The Last Look…

Feedback on industry consultations is often very dry – at least in its public form – so it is both telling that the ISDA/FIA response to IOSCO on pre-hedging suggests polarisation within their members; and important that IOSCO gets this process right.

It will not be an easy job, that is for sure, but that just makes it doubly important that IOSCO provides financial markets operators with sufficient clarity to operate effectively. Polarisation comes with the territory on this issue, of course, but I suspect that one camp – and it is of significant size – will be disappointed early. Reading between the lines of both the IOSCO consultation and the public responses, it seems clear to me that those pushing for a ban are destined to be disappointed – the very fact that IOSCO wants to define pre-hedging tells us that the practice is not going to go away.

This leaves us with the challenge of coming up with something that is fair for everybody – the customers get good fills without market impact, while the dealers can operate in an environment without fear of prosecution. The first obstacle, as far as I can tell, is that it is impossible to actually guarantee the former, and unless every major jurisdiction in the world signs up (improbable) then we cannot create the latter.

There are, naturally, many shades of ISDA and FIA member, but my perception of both is that they are “dealer” associations, the first predominantly for banks, the latter for non-banks. This means that any discord on pre-hedging is significant – dealers often like pre-hedging because it is a relatively risk-free way to maximise their dealing profit, it would be fascinating, therefore, to know what type of member firm had doubts and what they were? Is it about the challenge of actually providing transparency? Of getting the right surveillance structure in place? Or is it actually lingering legal concerns? I find it notable that the consensus that may be forming is coagulating around the various industry codes of conduct – they do not provide protection against legal action, as we have discovered before.

People that I talk to about this suggest the easiest way is to hand the decision over to the customers – do the surveys, take the consensus of those whose business is actually being pre-hedged, and decide accordingly. That is, with all due respect, plain wrong. These views should be heard, but too many are going to merely state that they want to put their dealers in competition, not take on market risk, and not allow pre-hedging, thus increasing “winner’s curse” in the markets.

I genuinely cannot see IOSCO coming up with a solution to this issue, and suspect they will fall back on the industry codes, which is OK, they play an important role, but I wonder if, in turn, this means the industry code setters need to seriously revisit the issue? There is no little irony in the fact that the Global FX Committee said it was waiting for the IOSCO consultation, and that that consultation is likely to merely fall back on the FX Global Code and its equivalents in other markets. The circularity is striking.

Thanks to the high numbers of non-bank firms operating on the multi-dealer venues, $1 million is price discovery level now

From a personal perspective I probably sit in the camp that says the practice should be frowned upon, probably banned. I was really concerned to read in the IOSCO publication last year, “While the net effect of pre-hedging practice on pricing is unclear, a reduction in market risk for dealers may potentially enable them to provide a better quote to the client.”

This seems to ignore one of the basic principles of modern markets – all trades have price impact at some level. It was not always thus, in the days before computers ran the risk and pricing, market norms in the G7 sphere were around 5 million dollars, several quoted in more as a matter of routine, and 1 and 2 million dollar trades were just soaked up. To illustrate this, look at the voice broking desks at some of the big broking shops. In USD/DEM (EUR/USD today kids!) these firms had three desks – one for over $20 million, one for $5-20 million and one for $5 million and less. Guess where the price discovery was? It wasn’t in the latter.

I wonder whether the debate on pre-hedging still reflects the views from those days? It shouldn’t, because in FX alone, the make-up of participants and market structure has changed dramatically – as it will in fixed income no doubt. Now, thanks to the high numbers of non-bank firms operating on the multi-dealer venues, $1 million is price discovery level – it has an impact, albeit in tenths of a pip increments rather than whole pips.

We have a situation therefore, where the size of the deals needing a price continues to rise, but the incremental amount it takes to move a market falls. Pre-hedging a billion-dollar transaction will involve trading in smaller amounts, so let’s suppose that the pre-hedging is very conservative and only seeks to execute $200 million? Of this, perhaps $50 comes in from pricing without skew and the balance from skew and aggressive trades – both of which will have an impact. What we are effectively saying is that 50 or 100 trades for $1 million will not have an impact, which is patently wrong in the vast majority of circumstances.

Now push that scenario into a more realistic realm, where 40% of the order is being pre-hedged, or even worse, the customer has put three dealers in competition, all of whom are pre-hedging? It is not a leap of imagination to say that across the market, 120% of the trade could be pre-hedged, and we are seriously trying to say this won’t have an impact on the price?

Just this scenario makes me think that the industry bodies – ideally those like the GFXC with a good spread of members – should re-visit the issue, rather than wait for IOSCO to inevitably throw it back into their laps, but there are, no doubt, many other scenarios. There are arguments that pre-hedging allows the dealer to quote a tighter price, and they are valid, but we need to have better analysis of how much tighter, rather than bland, sweeping statements.

I don’t think anything is going to come out of the IOSCO consultation other than a definition that reflects what we already know, and is already divisive

The Westpac saga in interest rate swaps a few years back was insightful because, putting aside the disclosure and transparency issues, the customer still got significant improvement on the next best price quoted (9bp if I recall correctly?) Is this a good representation of the benefits of pre-hedging or a lucky one-off? An empirical study would be very helpful and insightful, with one proviso.

Please can we get away from this nonsense that smaller trades need to be pre-hedged. They don’t. If the dealer doesn’t want the level of risk involved, don’t quote for the trade. While I do sit in the “end it” camp, I also acknowledge that the arguments for pre-hedging are more persuasive for larger trades only, so let’s analyse for those trades only

So, more analysis please and another good, hard, look at the whole practice by industry bodies and experts through the prism of highly automated markets, with more smaller, but influential, dealers. As noted, I don’t think anything is going to come out of the IOSCO consultation other than a definition that reflects what we already know, and is already divisive.

Of course, I would not sit in the “end it” camp if we adopted another way. Sorry to get all “old-school” on you, but what is wrong with the customer talking to the dealer, allowing pre-hedging, and then the two parties sharing any improvement (or, very rarely, deterioration) in the end price? The dealer can quote an aggressive price to win the trade, start dealing straight away, but it is in their interests to minimise market impact because they will share in the rewards for doing so. This used to be called “working an order” where the economic benefit (or detriment) is shared. Yes, this does mean dealers giving away some of what they would make in the current circumstances, but I reckon a basis point or two is better than a year or more in lawyers’ offices and a court room.

colin@thefullfx.com