The Last Look…
Posted by Colin Lambert. Last updated: June 23, 2021
OK. Tin hat on? Check. Flak jacket? Check. Let’s dive back in to pre-hedging!
I have been asked by quite a few people what I thought of the GFXC’s response to my column in May in which I argued that we were lacking clarity on pre-hedging. My answer is unequivocal – I welcome any clarity provided on the subject and this letter did that – I understand my column may have been less than welcome in some circles, but it represented a genuine desire to stop the industry sleepwalking into another period of legal strife.
One thing that I think everyone agrees on is that the subject is very complex and there is no easy answer – and this is highlighted by two of the indicative examples of unacceptable practices cited in the letter.
The first is “buying or selling an amount shortly before a fixing calculation window such that there is an intentionally negative impact on the market price and outcome to the Client”; the second is “showing large interest in the market during the fixing calculation window with the intent of manipulating the fixing price against the Client”.
On the first, I read a report last week about the arguments currently being heard in the UK High Court in the ECU Group vs HSBC lawsuit. ECU alleges HSBC front ran several stop loss orders, however the bank has counter-argued that while related trading may have taken place ahead of the order, it was not intended to affect the market price.
This highlights the argument I was making in my original column and the challenge facing the GFXC with the Code – proving intent to push a market through a certain level is difficult, but the fact remains the market did go through the level and the optics are not good. I think we, as an industry, need to reflect on the perception of our arguments – it just sounds lame to argue that we buy and sell in the market and don’t expect it to affect the market price.
We need to acknowledge that the likelihood is that pre-hedging (or hedging ahead of the fixing window depending upon which terminology you prefer) will affect the market price
It’s not the fault of the executing parties, it’s just reality. There are a host of market participants out there who spend their time trying to sniff out orders and jump ahead of them. They are using public information and are not breaking any rules, the way the market works allows them to do that.
This means we need to acknowledge that the likelihood is that pre-hedging (or hedging ahead of the fixing window depending upon which terminology you prefer) will affect the market price. If a client doesn’t want their order pre-hedged they should accept a longer execution window (and yes, they should be offered one by benchmark providers!)
This brings me to the second of the above examples in the GFXC letter. Most agree that showing large interest in the window will have market impact because the window is too short to allow it to be consumed by natural interest – and given how most Fix business is conducted by algos according to a set pattern, there should be no intent to manipulate the fixing price. The fact is, again, that it most likely will affect it, though.
I understand why the key word in the Code is “intent”, however that leaves too much ambiguity – and as history indicates, there are plenty of people out there willing to claim “intent”.
The two examples highlight the scale of the problem – showing large interest ahead of the window can move the market, as can showing large interest in the window itself. Thrown in the fact that clients are pumping such large interest into the window and you have the whole issue in a nutshell. Large risk ahead of the window can be misinterpreted, as can a large move during the window.
We have been going to-and-fro on pre-hedging pretty much since the embryonic version of the Code was first published five years ago and my call in my original column remains the same – I think we need to make an exception and be more prescriptive on pre-hedging (and last look for that matter).
The “cleanest” way to solve this is issue is for executing parties to stop pre-hedging altogether – a few blow outs in the window will highlight the scale of the issue and bring users (and providers) to their senses.
Personally, the way I read the Code, I think it’s pretty clear that, as the letter stated, “pre-hedging should be more of an exception than the norm”, i.e. that it should be avoided as much as possible. With legal actions in the UK and Australia (albeit in interest rate swaps in the latter case) that both seem to revolve around pre-hedging, there may be a few observations to be made on the Code post-decision, but in the meantime I think the messaging has to change.
The “cleanest” way to solve this is issue is for executing parties to stop pre-hedging altogether – a few blow outs in the window will highlight the scale of the issue and bring users (and providers) to their senses. Whichever way we look at it, by trying to make the overall execution better through lower market impact, the executing parties are running future legal risk.
Even I recognise, however, that is unlikely, therefore clients need to be told that pre-hedging will affect the market price and be given the choice on their orders. For stop losses, they can choose between taking a fill involving pre-hedging that reduces the risk of a market blow out and significant slippage, but offers an increased likelihood of the order being triggered; or they can trust to the market and accept whatever slippage comes from the execution of their order the (milli)second the execution criteria is filled.
For fixing orders it’s a little tougher, but they have the choice between smoother execution with the executing party making money out of the pre-hedging (or hedging), or the risk of a blow out in the window.
That means a more positive approach to the issue, rather than trying to finesse and keep all parties happy. And if anyone out there is in any doubt as to what I think should happen, let me make it clear – short of WM doing the right thing and easing the fixing problem, it’s time for the client to take some responsibility and make an informed decision. Where the GFXC and the Code can help, in my view, is by making it even clearer than it currently does that the relevant information should be provided – and not just in a generic disclosure.
It’s hard trading in this market without impact, significantly more so when the amounts are large (and the definition of “large” is diminishing), it’s about time the client base was woken up to this fact. Only then, can say that we have solved the issue of pre-hedging, when, to paraphrase the GFXC’s letter, legal action becomes the exception rather than the norm.