As flagged in Thursday’s column, I want to revisit the subject of pre-hedging and the FX Global Code – and it is timely to do so given that the US Supreme Court is expected to review Mark Johnson’s petition to have his case heard and, eventually, overturn his conviction.

The “offense” committed by Johnson, even though he was following standard industry practice, was largely about the pre-hedging of the Cairn order. We all sometimes wish we could turn back time and purely from an ascetic viewpoint, I would love to have seen HSBC try to buy over two yards of sterling in one minute. The world would, I suspect, be treated to the epitome of market impact, as I have argued countless times in these columns.

What HSBC did was standard industry practice because everyone knew the order could not be handled in the fashion first argued by the US government (which, as we all know, later changed its tune) unless a high netting ratio with other orders could be guaranteed. It couldn’t be guaranteed of course, as repeated fixes both then and since have proven, therefore the only solution is to wear the risk and incur a hefty loss, or pre-hedge.

I have absolutely no problem with pre-hedging, under the right conditions and with the appropriate transparency to the client, prior to 2020 – and while I accept that this year has been a horror show and is therefore not the best time to have an in-depth debate about best practices – the fact is the market, as is the case with last look, has moved on and is in danger of leaving the FX Global Code behind.

As we all know, when best practice lags market evolution, the industry enters a period of heightened risk, so tough though conditions may be, I feel we need to have another look at pre-hedging.

Whichever way it is put – and to reiterate I agree with the practice for certain orders – the optics around pre-hedging are not great. Every time the market moves in the 10 minutes before a fix, or accelerates imperceptibly towards a stop loss, everyone knows someone is pre-hedging.

So, what is different now compared to when the Code was written? Again, it is the data and analytical tools available. Every major player has an analytics framework, often available to customers, to give their best estimate of market impact and, importantly, the optimum time window over which the order should be executed to minimise that impact. The very fact that these analytical tools tell the bank to pre-hedge a fix, for example, tells us that the order cannot efficiently be executed within the previously specified time frame.

We have these analytics that paint a largely accurate picture of predicted execution performance (with the usual rider about past performance etc…) so perhaps the Code should more explicitly encourage the use of them? If a customer wants to execute five yards of sterling at the fix and the analytics say it is better executed over a 30 minute window or longer – execute over that window. The fix window can still be a part of the overall window, but instead of pre-hedging, the bank will be executing what could be the same basic TWAP, but over a longer time horizon. The order would be worked in entirety rather than with a degree of pre-hedging.

On stop losses, perhaps best practice should be the executing party does not touch the market until the stop loss conditions are triggered? I can already hear some customers bleating about the cost but perhaps we should be asking, is it fair to give such an order in the first place? Especially if, as happens, the order is part of a larger ticket split between multiple players?

I would argue in this way there is less chance of the stop loss being hit because the laws of mathematics and economics that state every trade has an impact on the price are not in play. The stop loss may cost another five pips but it would be a genuine taking out of the stop, not something aided and abetted by a skewed price and pre-hedging.

I am not in the school that believes pre-hedging is a polite term for front running, but we, as an industry, need to understand that to most outsiders it is obviously trading ahead of the actual deal – which is…front running.

Just as there are vested, entrenched, interests on the Global FX Committee around last look, my sense is there is a reluctance on the part of members to engage fully on what remains a tricky issue, not least when it comes to their all-important client relationships. This is, perhaps, a time when the buy side members of the committee should take a lead (I’m not holding my breath – the FX industry remains hamstrung by customers wanting to be led by their banks and the banks wanting to listen to their customers) by raising the issue? The buy side seems to be taking more interest in FX execution quality generally, perhaps get the GFXC involved more by raising the issue there?

Of all the conduct-related legal risks facing the FX market, pre-hedging worries me the most, because even with disclosures in place I am sure that one day a sharp legal mind will look at it and argue that the data and analytics highlighted the problem ahead of the trade, therefore why did the bank or executing broker not recommend to the client they execute over a longer window?

In case anyone is in doubt over this matter, the Johnson case should serve as a stark reminder that the US legal system for one (I am sure others are in the same boat) does not collectively understand the nuances between listed and OTC markets.

Hopefully Mark Johnson will win the right to have his conviction overturned as I believe he should because the bank followed standard industry procedure. What should concern people is that we are all now well aware of the challenges around pre-hedging and should equally be aware that disclosures alone may not provide the desired level of protection.

Three years ago, providing the benefit of pre-trade analysis to clients would have been the domain of a few. Now it is not. For that reason alone, I believe the debate over pre-hedging has to be intensified and a solution arrived at that takes into account the modern tools and services available to us. If nothing else, it may help another unfortunate avoid five years (and counting) of hell in trying to overturn a conviction.

Pre-hedging in the modern FX market is a flawed concept – it needs to reconsidered, now.

Colin_lambert@profit-loss.com

Twitter @lamboPnL

Colin Lambert

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