this is for the parties to actually work together in an open and transparent manner? By taking this approach, the customer would have saved $4.7 million because all trades would have been included in the TCA, and it would have received best execution at the cheapest mark-up. The bank, in turn, would have made its money and boosted its reputation for handling big trades in a fair and professional manner.

In this case, the lack of trust served neither side well, and while we can reasonably point to the actual events as evidence trust doesn’t work, that would be wrong. Independent TCA enforces trust and ensures that trades are executed in a fair fashion – cause excessive market impact and the data will show it.

All that has really happened here is, yet again, a lack of trust has led to the lawyers getting rich – hopefully now the adults in the room take control of these situations and these trades are executed in the way they should be – fairly and in the best possible fashion for both sides.

colin@thefullfx.com