The financial world is abuzz with concerns surrounding the practice of pre-hedging, where dealers leverage insights from investors about upcoming trades to execute their own orders ahead of time. While this strategy can mitigate risks associated with transactions, investors fear it may manipulate market prices to their disadvantage—a practice some deem front-running. With past incidents in currency trading leading to over $13 billion in penalties for banks, getting the regulatory framework right is essential to prevent further controversies.

Understanding Pre-Hedging and Its Implications

Pre-hedging occurs when a dealer anticipates an investor’s order and either buys or sells the same securities just moments before fulfilling the actual trade. This is particularly controversial in scenarios where investors solicit multiple dealers for price quotes—a process known as competitive request-for-quotes (RFQs).

• Potential Risks: The core issue lies in distinguishing between legitimate pre-hedging and abusive market practices. This ambiguity raises questions about fairness and transparency in trading.

Calls for a Ban on Pre-Hedging

The European Securities and Markets Authority (ESMA) has highlighted that pre-hedging can lead to conflicts of interest and potentially abusive behaviors. Despite this, a blanket ban has yet to be enacted. Notable asset management companies and non-bank market makers, including Susquehanna and Jane Street, have pushed for a clear prohibition on pre-hedging within competitive RFQs. Jane Street even stated in a 2022 submission to ESMA that such practices could be deemed “market abuse.”

• Market Maker Positions: XTX Markets asserts on its website that it does not engage in pre-hedging within currency markets, though they did not provide comments on the ongoing discussions by the International Organization of Securities Commissions (IOSCO).

IOSCO’s Stance and Industry Reaction

Currently, IOSCO has refrained from proposing a ban but suggests that pre-hedging should be conducted only for “genuine risk management purposes.” They emphasize that dealers must act “fairly and honestly,” prioritizing client interests while minimizing market disruption. An IOSCO spokesperson noted, “A global approach to pre-hedging seeks to promote a level playing field for the industry.”

Rising Concerns About Misconduct

The consultation revealed that IOSCO members suspect misconduct linked to pre-hedging activities. Reports from France’s financial regulator indicate that pre-hedging is often associated with the highest number of suspicious activity reports from dealers. A staggering two-thirds of these reports pertain to pre-hedging in fixed income and foreign exchange markets.

• Legal Distinctions: Lawyers from Jones Day clarify that the line between pre-hedging and front-running is based on intent. Pre-hedging aims to mitigate risks for the client, while front-running is primarily to benefit the dealer, often at the expense of the client.

Perspectives on Pre-Hedging’s Legitimacy

While some in the investment community acknowledge that pre-hedging can be justifiable under certain conditions—particularly for large, tailored trades in less liquid markets—banks argue that this practice is equally valid in liquid markets. Adam Farkas, CEO of the Global Financial Markets Association, supports the notion that dealers must manage risks in all market conditions.

A Complex Path Forward

Finding a consensus on pre-hedging regulations that satisfies all parties seems unlikely. As IOSCO’s proposals are set to put a spotlight on dealers’ practices, national regulators are expected to implement these findings in the coming years. According to Jones Day attorneys, “In its current form, the proposed framework would significantly impact dealers, potentially requiring changes to their risk management and compliance programs.”

The evolving landscape of trading practices and regulations promises to keep both investors and dealers on their toes as they navigate the complexities of market dynamics and compliance.