Pre-Hedging: IOSCO publishes its long-awaited Consultation Report
Introduction
Pre-hedging has long been seen as a notorious and controversial grey area in global regulatory terms, leading to different practices in different jurisdictions with different conduct risk outcomes.
As it is largely undefined, the International Organisation of Securities Commissions (IOSCO), the leading policy forum for securities regulators has published a valuable and long-awaited consultation report, with the aim of providing a consistent international regulatory approach.
IOSCO looks at the potential conduct and market integrity issues associated with the practice of pre-hedging and puts forward a definition for the practice together with a set of recommendations for regulators to help them decide where pre-hedging practices may be acceptable and to manage the associated conduct risks effectively.
The practice of Pre-Hedging
Pre-hedging can be applied to a range of assets including equities, fixed-income, currencies and commodities. It is used by dealers to manage risks associated with anticipated wholesale principal orders in relation to primary market offerings and secondary market transactions and can occur across various markets including securities and derivatives, on trading venues and over the counter markets.
Clients seek prices from dealers prior to entering into an irrevocable agreement on a primary market or secondary market deal or accepting an executable quote from a dealer. In doing so, the client passes information to the dealer about the interest to trade, such as the security or securities they wish to trade in, the size, direction, price range and speed of execution among other things.
Some dealers use this information about an anticipated transaction with a client as a risk management tool to buy or sell related inventory to manage the risk of assuming the position associated with the anticipated transaction. This is what’s often referred to as "pre-hedging" or "pre-positioning".
In traditional hedging, the inventory risk is certain and risk management by the dealer takes place after the client (or a market intermediary on the client’s behalf) has an irrevocable agreement on a deal or accepted an executable quote from a dealer. In contrast, in pre-hedging the risk management trading commences prior to the client having an irrevocable agreement on a deal or accepting an executable quote from a dealer.
Pre-hedging may reduce market risk for dealers and the market impact of trading by lengthening the hedging window, which can allow better pricing for clients.
However, these benefits may come with increased risks due to the perceived potential conflicts of interest the practice may pose from an investor protection and market integrity perspective, including the misuse of information, a lack of transparency and a lack of client consent and understanding.
There are currently differing definitions of pre-hedging in the market - at present ESMA has its own definition as does the Global FX Code.
IOSCO definition of Pre-hedging
For the purposes of its consultation, IOSCO is proposing a common definition of pre-hedging to its member regulators as:
Trading undertaken by a dealer, in compliance with applicable laws and rules, including those governing frontrunning, trading on material non-public information/insider dealing, and /or manipulative trading where:
i. The dealer is dealing on its own account in a principal capacity;
ii. The trades are executed after the receipt of information about an anticipated client transaction and before the client (or an intermediary on the client’s behalf) has agreed on the terms of the transaction and/or irrevocably accepted an executable quote; and
iii. The trades are executed to manage the risk related to the anticipated client transaction.
IOSCO qualifies that definition by putting forward various recommendations
- three recommendations for determining when pre-hedging is acceptable (A1-3)
- and six recommendations for the management of conduct risk arising from pre-hedging (B1-6):
A. Three cumulative recommendations for circumstances when pre-hedging is viewed as acceptable
Consistent with any existing jurisdictional obligations:
• Recommendation A1: Dealers should undertake pre-hedging only for a genuine risk management purpose.
• Recommendation A2: Dealers should
i. act fairly and honestly to clients; and
ii. undertake pre-hedging only with the intention to benefit the client.
• Recommendation A3: Dealers should
i. minimise market impact; and
ii. maintain market integrity when pre-hedging.
B. Six Recommendations for managing the conduct risk from pre-hedging
Consistent with any existing jurisdictional obligations:
• Recommendation B1: The dealer should document and implement appropriate policies and procedures for pre-hedging.
• Recommendation B2: The dealer should provide clear disclosure to clients of the dealer’s pre-hedging practices.
• Recommendation B3: The dealer should obtain prior consent from the client.
• Recommendation B4: The dealer should implement appropriate compliance and supervisory arrangements for pre-hedging including:
i. Supervisory systems and reviews; and
ii. Trade and communications monitoring and surveillance.
• Recommendation B5: Dealers should appropriately manage access to and prohibit misuse of confidential client information and adequately manage any conflicts of interest that may arise in relation to pre-hedging. Dealers should consider establishing, monitoring, and regularly reviewing appropriate physical and electronic information controls to align with changes to the dealer’s business risk profile.
• Recommendation B6: The dealer should maintain adequate records of pre-hedging to facilitate supervisory oversight, monitoring and surveillance.
IOSCO then goes on to ask a series of 25 detailed questions on its definition and recommendations and invites responses from regulators and interested parties to be received by 21st February 2025, with a view to publishing a final report during 2025. Once finalised, national regulators can consider how they wish to apply the recommendations to dealers in their own jurisdictions, taking into account their relevant legal framework. It is strongly recommended that interested parties read the full 48-page IOSCO report which is available on IOSCO’s website, www.iosco.org, to consider the subject in detail and/or if considering responding.
FMCR has considerable front-line and consulting experience in the various aspects of pre-hedging transactions and is very able to provide relevant and appropriate advice and assistance.
In the first instance please contact FMCR at contact@fmcr.com.