The International Organization of Securities Commissions conducted a consultation session in February 2025 with market participants intending to introduce some best global pre-hedging practices in the financial sector later in 2025. The expected changes in the pre-hedging rules seem to have created a major split in the financial industry, with banks being in favour of it while asset managers and market makers are against it.
Pre-hedging has been a matter of division between investors and banks in the modern financial ecosystem. The controversy centres around the new market regulation aimed at regulating this practice, with both sides having firmly established their views on what is considered fair for the market. This article covers different aspects of pre-hedging in the global markets.
What is Pre-Hedging?
Pre-hedging refers to the practice where a dealer or bank trades ahead of an anticipated client transaction to manage potential market risks. In simpler terms, when a bank expects a large client order that might impact market prices, it may start trading before the actual transaction to minimise risk.
For instance, if a client plans to buy a substantial amount of currency that would likely drive up prices, the bank might begin purchasing some of that currency beforehand as one of their trading strategies. The European Securities and Markets Authority (ESMA) defines pre-hedging as a trading activity where:
- The investment firm deals with its own account
- Trading aims to mitigate an anticipated inventory risk from a possible incoming transaction
- The trading occurs before the transaction in question is executed
- The activity is at least partially intended to benefit the client or facilitate the trade
The Current Regulatory Landscape
In July 2024, the Financial Markets Standards Board (FMSB) released a Spotlight Review on pre-hedging to address the uncertainty surrounding when and how pre-hedging may be appropriate. This review came as regulatory authorities across the globe started to take a closer look at the market regulation.
The International Organization of Securities Commissions (IOSCO) issued a Consultation Report in November 2024, which prompted strong responses from industry associations representing investors. These associations, including SIFMA AMG, ICI, and ACLI, expressed concerns about the report’s apparent assumption that pre-hedging should be widely permissible. On February 21, 2025, the International Swaps and Derivatives Association (ISDA) and Futures Industry Association (FIA) seconded the report. They agreed that a well-understood framework is required for conducting safe and efficient pre-hedging.
Why Banks Defend Pre-Hedging?
Banks and dealers generally support pre-hedging as one of their trading strategies for several reasons:
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Risk Management
Banks argue that pre-hedging allows them to manage the substantial risks associated with large client orders in less liquid markets. This risk management, they claim, ultimately benefits clients by enabling better execution prices.
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Client Benefits
Banks maintain that when done properly, pre-hedging can improve execution outcomes for clients. For example, in a case where a large buy order would drive up prices, pre-hedging might allow the bank to secure some inventory at lower prices, potentially passing those savings to the client.
What is Causing the Concerns Amongst Investors?
Investor concerns regarding pre-hedging practices have grown substantially in recent years:
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Misuse of Information
Investors worry that pre-hedging allows banks to trade based on confidential client information. The Securities Industry and Financial Markets Association Asset Management Group (SIFMA AMG) argued that pre-hedging involves a dealer trading ahead of a client based on information regarding an anticipated trade received from its client.
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Potential Conflicts of Interest
There is a concern that pre-hedging creates inherent conflicts between banks’ interests and those of their clients. Critics suggest it is difficult to ensure that pre-hedging activities genuinely benefit clients rather than just the banks themselves.
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Lack of Transparency
Many investors feel there is insufficient transparency around pre-hedging practices. Without clear disclosure and consent requirements, they argue that clients cannot make informed decisions about whether to allow pre-hedging.
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Market Impact
Critics argue that pre-hedging can move markets before the client’s transaction occurs, potentially resulting in worse execution prices for clients. This is particularly concerning for large orders that might significantly impact market prices.
The Current Debate Over New Rules
The debate has intensified as global regulators consider new frameworks for pre-hedging. The Consultation Report from IOSCO has become a focal point, with investor groups pushing back against what they believe to be an overly liberal approach.
Investor associations have urged regulators to establish clear boundaries to limit the practice to minimise the harm that can arise from dealers trading before their clients. They argue that pre-hedging should only be allowed with express affirmative consent on a trade-by-trade basis following appropriate disclosure and only when it is designed to benefit the client.
However, banks and their representatives continue to call for flexibility in the rules, which would allow pre-hedging to be seen as a legitimate risk management tool if properly conducted with adequate controls in place.
Finding Middle Ground: Potential Solutions
Industry experts suggest several approaches that might help resolve the current standoff:
- Clear Disclosure Requirements: Both sides generally agree that transparency is crucial. Specific, clear disclosures about when and how pre-hedging might occur could help clients make informed decisions.
- Client Consent Framework: Developing standardised frameworks for obtaining client consent for pre-hedging activities could address investor concerns about information misuse while giving banks clarity on when the practice is permitted.
- Enhanced Surveillance: Improved monitoring of trading activities around client orders could help detect and prevent abusive practices, providing reassurance to investors while allowing legitimate pre-hedging activities.
- Principles-Based Approach: Some market participants suggest that, rather than rigid rules, a principles-based approach to market regulation, focusing on client interests, might be more effective in addressing the complexities of different market situations.
What does this Mean for Indian Financial Markets?
For Indian investors and financial institutions, these global debates are particularly relevant as the markets are increasingly integrated with international financial systems. Any consensus on pre-hedging will introduce a new set of rules that Indian banks and brokerages participating in global markets must comply with.
As an increasing number of Indian investors tap into international markets, it will be crucial to understand how trading strategies, such as pre-hedging, can impact execution quality. While domestic market regulation frameworks might differ, the global standards being developed will likely influence Indian market practices over time.
Final Thoughts
All market participants will need to adapt to the practices per the changes in the regulations to ensure compliance while continuing to serve client needs effectively. For investors, these developments should be closely followed to help form reasonable expectations for their trading strategies.
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