Pre-hedging is currently a hot topic in the industry and more recently ESMA has sought to conclude diverging opinions via a call for evidence. This aims to promote a dialogue among stakeholders and help collate further evidence to be able to publish well-informed guidance.
The result of such guidance will have the potential to impact market makers, banks/brokers, proprietary traders, asset managers and investors. This is a far-reaching subject and the outcome of ESMA’s review is of importance to many.
Pre-hedging is a form of hedging inventory risk in anticipation of a potential incoming transaction. Examples of pre-hedging include a liquidity provider – having received a request-for-quote (RFQ) from a client showing their interest in a potential trade – pre-hedging the hypothetical position that would be taken if they won the trade prior to final confirmation.
Interpretation of pre-hedging is not uniform and what constitutes pre-hedging is contested.
Another example – viewed by some as hedging instead of pre-hedging – could be a trade proposal from an investor where it is pre-agreed that the trade will be executed at a later date, or the finer details of the trade are yet to be confirmed – but there is clear, transparent communication between the investor and liquidity provider. The investor is aware and gives consent to pre-hedging.
Some market participants may take the view that pre-hedging can be seen as a risk mitigation tool as the liquidity provider would place a trade to manage the risk associated with a potential trade that would result on the back of an anticipated order.
Some would argue this intention to increase facilitation capabilities would feed into more competitive pricing for the investor, reduced volatility, and lower costs to the market.
However, how each liquidity provider interprets and translates these different factors into pricing is subjective and may lead to a fragmented market and less resilient and volatile trading behaviour of a security.
Furthermore, the requirement for a genuine risk management rationale is greatest in a competitive RFQ market, where it is difficult for the liquidity provider to know with certainty whether they will win the trade.
In the instance when a client sends an RFQ to multiple liquidity providers, the pre-hedging of one party may move the market, consequently affecting the levels subsequently shown to the client by other liquidity providers.
This ‘first mover advantage’ could not only put the pre-hedging party in an advantageous position to win the trade but it could also impact the final price – positively or negatively – at which the trade is executed.
In this way, RFQs could be seen to contain price sensitive information that is not yet publicly available. It is therefore paramount that stringent market integrity controls should be implemented by the liquidity provider.
To avoid information leakage and reduce potential negative impacts of pre-hedging, investors can follow the practice of requesting two-way prices for both a buy and sell, serving to conceal the trade direction. Carefully selecting the liquidity provider’s distribution lists for RFQs would also be to the same effect.
Fulfilling our fiduciary responsibility to clients as an investment manager, the impact on the end investor is the central focus when evaluating pre-hedging. Liquidity, stability, and integrity of the market are also factors to be considered during evaluation. As always, different exposures require varying execution strategies.
Ultimately, transparency and an equal playing field is vital for pre-hedging to play a legitimate role in ETF trading – and broader securities trading in general. To achieve this, ESMA is required to guide current mixed interpretations.
For a future of pre-hedging to be permitted, ESMA must utilise the call for evidence to properly govern market makers on what should be considered as MAR-compliant in terms of pre-hedging and what behaviour might constitute frontrunning.
Additionally, from a competition perspective, regulatory clarity is paramount as liquidity providers who pre-hedge may have an informational advantage on market liquidity and impact.
This clarity should delve into the procedural aspects of pre-hedging including the documentation required, necessary internal policies and transparency regarding pre-hedging arrangements by liquidity providers to their clients.
Fundamentally, if pre-hedging is a clear benefit to the client, they are aware pre-hedging will take place, give explicit consent and aware of the risks involved then – with the necessary guidance from ESMA – there is a place for pre-hedging to enhance the markets with greater efficiency and reliability for all participants. In the meantime, the industry waits for the EU’s securities markets regulator to guide good practice.
Keshava Shastry is head of capital markets at DWS, chair of ETF task force at EFAMA and chair of the ETF committee at the Investment Association
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here.