ESMA’s latest shot at ‘pre-hedging’ must now bring a clear set of rules

John Keogh, managing director at Susquehanna International Securities (SIG), makes the case for banning the controversial practice, in the wake of ESMA’s latest request for industry input. 

On 30 September 2022, the European Securities and Markets Authority (ESMA) closed a Call for Evidence on pre-hedging (the results of which were not yet published at the time of going to press), which requested insights from market participants as to the current practice, and their perspective on what appropriate guidance should look like. The request for input was a follow-up to the Market Abuse Regulation (MAR) review carried out by the regulator in 2019, with ESMA acknowledging the diversity of opinion on pre-hedging in its post-review report and highlighting the urgent need for clarification around the rules of the practice.

What is pre-hedging and why is it a big deal?

So called pre-hedging occurs when a liquidity provider that has received a request for a price quote from a potential counterparty (sometimes referred to as a Request for Quote or RFQ) trades in the market prior to finalisation of any transaction with the requesting counterparty. This, proponents say, is done to ‘hedge’ the position that the liquidity provider might acquire if it actually trades with the counterparty making the original pricing request. For example, an asset manager may ask a number of liquidity providers to show a price at which they are prepared to buy a large quantity of shares in Company X from that asset manager. 

The fact that the asset manager wants to sell the block of Company X shares isn’t public information. The fact that there is a large seller would suggest that Company X’s share price will move lower than the current price. In this circumstance, liquidity providers who engage in pre-hedging sell Company X shares for their own account in the market on the basis that that this trade would offset or ‘hedge’ the position that they might acquire if the asset manager accepts their bid price to buy the Company X shares. These liquidity providers claim that such an approach enables them to provide better pricing and liquidity. 

What is the argument against the practice?

Pre-hedging shouldn’t be acceptable for a number of reasons. First, we must address the age-old question: cui bono? There isn’t any evidence that pre-hedging improves prices for clients. Indeed, if a liquidity provider sells before the price is agreed with the client, their proposed bid (and the bids of other competing liquidity providers) may be adjusted lower based on a move in the share price arising from these pre-hedging market sales.  This results in a worse price for the client. Second, if all liquidity providers ‘pre-hedged’, then multiple orders would be sent into the market resulting in a disproportionately negative impact on the market price and consequently the price that the client receives.

Pre-hedging, however, is likely to result in a favourable outcome for the liquidity provider that pre-hedges – if they sell and they win the trade then they may have sold at a better price than they buy from the client. If they sell and they don’t get awarded the trade, their short position will be advantaged by the downward pressure on the share price arising from the sales of the liquidity provider who won the trade. This results in a ‘heads they win, tails they win’ outcome for the so-called pre-hedgers.

The term ‘pre-hedging’ can also be misleading, as some market participants use this expression to justify a behaviour that might more accurately be characterised as front-running. Rather worryingly, proponents of the practice account for a large amount of the volumes that are transacted in the European markets.

What are the key concerns?

ESMA correctly identifies these problems in its Call for Evidence when it stated: “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.”

We fully share this concern, which we see as a high and real risk. Absent a total ban on pre-hedging, a partial solution would be for ESMA to make it clear that pre-hedging is not permitted at a time when a liquidity provider is in competition with several other liquidity providers to respond to a request for a quote from a counterparty.

What would you like to see change?

If ESMA and EU policymakers want to ensure confidence in European financial markets, they should act and put an end once and for all to this damaging practice for our industry, our counterparties, and end-investors. This is not only about mitigating risk, but also about building a more cohesive, competitive, transparent, and efficient capital market in Europe, and indeed, one better equipped to compete with other major markets. Greater confidence will bring more participants, which will in turn improve markets and prices for everyone. Not creating a clear set of rules around this practice is only going to lead to a continued lack of clarity, meaning a perpetuation of different interpretations and approaches between markets, participants, and regulators.

With a direct and significant impact on the prices that pension and other funds receive for the securities they buy and sell, pre-hedging is a key market cleanliness issue with broad implications for the investment industry, but also the end-investor and the public at large. It should not be overlooked this time around, for it could become a LIBOR moment for market confidence. 

We believe it is critical that ESMA achieves a new set of rules clearly defining and eliminating pre-hedging.