What is pre-hedging?
The practice is generally understood as hedging where ‘liquidity providers aim to hedge inventory risk in an anticipatory manner’. ESMA refers to ‘any trading activity undertaken by an investment firm, where (i) the investment firm is dealing on its own account, and the trading activity is undertaken (ii) to mitigate an inventory risk which is foreseen due to a possible incoming transaction, (iii) before that foreseeable transaction has been executed, (iv) at least partially in the interest and benefit of the client or to facilitate the trade’. FMSB adopted ESMA’s definition for the purposes of its work.
Why is FMSB examining the practice?
A founding objective of FMSB was to ‘address areas of uncertainty in specific trading practices’ through the development of guidelines and practical case studies. In principal markets, there remains uncertainty as to how and when pre-hedging may be undertaken, the rationale and client benefits deriving from the activity as well as the distinction between inventory management, pre-hedging and front running. The Spotlight Review considers trading practices, across the size and liquidity spectrum, in fixed income, FX and exchange traded funds (ETFs). It also considers evolving risk management practices around new issuances.
What is FMSB recommending?
The Spotlight Review supplements existing FMSB guidance applicable to pre-hedging deriving from the FMSB’s Standard for the execution of Large Trades Large Trades in FICC markets with a series of considerations, derived from case studies, debated by FMSB’s Pre-Hedging Working Group. The table in the Summary paper summarises the guidance set out in the Large Trades Standard and the supplementary considerations from the Spotlight Review.
Who participated?
The Spotlight Review was developed by an industry-led FMSB Working Group chaired by David Morris, Head of Rates for Europe at BlackRock, under FMSB’s Market Practices Committee, chaired by Kieran Higgins, Head of Flow Rates Trading, EMEA and Co-Head of Global Finance & Rates SM at Citi.
Next steps
This Spotlight Review is intended to advance the industry debate on pre-hedging but not codify standards of behaviour. In due course, FMSB will determine if standard-setting would be beneficial in this area, also taking into account international regulatory developments with regard to pre-hedging.
David Morris, Chair of FMSB’s Pre-Hedging Working Group said:
“I have enjoyed chairing the FMSB Working Group on pre-hedging which is a topic of material importance for market participants. A lot of time and effort has gone into the case studies given the broad range of expert views and I think the final paper is a valuable contribution on a complex topic.”
Kieran Higgins, Chair of FMSB’s Market Practices Committee said:
“These case studies are a helpful practical contribution to the broader industry debate around pre-hedging. This is precisely the type of topic where FMSB, in bringing together a diverse set of market experts, can play a valuable role.”
Myles McGuinness, FMSB CEO, said:
“When FMSB was established, it was tasked with addressing gaps between regulation and actual market practices. Pre-hedging sits squarely in this space. This Spotlight Review will inform further debate on the practice, improve transparency and understanding of when and how pre-hedging occurs and the impact it may have on client execution through practical case studies. We await further work on the topic, including from the international regulatory community, with interest and will consider how this may inform our next steps. I would like to thank our Members for their contribution and to Blackrock’s David Morris, for chairing the Working Group.”
Notes to editors
- Financial Markets Standards Board (FMSB) is an industry-led, member-funded global standards body for the wholesale financial markets.
- Created out of the Fair and Effective Markets Review (FEMR) in 2015, FMSB brings together its Members from banks, investment institutions, infrastructure providers,corporates, pension funds and interdealer brokers, to develop Standards, Statements of Good Practice and Spotlight Reviews that raise standards of behaviour, competence and awareness – to promote the fairness and effectiveness of wholesale financial markets.
- As well as standard setting, subject matter experts from Member firms debate issues in Working Groups and are able to benchmark their approaches against industry peers, thus helping to lift standards of conduct.
- Our full membership list is here.
For more information
Laura Conaghan
Laura.Conaghan@FMSB.com/ +44 7929 726 659