This is a follow-up to the previous article – ‘Primary Market Manipulation - An Emerging Surveillance Risk’. That report created a lot of interest and discussion, particularly around the theme of pre-hedging. Those discussions justified a follow-up to provoke further useful discussion on this important topic.
Broader Issues
Whilst the previous article spoke of market manipulation related to primary
market activity, the problem actually relates to a wider set of problems: those
of all financial market transactions where a private fixing is involved.
In this case, the term private fixing relates to any case where a transfer of
risk off-exchange takes place between parties at a price determined by
reference to a screen price. The screen will display prices where market
participants are willing to trade. For example, as described in Commodity
Futures Trading Commission (CFTC) vs John Patrick Gorman III, a bond
issuance and issuer swap were priced using the ‘19901’ screen, which
displayed prices from a SEF (Swap Execution Facility) Broker Firm, including
prices for U.S. dollar interest rate swap spreads with a ten-year maturity
(“Ten-Year Swap Spreads”).
We described enforcement cases related to the fixed income and FX markets
in all cases where a screen fixing was used to determine a risk transfer
price between parties. However, the commodity and equity markets also
feature trades conducted on the same basis. Whilst enforcement cases
may not have featured in these markets, the same problems will almost
certainly exist.
Risk Assessment
Expressed as a general principle, the problem arises when a large volume
of risk is priced over the counter with reference to a screen, where the
contemporaneous volumes may be much lower. The issue is particularly
acute where the reference instrument (i.e., the instrument whose price is
displayed on the screen) generally trades in low volume and whose price
is volatile.
To some extent, we can break the problem down into two separate
components: those of pre-hedging and disclosure and those of market
manipulation.
Pre-Hedging
It seems logical that, when agreeing to a very large, risky trade with a
customer, two possible approaches to pricing can be taken.
1. The customer assumes the execution risk. In this case, the bank
performs all the required hedges and passes on the weighted average
price to the customer, plus an agreed profit margin. In this case, the
question of pre-hedging is not a relevant one; the actual execution
prices of the hedge trade achieved by the bank are simply passed on to
the customer and no screen price needs to be referenced.
2. The bank assumes the execution risk. In this case, the agreed trade
price includes a premium that the bank charges in exchange for
assuming the entire execution risk (the risk that the market moves
against the bank before the hedging can be completed). In this case, it
seems reasonable that pre-hedging would not be allowed since the bank
is explicitly charging a premium for assuming the risk that pre-hedging
negates. Additionally, pre-hedging is likely to cause the price of the
reference instrument to move against the customer, thus prejudicing the
customer’s interests.
Both options 1 and 2 seem reasonable. However, it seems that it would
be unreasonable to agree to option 2 with a customer, quote a full-risk
transfer price and then engage in pre-hedging. Charging a full transfer
price (in exchange for all the execution risk) and mitigating that risk by
pre-hedging (and in doing so, possibly disadvantaging the customer) seem
incompatible.
Whilst such an action isn’t necessarily market abuse, it seems dishonest
and possibly fraudulent. In its accusations against Westpac, ASIC
(Australian Securities and Investment Commission) labels the behaviour
“unconscionable conduct”. Additionally, within the ‘ESMA (European
Securities and Markets Authority) Evidence on pre-hedging’ published July
2023, ESMA finds insufficient evidence to ban the practice of pre-hedging
outright but concludes "that pre-hedging… might give rise to conflicts of
interest or abusive behaviours”.
Additionally, in both cases, but particularly with option 1, there is a risk of
over-facilitation by the executing trader. This is essentially front running;
just before executing the hedge / pre-hedge trades, the trader executes
trades for his own account in the knowledge the large amount of risk
associated with hedging the client trades will impact the market price and
profit the own-book trades.
Many banks have a pre-agreed right to pre-hedge stated in various
disclosure documents provided to their customers. Whilst that might help,
there is undoubtedly a disclosure issue at play which needs to be thought
through carefully on a case-by-case basis. For example, in Mizuho Capital
Markets LLC enforcement action brought by the CFTC, Mizuho would
pre-disclose to its client that it “may” seek to pre-hedge transactions
and that pre-hedging “may” affect the price of the underlying asset, but
Mizuho did not specify to clients that it might engage in trading in the
“minutes or seconds” before execution. The CFTC found that trading FX
spot in this manner allowed Mizuho to hedge its spot exposure at a more
favourable rate than would have otherwise been available. This resulted in
counterparties obtaining less favourable exchange rates on the forward
transactions at issue.
The CFTC found that Mizuho’s failure to disclose its pre-hedging activity
with sufficient specificity violated Section 4s(h)(3)(B)(ii) of the Commodity
Exchange Act (CEA) and 17 C.F.R. §23.431(a)(3)(ii), which requires swap dealers
to disclose “[a]ny compensation or other incentive from any source other
than the counterparty that the swap dealer or major swap participant may
receive in connection with the swap.” The CFTC explained that because
Mizuho had an incentive to trade in the minutes or seconds before the
transaction to obtain a more favourable spot rate on its pre-hedges, which
could negatively affect the rate its clients would receive on the transaction,
Mizuho had a conflict of interest that needed to be adequately disclosed.
Based on the alleged inadequacy of the disclosure, the CFTC also charged
Mizuho with violations of Section 4s(h)(3)(C) of the CEA and 17 C.F.R.
§23.433, which requires that swap dealers “communicate in a fair and
balanced manner based on principles of fair dealing and good faith,” and
with a failure to supervise under Section 4s(h)(1)(B) of the CEA and 17
C.F.R. §23.602(a) based on alleged shortcomings in Mizuho’s policies and
procedures related to its pre-hedging practices.
Similarly in the CME (Chicago Mercantile Exchange) NOTICE OF
DISCIPLINARY ACTION - COMEX 19-1158-BC, dated 19 May 2022,
against J. Aron & Company LLC, the CME noted ‘A party acting principally
in a block trade negotiation that plans on engaging in pre-hedging
activity must ensure it is clear to its counterparty that the party is trading
principally and, as such, owes no agency duties to the counterparty. In that
regard, initial disclosures in account opening agreements or other similar
communications may be deemed insufficient in the event that the block
trade negotiation itself is indicative of the party assuming agency duties to
the counterparty.’
Market Manipulation
It might be possible to argue that pre-hedging is permitted even when the
customer trade is executed at a price which references a screen price.
However, regulators are clear that such permission does not create a
licence to manipulate market prices.
Pre-hedging activity in this case should be executed in such a manner as
to create minimal market impact. Recklessly creating market impact by
executing large trade volumes just before the screen price is referenced
is likely to constitute market abuse both with and without pre-hedging
rights. Indeed, it seems reasonable that traders' pre-hedging transactions
have a general responsibility to create minimal market impact ahead of
private fixings. For example, the FICC Markets Standards Board, “Standard
for Execution of Large Trades in FICC Markets,” notes that “Pre-hedging
should be reasonable relative to the size and nature of the anticipated
transaction.”
The amount of pre-hedging and the hedging mechanism employed to
avoid unfair market impact and the risk of creating a false or misleading
impression of the market price is extremely nuanced and will depend upon
the market and the circumstances. This has been highlighted by bodies
such as the Global Foreign Exchange Committee within the FX Global
Code where they note that in assessing whether pre-hedging is being
undertaken in accordance with the principles outlined within the Code, a
“Market Participant should consider prevailing market conditions (such as
liquidity) and the size and nature of the anticipated transaction.”
Regulatory Scrutiny
The regulatory complaints and prosecutions brought by various global
regulators clearly indicate that there is significant concern that primary
market transactions are not systematically monitored for market abuse and
customer conflicts of interest.
In many banks, primary market transactions are monitored on a random
selection basis. Selected transactions undergo a “deep dive” where
communications associated with the trading activity are analysed and, in
some cases, the hedge trades themselves are analysed.
This approach is unlikely to be acceptable to regulators and the
recent enforcement cases make clear that this is an area of increased
regulatory focus.