IOSCO Releases Consultation on Pre-Hedging Practices

In November 2024, IOSCO released a consultation report on pre-hedging in financial markets, seeking to increase clarity and international regulatory alignment in the space. In its report, IOSCO proposes a definition of "pre-hedging" for adoption by regulators, along with several recommendations intended to guide regulators and market participants on: (i) when pre-hedging may be acceptable; and (ii) how best to manage associated conduct risks.  

This consultation comes at a critical juncture, as market participants continue to grapple with varying interpretations of pre-hedging across jurisdictions and asset classes. With its global scope, IOSCO's initiative has the potential to bring greater consistency to pre-hedging practices and establish robust safeguards against misconduct. The consultation follows recent reports on pre-hedging from ESMA in 2023 and FMSB this past August.  

Stakeholders, including dealers and their clients, have until February 21, 2025, to submit feedback on the report. IOSCO plans to publish its final recommendations in 2025. Although ultimately merely advisory, IOSCO's final recommendations will provide persuasive guidance for national regulators as they seek to more effectively regulate pre-hedging activities. Accordingly, firms stand to be significantly impacted by the guidance and should proactively review their current pre-hedging practices in advance of potential regulatory shifts. 

What is Pre-Hedging? 

There is no universally accepted definition of "pre-hedging," and it can often be difficult to distinguish pre-hedging (a legitimate risk-management strategy) from "frontrunning" (a form of market abuse). Both pre-hedging and frontrunning involve a dealer's use of advance knowledge of a pending large order to trade for their own account before executing the client's order. The distinction primarily relates to the purpose behind the trades: while pre-hedging is done to reduce the risk of market impact or adverse price movements caused by the large order (often for the client's benefit), frontrunning seeks to exploit the inside information for the dealer's benefit (often at the client's expense). 

The Proposed Definition 

IOSCO proposes to define pre-hedging 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: 

1. the dealer is dealing on its own account in a principal capacity; 
2. 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 
3. the trades are executed to manage the risk related to the anticipated client transaction."

 The proposed definition largely aligns with the definitions offered in ESMA's 2022 Call for Evidence and in the FX Global Code, with the primary difference being that IOSCO's definition is agnostic to conduct/integrity issues (including whether a pre-hedging trade must, by definition, benefit the client). Instead, IOSCO deals with such issues in its recommendations and consultation questions later in the report.  

Recommendations for Acceptable Pre-Hedging Practices 

While the report acknowledges the potential benefits of pre-hedging in facilitating liquidity and efficient pricing, it also highlights the potential for conduct and market integrity issues, including the misuse of information, lack of transparency, and lack of client consent. Currently, there is no universal regulatory guidance as to when pre-hedging is acceptable. Although some existing industry codes and standards do address pre-hedging, their application is generally limited to specific asset classes, and they lack monitoring and enforcement mechanisms necessary to ensure compliance. 

In response to these risks, the report sets out a series of recommendations aimed at providing guidance for regulators (as they draft their own rules at a national level) on when pre-hedging may be appropriate and how to manage associated conduct risks: 

• Genuine Risk-Management Purpose. Dealers should undertake pre-hedging only for genuine risk-management purposes, such as managing market risk exposure from anticipated client transactions, lengthening the duration of time for managing risk to reduce transaction costs, and testing market prices and liquidity. This includes considering: (i) whether there is a legitimate expectation of a client transaction; (ii) available liquidity; (iii) market conditions; and (iv) the extent of pre-hedging that is required (i.e., proportionality).
• Fairness and Client Benefit. Dealers must act fairly and honestly toward clients and undertake pre-hedging with a demonstrable intention to benefit the client. In deciding whether pre-hedging would be fair and to the client's benefit, dealers should consider client instructions, price and speed of execution, expected market impact, trade size, and liquidity—and be prepared to demonstrate how they have reasonably considered such factors. Of course, dealers must also continue to comply with existing laws and regulations governing dealer conduct in their jurisdiction (including regarding frontrunning, trading on material non-public information/insider dealing, and/or manipulative trading).
• Minimizing Market Impact and Maintaining Market Integrity. Dealers should minimize the market impact of pre-hedging strategies to avoid adverse effects on the client and other market participants. This includes considering the potential for price slippage and the cumulative effect of pre-hedging transactions on the market price (especially in a competitive request-for-quote ("RFQ") scenario, where adverse effects can be magnified by duplicative pre-hedging by multiple competing dealers). Dealers should also consider how to avoid disrupting market integrity when closing out pre-hedging positions built in connection with a transaction that does not proceed. 

Management of Conduct Risk 

IOSCO also makes several recommendations for managing conduct risks associated with pre-hedging: 

• Policies and Procedures. Dealers should implement appropriate policies and procedures covering the identification, assessment, management, and avoidance of conduct risks.
• Disclosure and Informed Consent. Dealers should clearly communicate pre-hedging practices to enable clients to make informed decisions. Disclosure can take various forms, including upfront, trade-by-trade, or post-trade disclosure, and the appropriate type will be influenced by the nature of the transaction and the client's sophistication. Each has its own set of challenges and considerations, particularly in the context of electronic trading platforms and competitive RFQs.
• Compliance and Supervision. Dealers should implement robust compliance and supervisory arrangements to ensure that pre-hedging activities align with internal policies, procedures, and controls (including supervisory systems, trade and communications monitoring, and post-trade reviews to assess the market impact and execution outcome of any pre-hedging). Dealers should also have internal controls to differentiate pre-hedging from inventory management.
• Information and Conflicts. Dealers should manage access to confidential client information (including implementing information barriers) and manage conflicts of interest that may arise.
• Record-keeping. Dealers should maintain adequate records of pre-hedging activities to facilitate front-office supervisory oversight, monitoring, and surveillance. 

Impact on Dealers 

For dealers, the proposed framework has wide-ranging implications to the extent it is ultimately adopted in a similar form by national regulators: 

• Enhanced Risk Management. Dealers may need to refine their methodologies for assessing transaction risk and determining the appropriate scale of pre-hedging activity to ensure proportionality and client benefit. This might involve recalibrating internal models for assessing liquidity and risk exposure.
• Operational and Compliance Overhaul. The guidance calls for enhanced policies, record-keeping, and surveillance systems to manage pre-hedging conduct risks effectively. Dealers may need to expand compliance teams and infrastructure to monitor adherence to the proposed transparency and accountability requirements.
• Market Strategy and Pricing. The consultation highlights potential client scrutiny over pre-hedging practices, particularly in competitive RFQ environments. Dealers may face pressure to refine pricing strategies and justify execution outcomes, particularly in highly competitive markets, such as FX or commodities.
• Cross-Border (and Cross-Asset) Alignment. Despite IOSCO's push for an internationally aligned approach to the regulation of pre-hedging, significant jurisdictional variations remain (and likely will for some time before regulators begin to implement IOSCO's proposals). During this time, dealers operating cross-border will need to navigate potentially conflicting requirements while aligning with new global best practices. Dealers active in multiple asset classes will also need to navigate the fragmented landscape of industry codes and standards, in addition to new global best practices, until greater cross-asset alignment is achieved. 

Conclusion  

IOSCO's consultation report on pre-hedging practices represents a significant effort to establish a globally consistent regulatory framework for pre-hedging, with the aim of balancing dealers' legitimate risk-management needs with the principles of transparency, fairness, and market stability. 

We encourage firms to review the full report and consider providing feedback to IOSCO by the deadline of February 21, 2025. This consultation provides an opportunity for market participants to shape the evolving regulatory framework for pre-hedging and ensure that their needs (including for the continued flexibility and competitiveness of dealer markets) are reflected in IOSCO's recommendations.  

We also recommend that firms proactively review their current pre-hedging practices and closely monitor developments to ensure compliance with evolving regulation.