[ C L O S I N G B E L L ]
ESMA ’ s latest shot at ‘ pre-hedging ’ must now bring a clear set of rules
On 30 September 2022 , the European Securities and Markets Authority ( ESMA ) closed a Call for Evidence on pre-hedging ( the results of which were not yet published at the time of going to press ), which requested insights from market participants as to the current practice , and their perspective on what appropriate guidance should look like . The request for input was a follow-up to the Market Abuse Regulation ( MAR ) review carried out by the regulator in 2019 , with ESMA acknowledging the diversity of opinion on pre-hedging in its post-review report and highlighting the urgent need for clarification around the rules of the practice .
What is pre-hedging and why is it a big deal ? So called pre-hedging occurs when a liquidity provider that has received a request for a price quote from a potential counterparty ( sometimes referred to as a Request for Quote or RFQ ) trades in the market prior to finalisation of any transaction with the requesting counterparty . This , proponents say , is done to ‘ hedge ’ the position
John Keogh , managing director at Susquehanna International Securities ( SIG ), makes the case for banning the controversial practice , in the wake of ESMA ’ s latest request for industry input .
that the liquidity provider might acquire if it actually trades with the counterparty making the original pricing request . For example , an asset manager may ask a number of liquidity providers to show a price at which they are prepared to buy a large quantity of shares in Company X from that asset manager .
The fact that the asset manager wants to sell the block of Company X shares isn ’ t public information . The fact that there is a large seller would suggest that Company X ’ s share price will move lower than the current price . In this circumstance , liquidity providers who engage in pre-hedging sell Company X shares for their own account in the market on the basis that that this trade would offset or ‘ hedge ’ the position that they might acquire if the asset manager accepts their bid price to buy the Company X shares . These liquidity providers claim that such an approach enables them to provide better pricing and liquidity .
What is the argument against the practice ? Pre-hedging shouldn ’ t be acceptable for a number of reasons . First , we must address the age-old question : cui bono ? There isn ’ t any evidence that pre-hedging improves prices for clients . Indeed , if a liquidity provider sells before the price is agreed with the client , their proposed bid ( and the bids of other competing liquidity providers ) may be adjusted lower based on a move in the share price arising from these pre-hedging market sales . This results in a worse price for the client . Second , if all liquidity providers ‘ pre-hedged ’, then multiple orders would be sent into the market resulting in a disproportionately negative
94 // TheTRADE // Q4 2022