The Last Look…

I think everyone knows by now that pre-hedging bothers me – it raises too many risks, is cloaked in ambiguity, and lacks transparency – but reading through the IOSCO report on the practice, it struck me that not only do some people have a strange idea of what pre-hedging is, they also appear to be engaging in, or at least suggesting, conduct that I would argue is unacceptable.

The theme that got me worried was when the IOSCO document noted how some queried the practicality of trade-by-trade disclosure for pre-hedging. It states, “For example, some respondents do not believe that trade-by-trade disclosure is practical for competitive RFQs sent on electronic trading platforms, as these are largely executed by automated trading algorithms, and dealers may not have a direct relationship with clients.”

I would be highly surprised if a client sent an RFQ for a trade that was big enough to need pre-hedging, to a counterparty with whom it didn’t have a relationship, without any prep. The normal way of handling these things is to ask competitively for a two-way price, or to engage in discussions with various counterparties about the expected spread and liquidity conditions, before trading.

To me, those firms feeding back that opinion are likely to be, or are promoting the concept of, pre-hedging “normal” trades, i.e. in amounts that shouldn’t present a problem for risk managing. If that is the case, then they are not “pre-hedging”, they are front-running – and that, in a nutshell, is why I have a problem with how we deal with the issue; the two strategies are simply too similar.

I would also ask the question, are those parties also trading in the last look window? It seems to me that they are talking about a “problem” with a standard RFQ, therefore, the chances are the “pre-hedging” they conduct is actually trading in the last look window, which has been officially frowned upon.

The IOSCO report reinforced this in my mind by also noting, “Certain industry respondents noted that sending competitive RFQs on electronic trading platforms typically involve smaller trade sizes and that the ability to provide trade-by-trade disclosure is not a function generally available on these platforms and would require systems changes.”

If a client is sending smaller trades in competition, why should a dealer be pre-hedging? They’re just being asked a price

The question remains, why would they need to pre-hedge smaller trades? I can only think of two types of player that might believe this, firstly, the prime-of-prime/broker type that is executing on behalf of – but then why would they have to disclose pre-hedging? They’re an agent, and I think we all agree pre-hedging in an agency environment is…what’s the phrase?…that’s right, front-running. I should note here, that I hope this doesn’t involve another one of my detested phrases that have entered the FX market lexicon over the past 15 years, “riskless principal”.

The second type of player is one among the host of non-bank “market makers” that actually only make in one million units (or less). For all their protestations that they hold risk, if they do it’s for milliseconds, so perhaps these firms are trying to get pre-hedging more in the mainstream so that they can compete (and pre-hedge) trades for three-to-five million units?

The IOSCO paper also states, “Industry respondents have also suggested that clients on electronic trading platforms are generally sophisticated institutional investors who may not need disclosure and would prefer to avoid delay in the speed at which their trades are being executed.”

Fair enough, but again, if they’re sending smaller trades in competition, why should a dealer be pre-hedging? They’re just being asked a price. This is especially worrisome when it comes to “full amount” trading, which is, naturally in the modern market, nothing of the sort. Are these participants suggesting that they would pre-hedge future trades in a “full amount” relationship? Again, sounds like front-running to me.

If the IOSCO consultation was just about fixed income markets, I think there could be a case for some of these comments, especially in illiquid bonds, but they are including FX in it, which doesn’t need the same structure built around the practice because liquidity conditions are so different.

There was an interesting couple of insights elsewhere in the consultation paper, one stating the obvious, the other obvious to anyone in the know. Firstly, the paper states, “Pre-hedging more than the anticipated full amount of a client transaction may not meet the objective of genuine risk management and is more likely to negatively impact market integrity and result in a worse outcome for the client.”

Well yes, obviously, and this could also be viewed as insider trading, because the dealer is, inadvertently or not, taking a position on the information about the impending trade, but I suppose it needs to be said. What happens, however, if a client decides to split a trade? Then a dealer has “over-hedged” and is in a tricky spot – they haven’t done it deliberately (supposedly), but they are vulnerable, is that a legal risk?

This leads into the second interesting point from the paper, and I paraphrase, “dealers need to consider how to exit positions built through pre-hedging, if they don’t win the trade”.

This is naïve in the extreme. In the first instance, only someone with less than honourable intent is likely to pre-hedge 100% or more of the trade (last time I checked, that was “working an order and passing on the fill”; in the second, what do they think the dealer is going to do? They will let the “winner” do the trade and then stick the bid or offer in, making nice money along the way.

This consultation paper has done nothing to allay my fears that pre-hedging remains a ticking time bomb for the FX industry

I like how IOSCO explicitly observes that these positions could be in correlated markets, this at least shows it is aware of the need to check these positions as well. Equally, I do think it important that we have some clarity over the practice of pre-hedging to provide some semblance of legal certainty for players using it.

Overall though, this consultation paper has done nothing to allay my fears that pre-hedging remains a ticking time bomb for the FX industry. It’s clear that some people think it OK to “pre-hedge” smaller trades where there is plenty of liquidity available, but the reality is that this practice should only be thought about for very large trades in reasonably liquid markets (and we all know what they are, and if liquidity disappears, that’s just bad luck).

There should also be a message for the clients here, don’t put these trades in competition, even though that does raise issues around best execution policy. I have stated many times before, ask three dealers for their price, if all three pre-hedge 40% you’ve wrecked your market – unless of course, they are happy to pass on their fills, which would be…what is it?…oh, yes, working an order!

When the FX Global Code was first published, the two main issues that were not resolved in many minds were last look and pre-hedging. To a degree, the former has been dealt with, but the latter remains a sore that continues to trouble the industry, and even after this much-awaited paper, it shows no sign of being resolved.

colin@thefullfx.com