The Last Look…

There are many things in life that inevitably end in disappointment, West Ham going 2-0 up only to lose; every second date I’ve had that realised I peaked early; new governments: To this we can add pre-hedging reports from IOSCO – was that it? Was that what we were waiting for? But also, was it as disappointing as some thought? A couple of things jumped out of the pages of the report at me.

First of all, it is important to establish one fact – the reality is IOSCO was never likely to blaze a new trail on pre-hedging – as I have written before, it’s just too difficult to achieve. This means the headline take-away from the report is that nothing has really changed, but there are some points worth making.

Firstly, the definition of pre-hedging, which was very much in line with the various Codes, said the following; The dealer has to be acting as a Principal – tick. The trades are executed in the same/related instruments in anticipation of winning a deal, (before the client has agreed) – tick. And, interestingly, the trades are executed with the intention of benefiting the client.

The latter is, in itself, not interesting, but the accompanying footnote states, “’Client’ in this context includes counterparty and does not give rise to any agency relationship or fiduciary duty.” So, this applies to all counterparties? Mark Johnson must be bewildered, given one of the planks of the prosecution’s case that ended up with him in a US jail was that he had a fiduciary duty to Cairn Energy…

The second point is the report stresses that the recommendations should not be regarded as a “safe harbour” from applicable market abuse rules, which suggests the world has not got any safer for those that use pre-hedging – all it will probably need is one instance of the practice going wrong and someone will be in trouble, innocent or not.

Third up, from what I can see, the only rationale proponents of pre-hedging of competitive RFQs had was it “may” promote competition by allowing smaller dealers to compete. Is that it? These are probably very intelligent people, but how dumb, or wilfully ignorant, do you have to be to think that if four dealers make a price to a customer, three will think they won’t win it?

By providing “a clear process to modify or revoke that consent at any time with reasonable notice” IOSCO does appear to have opened a door, and it is one that few dealers will be happy going through

I cannot comprehend how people could think this – in the above instance, all four will be pre-hedging, because now they will know which way the market is going and how are you going to prove that three of them didn’t think they’d win the trade? It’s nonsensical, and it’s why customers should either ask for a two-way (although even here the direction will be obvious on a majority of occasions), or refrain from putting such trades in competition and using an independent TCA provider (they could also delay the trade – that could cause some fun and games…)

The commentary around Recommendation A2 is interesting. The Recommendation states, “Dealers should undertake pre-hedging only with the intention of benefiting the client.” In its discussion however, IOSCO also states that it agrees with “certain respondents” (I can probably name them!) “…that market conditions and the actions of other market participants can lead to dealers not being able to capture the envisaged client benefits by pre-hedging. In this respect, the intent of the dealer to benefit the client – and the existence of policies and procedures– is an important element of meeting their responsibilities to the client.”

So it has to be for the benefit of the client, but may not be. I get that markets are notoriously difficult to predict, but once again, we head back to that very difficult to prove one way or the other factor – intent.

The main thing that jumped out of the pages of the report at me, however, involved Recommendations B2 and B3, which deal with disclosures. Providing a summary of the feedback, IOSCO says that there were “mixed views” on trade-by-trade and post-trade disclosures – nothing new there. There was “general support” for proportionate disclosure and “where feasible and appropriate” trade-by-trade disclosures, largely this seems to be around larger transactions, which makes sense, but does make one wonder if we are not leaving ourselves wide open to bad actors pre-hedging every deal, especially in an electronic environment?

Ultimately though, B3 is the big one for me. It states, “Dealers should (i) seek to receive prior consent to pre-hedge from the client at the outset of the relationship, and (ii) give the client a clear process to modify or revoke that consent at any time with reasonable notice.”

Inevitably, some respondents (again, I think we know where they are from) argued that the blanket disclosures in the Terms of Business signed by every client was sufficient, but IOSCO seems to have come down on the side of encouraging dealers to seek explicit permission on certain trades – i.e. large tickets or trades in very illiquid markets.

My first read of the report had me believing, like so many correspondents over the past week, that there was nothing to see here, but perhaps we have under-estimated the potential of B3 to change things?

That’s pretty much in line with the practices in the Codes, but the second half is interesting to me, because it seems to give clients the opportunity to expressly forbid pre-hedging in certain circumstances. By providing “a clear process to modify or revoke that consent at any time with reasonable notice” IOSCO does appear to have opened a door, and it is one that few dealers will be happy going through.

IOSCO itself highlights the unhappiness of buy side firms (and prop trading firms, which makes me smile for some reason) when it comes to pre-hedging competitive RFQs, and the recent Acuiti report also found general dissatisfaction amongst buy siders with pre-hedging full stop, which suggests to me that if dealers have to provide a mechanism to revoke pre-hedging permission, clients will use it.

My first read of the report had me believing, like so many correspondents over the past week, that there was nothing to see here, but perhaps we have under-estimated the potential of B3 to change things? I am sure the lawyers are already several meetings in as they try to find a way round this, but to me I wonder if we are now in an era in which pre-hedging will be discussed when it needs to be discussed – i.e. before big trades in particular.

If that is the case, then perhaps this report – and I assume the relevant Code guardians will make the very few adjustments necessary – has made the market a safer place for dealers? If it has, that is a good thing. Profits may suffer a little (as will the spread quoted to customers who don’t want to be pre-hedged), but at least there will be some basis for a dealer to act knowing the customer is well-aware of what is going on.

Ultimately, this is all about transparency – as it has always been of course – so if customers exercise their right to revoke pre-hedging, dealers have to be transparent and the individuals on the desk may no longer be in harm’s way to the degree they were before. If nothing else, specific instructions on pre-hedging by customers should make it harder for the individual to suffer for the sins of the institution – unless they wilfully jump in front of the trade of course. In that case, throw the book at them…

colin@thefullfx.com