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impact on the market price and consequently the price that the client receives .
Pre-hedging , however , is likely to result in a favourable outcome for the liquidity provider that pre-hedges - if they sell and they win the trade then they may have sold at a better price than they buy from the client . If they sell and they don ’ t get awarded the trade , their short position will be advantaged by the downward pressure on the share price arising from the sales of the liquidity provider who won the trade . This results in a ‘ heads they win , tails they win ’ outcome for the so-called pre-hedgers .
The term ‘ pre-hedging ’ can also be misleading , as some market participants use this expression to justify a behaviour that might more accurately be characterised as front-running . Rather worryingly , proponents of the practice account for a large amount of the volumes that are transacted in the European markets .
What are the key concerns ? ESMA correctly identifies these problems in its Call for Evidence when it stated : “ A liquidity provider pre-hedging when in competition with other firms might trigger a price movement which in turn affects the quotes subsequently offered to the client by other liquidity providers . This ‘ first mover advantage ’ effect could not only render the prehedging party better positioned to win the trade , but it could also impact the final price at which the trade is executed .”
We fully share this concern , which we see as a high and real risk . Absent a total ban on prehedging , a partial solution would be for ESMA to make it clear that pre-hedging is not permitted at a time when a liquidity provider is in competition with several other liquidity providers to respond to a request for a quote from a counterparty .
What would you like to see change ? If ESMA and EU policymakers want to ensure confidence in European financial markets , they should act and put an end once and for all to this damaging practice for our industry , our counterparties , and end-investors . This is not only about mitigating risk , but also about building a more cohesive , competitive , transparent , and efficient capital market in Europe , and indeed , one better equipped to compete with other major markets . Greater confidence will bring more participants , which will in turn improve markets and prices for everyone . Not creating a clear set of rules around this practice is only going to lead to a continued lack of clarity , meaning a perpetuation of different interpretations and approaches between markets , participants , and regulators .
With a direct and significant impact on the prices that pension and other funds receive for the securities they buy and sell , pre-hedging is a key market cleanliness issue with broad implications for the investment industry , but also the endinvestor and the public at large . It should not be overlooked this time around , for it could become a LIBOR moment for market confidence .
We believe it is critical that ESMA achieves a new set of rules clearly defining and eliminating pre-hedging .
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