The regulator’s umbrella body needs to deliver recommendations that clearly prohibit pre-hedging where dealers are in competition, says Emma Lokko
Pre-hedging, friend or foe?
The practice, which is currently under review, is where dealers use the information received from an investor about a trade they want to execute to pre-hedge the exposure that they would take on if awarded the trade. In theory, the information is used by dealers to manage expected risk and offer a competitive price to investors. However, differences in interpretations of what is legitimate pre-hedging opens the door to malpractice, which is characterised by inherent conflicts of interest and, sometimes, outright abusive behaviour such as frontrunning that ultimately leads to investors being disadvantaged.
The known regulatory concerns associated with pre-hedging have brought a certain level of scrutiny from regulators. But to date, efforts made to fully protect investors have remained limited. It has now fallen on the International Organisation of Securities Commissions (IOSCO) in its recent consultation paper on pre-hedging to recommend an industry approach. However, the regulator’s forum’s recommendations are not conducive to resolving the existing concerns and creating enhanced market integrity.
At the heart of the problem is where an investor sends a request for quote/price (RFQ) to more than one dealer electronically or via the call-around market – RFQs are an essential tool to achieve price discovery.
To illustrate the issue at hand, let us take the theoretical example of an investor looking to buy a significant amount of any given stock. Before engaging in such trade, the investor would typically initiate an RFQ and provide non-public information to several dealers to assess best pricing before selecting a dealer for the trade.
“Some dealers that have not yet been awarded a trade are taking advantage of the investor’s price requests to make trading profits”
Emma Lokko, head of market infrastructure at Susquehanna International Group
If any dealer pre-hedges, i.e. trades in the same direction as the price request by buying the stock or a related product, this would directly impact the market price by pushing the price higher based on the increased demand. Most likely this would have a detrimental impact on the investor: the other dealers would be forced to increase their offer (price slippage) to reflect the stock’s new pricing and, if one of those dealers had originally offered the best price, this would result in a worse final price at which the investor can buy.
A direct impact on the prices that investors (and savers) receive for the securities they buy and sell should be of concern to all market participants. While these increases are often marginal, over time they add up to a significant cost for investors. The problem is clear: some dealers that have not yet been awarded a trade are taking advantage of the investor’s price requests to make trading profits and, in the process, move prices against the investor.
One of IOSCO’s recommendations suggests that a dealer can have a genuine risk management purpose for pre-hedging when they have a legitimate expectation of winning the trade based on several factors. This leaves too much room for interpretation and misses the mark where there is competition amongst multiple dealers, as a dealer cannot pre-determine with certainty that they will win the trade so pre-hedging should not be permitted.
Elsewhere, IOSCO sets out that where a dealer discloses that it may pre-hedge then this can enable the investor to make an informed decision when selecting a preferred dealer. However, again this would not negate the price slippage for the investor when multiple dealers are in competition.
It would also unfairly place the onus on the investor, who may lack the visibility and resources to accurately assess pre-hedging impacts, to protect themselves. In turn, this may lead investors to reduce the number of dealers they request quotes from, thereby restricting their ability to obtain the best price.
In our opinion, it is vital that IOSCO’s final recommendations are clear and decisive in prohibiting pre-hedging where dealers are in competition. Investors should be able to freely ask multiple dealers for a price without seeing prices move against them prior to their trade being agreed.
Only a clear, enforceable rule will eliminate ambiguities and foster investor confidence in fair and transparent market practices.
Emma Lokko is head of market structure (Europe), Susquehanna International Group, a market-maker. She is also a member of ESMA’s Securities and Markets Stakeholder Group.
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