The Last Look…

The pre-hedging Spotlight Review from the FMSB merely serves to highlight, in my view, just how difficult, and potentially risky, this practice is for the financial markets industry and how equally critical it is that either some legal certainty is provided, or the practice is discouraged in best practice documents.

You want an idea of how difficult the issue is? Well, the FMSB Review lays out the key characteristics of front running and pre-hedging (as well as inventory management), and they share two of six characteristics noted! It must be hard for non-experts (the majority of the world) to understand the nuanced arguments of the financial industry, when “using information provided by the customer relating to an upcoming trade or trades” and “necessitates knowledge as to nature of an anticipated trade e.g. indication as to instrument, size, direction etc.” are seen in the paper as key characteristics of both front running and pre-hedging.

I should stress, the FMSB’s review highlights how pre-hedging should benefit the client and not disadvantage them (this is pretty much the language in the FX Global Code as well), and that front running has the unique attribute of being a transaction “solely for a person’s own benefit taking advantage of the anticipated impact of the trade on the market”; nonetheless, it’s easy to see why people get confused.

One fear I have with the debate as it stands, (and IOSCO also has work going on in this field, but my sources say it is, at this stage, unlikely to provide any clear direction), is that we are heading to a world whereby pre-hedging will be judged empirically, post-trade. In other words, if the pre-hedging delivered a clear benefit to the client (and I am unsure if that can be proved on a systematic basis), then it is OK.

But what about occasions when the pre-hedging doesn’t deliver a better outcome? A better outcome is, and should remain, the intention of pre-hedging, but predicting markets is a difficult process, it will go wrong on occasion – what protections are in place for the LP in these circumstances? The pre-hedging could be taking place with all good intention, but another, unrelated, order could hit the market at the same time – how will be this be factored in?

The last thing we need is a loose system in place that judges the effectiveness of the pre-hedging by its outcome – and that is why we need, sadly for an OTC market, hard and fast rules from major regulators. Another challenge, of course, is even achieving that – some jurisdictions are definitely taking a dimmer view of pre-hedging than others.

Looking at the FX market specifically, the FMSB paper is helpful, but misses out on a big factor given its focus on RFQ deals. The Review notes that pre-hedging may take place from the quote until the trade is completed, at which time risk management activity is considered “hedging” as the risk transfer has taken place.

Fair enough, but this doesn’t deal with benchmark fixes. In these, the transfer has taken place, I agree, but at what rate? The “hedging” activity that takes place ahead of the window affects the price – as I have asked so many times, why would you (correctly) execute an order over 20 minutes and only accept TCA for the last five?

While the great and the good continue to argue that pre-hedging and “hedging ahead of the Fix” are different things, they share one very important factor – in neither case is the end price actually known – and any trading ahead of that order being completed, or Fix being established, will affect the price. We do not want to be heading down a road with pre-hedging where the practice is judged by market impact – again, this could be down to a host of factors, not just the pre-hedging.

On the fixes, it is pretty obvious, but never certain, that the dealer is not the only LP executing fixing flows – it only takes one poor execution to spoil the outcome for everyone – and sometimes (often!) that spoil comes from third-parties using the market data to speculate.

So, to go back to the FMSB paper and commonalities between front running and pre-hedging, what if multiple parties are using the information provided by the customer, or have knowledge of the size and direction? As things stand, a client could, under their best execution policy, put three dealers in competition, which would be a reasonable number to help achieve best execution.

The industry continues to walk a regulatory and reputational tightrope, with its actions measured by inconsistent and vague parameters

What happens, however, when all three dealers start pre-hedging? Yes, they will all be doing so prudently (whatever that actually means in these circumstances), but there will be market impact, and two of them will probably benefit from having stuck a position on and then having to buy it back when they lose the deal to the winner. This certainly benefits the winning dealer as they have liquidity to execute the balance, and it certainly benefits the losing dealers because they probably make some money on information from a trade they didn’t win, but the client? That’s a tricky one.

It could be argued, reasonably, that the client has created the situation by putting the dealers in competition, but if that’s their best execution policy, are we now saying that is wrong? Personally, I don’t think big trades should be put into competition, the information leakage is too much, but clients continue to do it – and when was the last time you heard someone say the client was wrong?

Surely a better way is for the client to work with one dealer to ensure the trade is executed reasonably, professionally and quietly (or actually do it themselves over time)? The problem with this is it does not, or should not, involve pre-hedging – the dealer would be executing on behalf of the client and passing the fills on. True, the client would have the market risk (I am sure that a maximum level of slippage can be agreed up front), but do we really think that a dealer would take advantage of the information to put on a position? That would be fulfilling the FMSB’s only unique characteristic of front running and would surely attract the attention of internal oversight and, eventually, external authorities?

And that is probably where the biggest obstacle to a solution to the pre-hedging conundrum lies – trust. It is clear to me that to minimise market impact and signalling risk, using one dealer is best for large trades. Equally I believe that all dealers would be willing to put a maximum slippage in place to ensure the client has a reasonable outcome should things go pear-shaped during the execution.

Both internal and third-party oversight can ensure the execution is handled well (I would also note that the client’s internal oversight should check communications out of the dealing area to ensure information security), meaning a trade is executed, with full TCA and transparency, and in a fair fashion to both dealer and client.

Given the amount of study going into the practice, it is clear that pre-hedging is not going to go away as an issue, we can only hope for legal certainty, but I, for one, am not holding my breath. Until then, the industry continues to walk a regulatory and reputational tightrope, with its actions measured by inconsistent and vague parameters.

The pity is, we could lose the whole “pre-hedging” thing and reflect back on it as a phenomenon of less than two decades, if we deploy modern technology in support of the old-fashioned concept of trust. Most of us had never heard of pre-hedging 20 years ago, the hope is our successors are not talking about it 20 years hence.

colin@thefullfx.com