Citing concerns about manipulative trading, global securities regulators are consulting on proposed guidance to deal with so-called “pre-hedging” transactions in securities and derivatives markets.
The International Organization of Securities Commissions (IOSCO) published a consultation report on the practice of investment dealers engaging in transactions, as a principal, to hedge the expected risk of a pending client transaction. These kinds of trades are executed on trading venues and over the counter (OTC) in a range of assets classes, including equities, fixed income, currencies and commodities, it noted.
The report said that, while there can be benefits from the use of pre-hedging for dealers and clients, various regulators, standards setters and industry firms, “have raised potential concerns about the appropriateness of pre-hedging practices.”
These concerns include worries about conflicts of interest and various forms of abusive trading, such as insider trading and market manipulation.
While there have been attempts to address these concerns in certain industry codes of conduct, the report said that these codes may not be effective as they are typically focused on specific asset classes, and primarily target OTC markets.
Additionally, these codes, “are not applied universally and generally not endorsed by regulators and there are no monitoring, oversight, supervision or enforcement mechanisms to ensure that conduct occurs in line with them,” IOSCO noted.
The regulators’ report reviews the potential market conduct and integrity issues associated with the practice of pre-hedging, considers existing regulatory approaches and aims to identify the gaps in oversight.
It also sets out a series of proposed recommendations for regulators to consider when addressing the risks posed by pre-hedging.
Among other things, the proposed recommendations include guidance on when pre-hedging is considered acceptable; sets obligations for dealers to act fairly and honestly with clients, and to only engage in pre-hedging trades to benefit the client; and calls for dealers to minimize the market impact of these trades.
It also includes recommendations for dealing with the risk of misconduct from pre-hedging, including disclosure, compliance and oversight requirements. It calls on dealers to obtain prior consent from clients before engaging in these trades. And it recommends that dealers develop procedures to control access to confidential client information and prevent its misuse.
The paper is out for comment until Feb. 21, 2025. Following the consultation, IOSCO will publish a final set of recommendations later in the year.