PRE-HEDGING – IOSCO Publishes Its Final Report
Following its consultation of November 2024, the International Organisation of Securities Commissions (IOSCO), the leading policy forum for securities regulators, has published its final report on pre-hedging and associated risks.
Background
As a reminder, 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 referred to as pre-hedging or pre-positioning. This is distinct from hedging, where the risk management trading by the dealer takes place after the client has an irrevocable agreement on a deal or accepted an executable quote from a dealer. With pre-hedging, risk management trading by the dealer commences prior to the client having agreed on the terms of the transaction and/or irrevocably accepted an executable quote from a dealer. This practice has caused much debate over many years.
In its final report IOSCO puts forward a definition of pre-hedging as guidance to assist regulators in providing a consistent international regulatory approach. The recommendations are not legally binding and IOSCO stresses it is up to each jurisdiction as to the extent to which they are implemented. In addition, the final report includes information and guidance for all other interested parties, including dealers, issuers, brokers, investors, and other wholesale market participants to consider in relation to pre-hedging. Their recommendations aim to promote greater clarity and guidance for regulators and market participants regarding pre-hedging practices.
During the 2024 consultation period other industry standard setting bodies raised concerns that conflicts might arise with their own pre-hedging practices, so IOSCO has amended its definition to align more closely with the definitions already used in the FX Global Code, the Global Precious Metals Code and the Financial Markets Standards Board’s “Standard for the execution of Large Trades in FICC markets”.
Adopting these amendments in their final report, IOSCO now defines pre-hedging as trading undertaken by a dealer where:
the dealer is dealing on its own account in a principal capacity;
the trades are executed in the same or related instruments after the receipt of information about one or more anticipated client transactions and before the client has agreed on the terms of the transaction(s) and/or irrevocably accepted the executable quote(s);
the trades are executed to manage the risk related to the anticipated client transaction(s);
the trades are executed with the intention of benefiting the client.
In its final report IOSCO forensically analyses its approach compared to the approach of the three other main industry standard setting bodies and codes and includes a summary of the feedback it received to its consultation. It then sets out its recommendations relating to the use of pre-hedging (see “A” recommendations below) and, particularly useful to market participants, the management of conduct risk arising from pre-hedging (see “B” recommendations below).
LIST OF RECOMMENDATIONS
“A” RECOMMENDATIONS
RECOMMENDATION A1: Dealers should undertake pre-hedging only for a risk management purpose associated with one or more anticipated client transactions.
RECOMMENDATION A2: Dealers should undertake pre-hedging only with the intention of benefiting the client.
RECOMMENDATION A3: Dealers should act fairly and honestly with clients when pre-hedging.
RECOMMENDATION A4: Dealers should seek to minimize market impact and should maintain market integrity when pre-hedging.
“B” RECOMMENDATIONS
RECOMMENDATION B1: Dealers should document and implement appropriate policies, procedures and controls for pre-hedging.
RECOMMENDATION B2: Dealers should provide clear disclosure to clients of the dealer’s pre-hedging practices.
RECOMMENDATION B3: 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.
RECOMMENDATION B4: Dealers should have appropriate compliance and supervisory arrangements that also cover 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 conflict of interest, including those 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: Dealers should maintain adequate records, including for pre-hedging, to facilitate supervisory oversight, monitoring, and surveillance.
Finally, it adds a list of considerations for clients:
List of Considerations for Clients
Clients could consider how to minimize the potential risk of price slippage. For example, this can include sending out two-way RFQs (non-directional).
Clients could consider implementing internal controls to monitor market pricing, execution outcome, market activity and assess the quality of execution where pre-hedging has been used by a dealer.
Clients could educate themselves about pre-hedging practices and the potential impact of pre-hedging, including asking the dealer about the intended pre-hedging strategy and the potential impact of pre hedging.
If a client does not want pre-hedging to be used, the client should inform the dealer.
Clients could consider asking the dealer for information on how pre hedging was undertaken for their transaction(s).
For anyone interested in studying IOSCO’s 49-page report in depth it can be found at www.iosco.org (Reference FR/14/2025).
FMCR would also be happy to utilise our extensive trading floor experience to assist clients and prospective clients with the practical aspects of pre-hedging.
In the first instance please contact FMCR at contact@fmcr.com.