ESMA calls for evidence in favor or against pre-hedging

Rick Steves

Responses are due by 30 September 2022.

The European Securities and Markets Authority (ESMA) has published a Call for Evidence on pre-hedging with the aim of promoting discussion among stakeholders and gathering further evidence in order to develop appropriate guidance.

The Call for Evidence requests contributions from stakeholders – both in favor and against such practice – in order to properly delineate its admissibility in the context of Market Abuse Regulation (MAR) and MiFID/MIFIR.

Stakeholders in this case include investment firms, credit institutions, proprietary traders, market makers, asset management companies, and any other market participants including trade associations and industry bodies, institutional and retail investors, consultants, and academics.

ESMA has previously identified fundamentally diverging opinions on pre-hedging: some market participants see pre-hedging as essential for risk management and the correct functioning of the markets, whereas other stakeholders consider that pre-hedging may amount to insider trading, the EU top financial watchdog stated.

The agency added that comments are most helpful if they:
1. respond to the question stated;
2. indicate the specific question to which the comment relates;
3. contain a clear rationale; and
4. describe any alternatives ESMA should consider

Responses are due by 30 September 2022.

Pre-hedging entails market abuse risks

A significant number of respondents considered that pre-hedging entails market abuse risks and that it may not be beneficial for the client or the integrity of the market.

For example, one stakeholder noted that trading venues making use of the RFQ trading system only provide the RFQs to the liquidity providers who have been asked to respond to it.

Other respondents stressed that pre-hedging might have detrimental effects where the client requests quotes from two or more liquidity providers: a liquidity provider pre-hedging when in competition with other firms might trigger a price movement which in turn affects the quotes subsequently offered to the client by other liquidity providers. This ‘first mover advantage’ effect could not only render the pre-hedging party better positioned to win the trade, but it could also impact the final price at which the trade is executed.

Restricted pre-hedging acceptable under FX Global Code

ESMA noted that pre-hedging is a frequent practice in financial markets that is not banned in other jurisdictions, provided that certain requirements are met: FINRA does not preclude a broker-dealer to trade for its own account to fulfil or facilitate a client’s block transaction.

However, when engaging in trading activity that could affect the market for the security that is the subject of the customer block order, the broker-dealer must minimize any potential disadvantage or harm in the execution of the customer’s order, must not place its financial interests ahead of those of its customer, and must obtain the customer’s consent to such trading activity.

In Canada, front-running a client order is banned except where the principal order is submitted to hedge a position that the participant had assumed or agreed to assume before having actual knowledge of the client order, provided that the hedge is commensurate with the risk and in accordance with the ordinary practice of the participant.

Even the GFXC and the FSMB standard for the execution of large trades in FICC markets describe the factors under which pre-hedging would be acceptable.

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