- Is pre-hedging the same as front running?
- In swap markets, pre-hedging describes a dealer taking on risk in anticipation of a possible incoming transaction.
- There are certain situations where pre-hedging is an allowable “best practice”.
- This includes when the pre-hedging is disclosed to the client, is intended to result in benefits to the client (as opposed to the dealer) and is consistent with non-manipulative market practices.
- Transparency and post-trade analysis are key to assess the effectiveness of pre-hedging practices.
FMSB
The FICC Markets Standard Board (see my 200th Clarus blog), known as the FMSB, recently published the paper “Spotlight Review on Pre-Hedging“. It makes great reading for anyone involved in Swaps markets – dealers, sales, trading, buyside. Read it!
What is “Pre-Hedging”?
According to the FMSB report, pre-hedging is the act of a dealer hedging risk in anticipation of a possible incoming transaction. Let’s flesh that out a bit with an example:
- A client calls a sales person and asks for a “live” price on a swap. This indicates that the client is ready to trade, not just looking for an indicative price/performing price discovery.
- The sales person should then ask the trading desk for a price that a trader would be willing to transact at.
- (There will likely be some to-ing and fro-ing at this point as the trader tries to get an idea from the sales person of how likely the client is to transact, how many other dealers are also competing for the trade, is it the total size etc. All of this “colour” is necessary for a trader to accurately assess the risk they are about to take on, particularly for less liquid markets).
- The trader will then quote a price.
- Typically, the trader is very unlikely to hedge the risk or transact in the market until the client says “done”. Assuming the client says this quickly and the market hasn’t moved significantly, the trader is now at risk and has to choose how to hedge the transaction.
- However, there are times where the trader may “pre-hedge” before providing a price. This might be because the client is asking for an unusually large size or the market is highly illiquid (and multiple other reasons).
- The FMSB paper provides four “Case Studies” of this trading behaviour – I concentrate in this blog on Case Study 4, a New Issuance Swap.
When Pre-Hedging is not Front Running
The FMSB references two specific cases of pre-hedging (see regulatory action from the CFTC here and ASIC here) that were considered too close to the behaviour of front-running for comfort.
Given these regulatory actions, some readers may see “pre-hedging” and think it is just a euphemism. In my opinion, that really isn’t the case, and the FMSB report provides a useful comparison table of the different practices:
To put it succinctly;
- Front running is bad!
- I think it has always been considered bad (illegal?) if you do not have the client’s best interests at heart.
- I imagine regulators have lots of precise definitions of what Front Running consists of, but it is basically using knowledge about an upcoming trade to try and profit from it (normally at the expense of the client).
In day to day business in Swaps markets, it has been typically sufficient that:
- There is lots and lots of competition in all swaps markets.
- If a dealer does something to really annoy a client, then the client will choose to trade elsewhere.
- The lack of anonymity in our markets works in favour of a client if they are subject to the actions of a “bad actor”.
- If a trader makes loads of money on a single trade, they typically have to justify it to lots of different people internally (desk management, risk, financial controllers, compliance etc etc). It would be very unusual for so many layers of management to turn a blind-eye to outsize profits from a single transaction.
That isn’t to say that Front Running could not happen in the case of a particularly motivated individual or a bad client relationship. So I really salute trade bodies, such as the FMSB, for trying to flesh-out what is acceptable behaviour and what runs contrary to best practice. The table highlights that it helps both dealers and clients to have something written down!
Information “leakage”
So why (and how) do clients give dealers even a sniff of the possibility of “front running” or “pre-hedging” a transaction? Well, swaps don’t really operate in a standardised, “click to trade” order book. A client will typically want to hedge a specific risk of theirs – e.g. an upcoming bond issue. This bond issue has to be marketed, with some degree of specificity (e.g. size, currency, maturity) to drum up interest from potential investors. That information makes its way onto news wires (see BondRumours for example). Good sales people who cover the accounts should then pick up the phone and say “do you want an indicative price from my bank to enter into a swap with you”?
The client now has a number of choices. Which would you choose?
- Deny all knowledge of what the sales person is speaking of. Great if you are junior, not so plausible if you are the treasurer of the company or work on the derivatives desk and trade swaps all day long.
- Say “hey, great, that’s a good idea, I hadn’t thought of that” and get a quote.
- Say “oh no, it’s fine, we’ve already done the swap”.
If you think about it, all of those actions contain some type of information leakage regarding the potential of a potential transaction! They are either saying “we are already speaking to your competitors, we don’t want to mess up their market” or “we plan to do a swap” or “we’ve done a swap”.
By the very nature of swaps being customisable instruments and requiring a conversation of some kind, information leakage can happen irrespective of whether a client explicitly asks for a price or not.
What Does the FMSB Say?
Helpfully, the specific case of a New Issuance swap is dealt with as Case Study #4. I think the FMSB does a great job of;
- Describing current market behaviour. Transparency is good!
- Explaining the rationale behind it.
- Highlighting the cost/benefits to the issuers and investors as a result of these actions.
Have a read. For clarity, a “JLM” is a Joint Lead Manager on the bond – i.e. the banks running the issuance process for the new bond (on behalf of the issuer).
In Summary
- Standard setting bodies, like the FMSB, can help clarify grey areas of regulation, such as what constitues pre-hedging and what is front-running.
- The impacts of information leakage and pre-hedging are highlighted in the FMSB report as part of the competitive bidding process for a New Issuance swap.
- It is really helpful to cast light on what are healthy market practices and highlight the benefits and potential costs of such behaviour.
- It is really hard to tread the line between publishing unspecific “standards” and lengthy lists of “don’t do this”. This particular FMSB report does not propose standards, instead laying the groundwork to codify specific standards at a later date.