ESMA Review of Pre-Hedging

What you need to know about ESMA’s latest report

Last year, the European Securities and Markets Authority (ESMA) issued a Call for Evidence around pre-hedging. Last month, it issued its report on the topic.

ESMA’s Report shows there are divergent views around many components of the pre-hedging process. On balance, ESMA finds insufficient evidence to ban the practice outright, but concludes "that pre-hedging… might give rise to conflicts of interest or abusive behaviours. These risks should be taken into account when issuing any future guidance."

Pre-hedging

Pre-hedging is a strategy used ostensibly to manage the market risk associated with executing large client orders. To quote ESMA:

Pre-hedging is generally understood as a form of hedging of inventory risk in an anticipatory manner in presence of a potential incoming transaction. More specifically, pre-hedging can be characterised as any trading activity undertaken by an investment firm, where:

  1. the investment firm is dealing on its own account, and the trading activity is
  2. undertaken to mitigate an inventory risk which is foreseen due to a possible incoming transaction,
  3. undertaken before that foreseeable transaction has been executed,
  4. undertaken, at least partially, in the interest and benefit of the client or to facilitate the trade

Suppose a bank anticipates a client order to buy a large amount of EUR against USD. The rapid execution of this order would cause the market to move against the client (in other words, the EUR/USD price would rise). The bank might start to buy EUR/USD ahead of the requirement being triggered, so that when the bulk of the order is being executed, if the price does move against the client, the bank is able to pass on some of its earlier purchase at a better price, thus improving the average outcome for the client.

Instances where this might happen are where a client places a large order for execution during a fixing window, or following a specific event (such as triggering a stop-loss order or an option barrier level).

The potential for conflicts of interest is clear. With opponents of the practice viewing it as a form of front-running or insider dealing, it has long been a source of contention (to the extent that the Call for Evidence grew out of a review into the EU Market Abuse Regulation). That said, widely-accepted codes of market conduct such as the FX Global Code and the FMSB Standard for Large Trades recognise that the practice takes place, and seek to put appropriate controls around it.

Insider Dealing?

The ESMA Report makes it clear that pre-hedging can only take place where the liquidity provider is acting as principal in the transaction. Where the asset is exchange-traded and the investment firm is acting as agent, it would be contrary to rules to trade without a specific client order. In other words, the client’s order will often become a market order when the triggering event (for example, a stop-loss level) occurs. The firm would not be permitted to execute trades ahead of that without specific client instructions (such as individual limit orders), which results in slippage (execution) risk remaining with the client.

Where the investment firm is acting as principal, this risk moves to the firm. As a result, it is in the firm’s commercial interests to provide as good execution quality as it can, which will sometimes involve taking on inventory ahead of the trigger level or event (that is, pre-hedge). One danger here which the firm must manage is the possibility that its pre-hedging activity might create the very problem that it is looking to solve, for example by triggering the stop level.

From the perspective of a compliance officer, the ESMA Report walks through several aspects of the pre-hedging process and in particular, examines pre-hedging in the context of MAR, MiFID II / MiFIR and managing conflicts of interest.

To avoid regulatory breaches, iths important that surveillance systems be able to identify large or unusual trades, and non-news-based insider dealing. Communications surveillance is also essential, since it provides context around a client’s needs (and expectations), and any guidance given by the firm, as well as insight into the timing of the firm’s actions and principal trades in the market.

There are clearly divergent opinions about pre-hedging. A number of legal cases involving aspects of pre-hedging have worked their way through the courts, and may even need to be revisited.

Several things are not up for debate, however. Financial services firms need to ensure that there is full disclosure to clients whose orders are being pre-hedged. And, the compliance department needs to be brought into the tent at an early stage, to ensure associated trading is done exactly as briefed, and meticulous execution and fill records are maintained.

With Compliancentral, NICE can help you stay in compliance with ESMA regulations. Compliancentral offers a suite of solutions that can help any firm, of any size, detect all types of market abuse, and comply with obligations around recording communications, recordkeeping, AML and surveillance.