Pre–Hedging and The IOSCO Paper: What dealers and clients need to know

What is Pre-Hedging?

We will assume a bit of knowledge here. Broadly speaking pre-hedging is when a dealer, who is in receipt of an order or RFQ (Request For Quote) from a client or counterparty, deals in the market for those instruments (or one very similar) before firmly accepting the client order or agreeing a quote.

Many of the markets work on a RFQ basis. These RFQs are usually a 2-Way RFQ where the client asks for a buy and sell price. Or 1-Way RFQ where the client asks for only a buy or sell price. These RFQs can be just to one dealer. Although it is not unusual to ask multiple dealers at the same time.

IOSCO’s Definition of Pre-Hedging

IOSCO in their final paper has defined pre-hedging as trading undertaken by a dealer where:

• the dealer is dealing on its own account in a principal capacity; and
• 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); and
• the trades are executed to manage the risk related to the anticipated client transaction(s); and
• the trades are executed with the intention of benefiting the client

Industry Debate Surrounding Pre-Hedging

The topic of Pre-Hedging has certainly not gone away. It remains an area of strenuous debate in parts of the industry. Particularly the more wholesale and dealer lead OTC products such as FX, Rates, Credit and Commodities.

This was a difficult topic when the FX Global Code was first drafted in 2016-17. It has remained, to some degree, unresolved since then largely due to opposing views. One side feels pre-hedging risks crossing over to front running (an offence under MAR and many equivalent regimes). Or that it might impact the market to the disadvantage of the clients with the order or RFQ. The other side sees pre-hedging as an important part of price formation and risk management in dealer markets like these. And overall beneficial to clients by enabling dealers to better understand liquidity and prevailing prices in these OTC markets.

Alignment with Industry Codes and Standards

The IOSCO paper recognises the sterling work done by the FX Global Code, Global Precious Metals Code, and the FMSB Large Trades Standard. As such many of the recommendations in the final report are consistent with these codes and standard.

It is also worth saying the IOSCO report serves as advisory guidance and suggests best practice. Implementation of any changes will require action from national regulators. Those with operations in the EU should be aware that this has previously been an area on which ESMA has consulted.

What should dealing firms do now?

Firstly, recognise the IOSCO paper is out there and will have gravitas coming IOSCO. So firms should review it and consider if they have fundamental disagreements. If so, take those up with their local regulators directly or via trade bodies. More importantly, it is a good chance to reflect on current approaches and how they comply with existing regulations, codes, and client disclosures.

However, there are some recommendations in IOSCOs final report that we think are worth highlighting and discussing further.

Additional controls

Dealers should document and implement appropriate policies, procedures, and controls for pre-hedging

Whilst many firms who have signed up to these codes or standard might feel this has been covered, it would be worth reviewing if the risks around pre-hedging are covered directly enough and with sufficient granularity. Firms that only have in place generic policies should consider expanding these. All firms should think about when they last did training on this and refresh it if appropriate.

Additional disclosures

Dealers should provide clear disclosure to clients of the dealer’s pre-hedging practices

Many firms do this off the back of codes. But there is still a debate (as noted by IOSCO) as to whether these should be done case by base, more generically at onboarding, or through some hybrid situation. You will need to think what is most appropriate for your business and client base. But try to avoid this being buried in a long term of business document, being upfront will help you here. In terms of what we mean by hybrid this is where more BAU / flow transactions are covered by general disclosures e.g. on your website. And larger more complex transaction are dealt with using a case-by-case disclosure when discussing execution approaches with your client. In our experience many banks take this hybrid approach.

Obligations on Dealers

Dealers should:

1. Seek to receive prior consent to pre-hedge from the client at the outset of the relationship, and
2. Give the client a clear process to modify or revoke that consent at any time with reasonable notice.

This potentially goes a bit beyond common market practice. And the current codes of clearly disclosing the possibility of pre-hedging to clients. It also seems to require clients to positively agree to this practice. It also suggests the opportunity for clients to withdraw this consent.

Firms will know the challenges of getting such ‘2-way consents’ in wholesale markets as well as the record keeping challenges it poses. For example, how do you make it clear to a trader / dealer which clients are OK to pre-hedge, and which are not? How does it impact streamed or quoted prices, would these need to be different for clients who decline pre-hedging?

Compliance and Supervision

Dealers should have appropriate compliance and supervisory arrangements that also cover pre-hedging, including:

1. Supervisory systems and reviews and
2. Trade and communications monitoring and surveillance.

What IOSCO seems to mean by this is that firms should be checking that what they say they will, and will not, do in policies, procedures etc. fits with what is happening in reality. Rather than creating new controls, firms should embed checks into existing processes like supervision, surveillance, and compliance monitoring.

They also recommend reviewing pre-hedging for conflicts of interest and providing training to reinforce policies. While training is straightforward, identifying pre-hedges versus similar trades is harder. Compliance should confirm pre-hedging was for risk management and client benefit, minimising market impact, though this is challenging. Firms should assess whether current surveillance and supervision already address these risks.

confidential information and conflictS

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. This would seem to have parallels to how some firms already manage sensitive client information between sales and trading. For example large transactions or clients resting orders.

That said traders / dealers will usually need to be engaged at some point pre trade and might be best placed to manage resting orders. So, this is not completely new to most sell side firms. But this might be a good time to review those policies, procedures. Check whether information that could lead to pre-hedging opportunities is shared as per your policies and procedures.

A very free and easy approach to sharing client orders / RFQs increases the risk of trading activity being viewed as potentially front running. For example, a trader not involved in the execution of an order type trading around the receipt of an order / RFQ shouted across the floor. IOSCO talk about ‘physical and electronic controls. So firms should consider if these are up to date and being followed in practice.

adequate records

Dealers should maintain adequate records including for pre-hedging, to facilitate supervisory oversight, monitoring, and surveillance. This should look like something that is very established and de rigueur across the sell side. Where there might be a challenge is if regulatory or client expectations move to having specific records of Pre-Hedging activity. Helpfully IOSCO say they think existing record keeping should be enough but an area to remain alert to.

Remember, this is not just about regulatory risk as clients can also take legal action where they consider their order or RFQ has been improperly dealt with. Being in line with industry best practice and making clear disclosures should help to mitigate this risk.

There can also be a difference of opinion between the sell side and the buy side so there is definitely a client angle to this. A good example is Colin Lambert’s recent article in The Full FX which covers a survey of European Asset Manager by Acuiti. This is worth a read (as the Full FX always is!) and paints a picture of some disquiet about pre-hedging from this client base.

What should client and counterparties of dealers do now?

This is broadly wholesale market activity so proactive client engagement with their dealers is expected and ultimately beneficial for everyone. The suggestions below from IOSCO are helpful and we have tried to add some practical colour to them.

risk of price slippage

Clients could consider how to minimise the potential risk of price slippage. For example, this can include sending out two-way RFQs (non-directional).

Experience suggests practice from the buy side is still mixed here. Whilst some firms are quite consistent on this, others still send one-way RFQs. Firms should consider whether their dealers should normally ask for a two-way RFQ.

Benefits of internal controls

Clients could consider implementing internal controls. This may include to monitor market pricing, execution outcome, market activity and assess the quality of execution where a dealer has used pre-hedging. There is a more general point here about monitoring for execution quality, not just where your counterparty has said they might Pre-Hedge, for example a counterparty might not Pre-Hedge but quote a wide bid offer spread. Where possible it is worth considering tools like Transaction Cost Analysis (TCA) to better understand the quality of execution across the counterparts you use and the various styles of execution.

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. This is crucial and requires conversations at the right level of experience for both firms. Have a think about what you want to find out, prepare your questions in advance, and probably give the sell side firm time to consider your questions before you discuss. Also bear in mind this process might take a while with back and forward and multiple conversations.

Handling requests not to pre-hedge

If a client does not want pre-hedging to be used the client should inform the dealer.

This sounds obvious but it rarely happens. As with recommendations above, this might well require conversations with the buy side firms you deal with. So you can understand if they are able to offer you alternatives and for you to consider if those alternatives work for you.

Get the details

Clients could consider asking the dealer for information on how pre-hedging was undertaken for their transaction(s). 

Whilst this could be done as a standalone exercise it might well work better done in conjunction with recommendation C3 so you can agree with your counterparty what information could be made available and how often it could be shared.

Conclusion

As we said earlier this is certainly not going away and the IOSCO paper acts as a bit of a call to arms for the sell side and buy side to engage more with each other and get into the detail of what is workable and fair.

For sell side firms who have not looked at this for some time it is a good point to reflect on your polices, process and controls to decide if they are still adequate in light of this IOSCO paper and any of the codes you have signed up to. What follows on from this is training you provide to staff who might have missed this previously or partially forgotten some of the detail.

Front line and controls teams including compliance should also consider what monitoring and testing is needed to give you assurance that practice on the grounds is consistent with what you are telling regulators and clients.

Leaman Crellin have lots of experience in this area and are happy to help you out with a risk assessment, policy review. training or an assurance review. Please reach out to us if you would like to discuss.