Pre-Hedging in FX: Balancing Risk and Transparency Without Any Standardization

As the industry digests the findings of IOSCO's review of the practice of hedging anticipated client trades, dealers are adamant that it is a procedure that benefits clients as well as those executing the trade. Pre-hedging (otherwise known as anticipatory hedging) has been a contentious topic in the over-the-counter (OTC) markets for some time.

Pre-hedging Must Be Fair and Transparent

The Global FX Code defines pre-hedging as ‘the management of the risk associated with one or more anticipated client orders, designed to benefit the client in connection with such orders and any resulting transaction’.

It states that market participants should only pre-hedge client orders when acting as a principal and should do so fairly and with transparency in a manner that is not meant to disadvantage the client or disrupt the market. They should also communicate their pre-hedging practices to clients to enable them to understand their choices as to execution.

One of the challenges for the FX market is that there is no global definition of pre-hedging or regulatory guidance on when it is acceptable and the management of conduct risks when it is used – the Global FX Code is widely adhered to but has no basis in regulation.

IOSCO has suggested that pre-hedging should be defined as ‘trading undertaken by a dealer, in compliance with applicable laws and rules, including those governing frontrunning, trading on material non-public information/insider dealing and/or manipulative trading, where the dealer is dealing on its own account in a principal capacity; the trades are executed after the receipt of information about an anticipated client transaction and before the client (or an intermediary on the client’s behalf) has agreed on the terms of the transaction and/or irrevocably accepted an executable quote; and the trades are executed to manage the risk related to the anticipated client transaction’.

Not Appropriate to Hedge Retail Risks

This is not an issue for all brokers. For example, the vast majority of Trade Nation’s clients are retail so it would be completely inappropriate for the firm to pre-hedge even if the client was made aware of the practice explains David Morrison, the broker's Senior Market Analyst.

“We always accept risk and then hedge,” he says. “In our business, pre-hedging would be tantamount to front-running as it would have the potential to misuse client information for the broker’s benefit. We actively hedge but this is carried out after the risk has been accepted and internalised and this is made clear to all our clients.”

According to Filip Kaczmarzyk, member of the management board of XTB, the reasoning behind pre-hedging FX trades is straightforward in that it helps manage risk and reduces potential market impact, thereby avoiding increased volatility.

“This practice also enables financial institutions to achieve more predictable and reliable outcomes,” he says, adding that it should not affect client pricing in general. “However, for large trades there will always be a market impact, regardless of how well the algorithms are configured. Moreover, when the market anticipates significant trades it is typically reflected in wider spreads.”

Positive Impact on the Offerings

IOSCO sits on the fence when it comes to the impact on pricing, observing that while the net effect of pre-hedging on pricing is unclear, a reduction in market risk for dealers may potentially enable them to provide a better quote to the client.

When done correctly, pre-hedging can have a positive impact on the price the client receives as it creates smoother execution (especially for larger orders), reducing the potential for sharp price movements against the client.

“It can also improve liquidity in the market, keeping spreads tighter and more competitive, reducing the potential for slippage on execution and allowing for a more timely and efficient execution of the client order, reducing the possibility for partial fills,” observes Ross Maxwell, global strategy and operations lead at VT Markets.

But if a broker prioritises its own profits before risk management the market can move before the client order has even been executed, creating adverse market movements and worse pricing. This can especially be the case in low volume markets.

A paper published in April 2024 by Roel Oomen (then Deutsche Bank’s global head of FIC quantitative trading) and academics from Imperial College, London and Carnegie Mellon University concluded that when the transient price impact dominates permanent impact and decays sufficiently quickly, the client’s all-in transaction costs can be lowered by pre-fix hedging.

However, when permanent impact dominates or transient impact decays slowly, they found that pre-fix hedging could be detrimental to the client.

Lack of Standard Procedure Is an Issue

Disclosure is another divisive issue. IOSCO recommends that dealers provide clear disclosure of their pre-hedging practices but acknowledges that there is no standard procedure for this and that dealers may use a combination of disclosure practices or choose not to disclose their pre-hedging practices at all.

It is also important that clients understand the distinction between pre-hedging and front-running. As they can appear very similar, clients would benefit from brokers taking time to ensure they understand how their trades are managed, why they are managed in that way and the benefits.

“Front-running seeks to profit illegally from insider information, whereas pre-hedging is a strategy used to manage and mitigate risks,” says Kaczmarzyk. “Pre-hedging is conducted with the client’s interests in mind and involves full transparency. I believe that transparency is essential in this context.”

As for whether IOSCO’s recommendations will improve market conditions, Maxwell reckons stronger regulation with stricter compliance standards would help enhance the reputation of the FX market whilst providing greater client protection by reducing the likelihood of front running and market manipulation.

“However, this could make brokers hesitant to conduct legitimate pre-hedging strategies which can benefit market liquidity and client execution for fear of being pulled up on stricter regulations,” he adds.

An increase in regulatory and compliance requirements could weigh particularly heavily on smaller brokers, pushing them out of the market and reducing competition by discouraging new entrants, reducing competition and again having an adverse effect on client pricing. There is also a danger that additional compliance costs would be passed on to the end client through transaction fees.

Finally, although a broader framework would provide consistency across different markets and under different jurisdictions, there is always the potential for different jurisdictions to apply and implement IOSCO’s requirements differently.