IOSCO Seeks Feedback on Proposed Definition of "Pre-Hedging"
Commentary by Joe Hughes
IOSCO requested feedback on a proposed definition of "pre-hedging." In its Consultation Report, IOSCO also proposed a set of recommendations as guidance for regulators.
IOSCO explained that "[p]re-hedging is used by dealers to manage the risk of anticipated wholesale principal orders in relation to primary market offerings and secondary market transactions," and that pre-hedging can occur in securities and derivatives transactions on trading venues and OTC markets and across a range of asset classes. IOSCO recognized that "pre-hedging can help to manage market risk for dealers when providing liquidity to clients and can lead to beneficial outcomes for clients," but can present risks and harm clients with poor controls.
To address these risks, IOSCO proposed to define pre-hedging as "trading undertaken by a dealer, in compliance with applicable laws and rules, including those governing frontrunning, trading on material non-public information/insider dealing, and/or manipulative trading where:
- the dealer is dealing on its own account in a principal capacity;
- the trades are executed after the receipt of information about an anticipated client transaction and before the client (or an intermediary on the client's behalf) has agreed on the terms of the transaction and/or irrevocably accepted an executable quote; and
- the trades are executed to manage the risk related to the anticipated client transaction."
IOSCO requested feedback on the proposed definition and its recommendations (as well as whether the proposed recommendations need to be adapted to specific circumstances). IOSCO notified members that, following feedback to this consultation report, it will publish a final set of recommendations.
Comments are due by February 21, 2025.
Commentary
The IOSCO Consultation Report does an excellent job describing the pros and cons inherent in the application of pre-hedging. However, the proposed definition is general and will fall short of informing the complex rulemakings that will be required—across different jurisdictions and transaction-types—to define appropriate pre-hedging practices or apply those definitions to existing rules (e.g. FINRA Rule 5270 ("Front Running of Block Transactions")).
An important observation from IOSCO's survey participants is that, in a competitive RFQ environment, there is a risk that dealers could "adversely affect[] prices and/or liquidity" through pre-hedging activities, something clients would be acutely concerned about. Nevertheless, the IOSCO Report makes the case for action to address the potential risk management issues and price benefits associated with pre-hedging.