Abstract electronic
Market Regulation

Where Is the Line? Sanctioned Hedging vs. Nefarious Pre-hedging

Michael O'Brien
Author
Michael O'Brien
Published

Recent actions by a number of exchanges have focused on the often-blurry line between sanctioned hedging and pre-hedging that represents a form of market abuse. Regulators have been seeking to define where exactly the line is and when a particular behavior evolves from being a legitimate hedging or risk management strategy to an activity that has the intent of anticipatory or aggressive pre-hedging of a customer transaction.  

Pre-hedging has remained a regulatory hot topic throughout the past few years. Those who were closely tuned in to the formation of the EU regulation, Market Abuse Regulation (MAR), will recall the significant consultation around pre-hedging by many, including The European Securities and Markets Authority (ESMA). As ESMA stated: 

The variety of replies received and fundamentally diverging opinions on whether pre-hedging should be allowed or not and may or not add value for markets are an indication that it is not possible to state, tout court, if pre-hedging is a legitimate behaviour or not.
(MAR Review Report - ESMA70-156-2391 – 23 September 2020)

Market participants have clearly divided opinions when it comes to the more aggressive pre-hedging practices, and regulators are still evaluating the best path forward in terms of oversight and guidance. ESMA already addressed pre-hedging in the context of the 2020 MAR Review, identifying the fundamentally diverging opinions on this practice: 

  • 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

This led to ESMA1 launching a call for evidence on pre-hedging in July 2022, asking stakeholders to contribute evidence of pre-hedging that could help ESMA to develop appropriate guidance.

Pre-hedging:  Where is the Line?

First, it is important to understand normal sanctioned hedging: 

  • When an intermediary or liquidity provider facilitates a client trade by taking on a position and the associated financial risk, it may start offsetting that risk. It may either partially or wholly offload the position, and/or it could mitigate that risk by taking offsetting positions in related products or derivatives. 
  • Hedging is, therefore, a normal and economically rational activity. It’s the managing of the P&L of a position that the participant holds.

In the next example, the line begins to blur toward nefarious hedging. What if the firm starts offsetting that risk before it actually holds that risk? What if the participant starts offsetting the risk in the expectation of that risk crystallizing?

  • This could happen, for example, where a client signals its intention by requesting a quote or where it signals its intention that it will accept a quote provided by the participant. Based on that expectation, the participant commences the management of that risk or the trading in a manner in which some profitability is “locked in.”  This can be construed as “pre-hedging.” 

In most literature and regulatory advice around pre-hedging, the general consensus is that it is usually acceptable if it is done with the primary intention of benefitting the client through facilitating the trade or hedge after the primary customer trade has been consummated.

Until the line between hedging and pre-hedging is agreed upon by regulators, exchanges and market participants alike, there will continue to be a debate on whether it is market abuse or not. 

Learn more about how Nasdaq Trade Surveillance can help detect nefarious hedging behaviors.

 

Sources:

  1. July 29, 2022. ESMA Launches Call for Evidence on Pre-hedging. https://www.esma.europa.eu/press-news/esma-news/esma-launches-call-evidence-pre-hedging
  2. September 26, 2022. FESE Response – ESMA Call for Evidence on pre-hedging. https://www.fese.eu/app/uploads/2022/09/220926-FESE-response-to-the-ESMA-call-for-evidence-on-pre-hedging.pdf
  3. NYSE American LLC. Letter of Acceptance, Waiver and Consent. 2019-2020.
    https://www.nyse.com/publicdocs/nyse/markets/nyse-american/disciplinary-actions/2020/Morgan_Stanley_NYSE_American_AWC_(20150442463_and_20170535088)(final)%20(3).pdf
    https://www.nyse.com/publicdocs/nyse/markets/nyse-american/disciplinary-actions/2021/Barclays%20AWC%20(executed%2011.11.21).pdf
  4. Finance Magnates. July 21, 2022. StoneX Entities to Pay ICE $650K for Possible Improper Pre-Hedging.
    https://www.financemagnates.com/institutional-forex/stonex-entities-to-pay-ice-650k-for-possible-improper-pre-hedging/
  5. NYSE American LLC. Rule 995NY. Prohibited Conduct. 2022. https://nyseamerican.wolterskluwer.cloud/rules/document?searchId=1060708697&treeNodeId=csh-da-filter!WKUS-TAL-DOCS-PHC-%7BA8AD70FB-55C5-4B1B-9B65-2E7F30F5BB22%7D--WKUS_TAL_1839%23teid-1081

Other Topics

Policy & Regulation Financial Risk Management Technology
Michael O'Brien

Michael O'Brien

Nasdaq

Michael O'Brien is the Head of Product Management for the Sell-side & Buy-side Technology business at Nasdaq.

Read Michael's Bio