Banks Face Off With Investors Over ‘Pre-Hedging’ Trade Rules

(Bloomberg) — An effort by global regulators to set new rules this year on a controversial trading practice is drawing dividing lines across the financial industry.

The issue in their crosshairs is so-called pre-hedging, where a dealer uses information from an investor about a planned trade to place their own order beforehand. While that can protect against the risk of the transaction, investors worry it can move prices to their detriment — with some calling it front-running.

The International Organization of Securities Commissions last month finalized a consultation with market participants and is expected to determine global best practices in a publication later in 2025. Responses seen by Bloomberg News reveal a split in the financial industry, pitting banks — who favor it — against asset managers and market makers who see it as a potential abuse of position. 

Getting the rules right is critical to avoiding more trading controversies, after front-running cases in currencies triggered over $13 billion in fines for banks. The challenge is defining where pre-hedging ends and market abuse begins.

“Differences in interpretations of what is legitimate pre-hedging has opened the door to a damaging practice, a behavior that might more accurately be characterized as front running,” Emma Lokko, head of European market structure at broker Susquehanna International Group, told Bloomberg. “Investors should be able to freely ask multiple dealers for a price without seeing prices move against them prior to their trade being agreed.”

A dealer anticipating an order may buy or sell the same securities in the split seconds or minutes before they actually need to fill the position. The practice is most contentious when an investor asks multiple dealers for a price, known as competitive request-for-quotes (RFQs).

Broad guidance has already been given in a mishmash of industry standards, with the European Securities and Markets Authority concluding it might “give rise to conflicts of interest or abusive behaviors.” A ban has been avoided so far. 

Asset management groups, as well as leading non-bank market makers including Susquehanna, have advocated for a definitive ban of pre-hedging competitive RFQs. Jane Street told ESMA in 2022 that pre-hedging a competitive RFQ can be considered “a form of market abuse.” XTX Markets states on its website it has “no ability to pre-hedge” in currency markets. Both declined to comment when asked about their views of the Iosco consultation.

By contrast the largest banks in the $7.5 trillion-a-day FX market do allow pre-hedging, according to a Bloomberg analysis of their trading disclosures to clients.

So far Iosco has not proposed a ban. It said dealers should only pre-hedge for “genuine risk management purposes” and that they must act “fairly and honestly.” They must also look to benefit the client’s interest and minimize market impact. “A global approach to pre-hedging seeks to promote a level playing field for industry,” an Iosco spokesperson said.

The consultation said its members are aware “that misconduct may potentially be occurring in connection with pre-hedging.” It cited data from France’s financial regulator, which showed pre-hedging is one of the issues involving the most “suspicious matter reports” from dealers. Nearly two-thirds of these related to pre-hedging in fixed income and FX instruments.

The distinction between pre-hedging and front-running relates to the purpose behind the trades, according to Jones Day lawyers. “While pre-hedging is done to reduce the risk of market impact or adverse price movements caused by the large order (often for the client’s benefit), front-running seeks to exploit the inside information for the dealer’s benefit (often at the client’s expense).”

The buy side accepts that pre-hedging is legitimate in some circumstances. A joint response to the Iosco consultation from three US asset management groups states it’s justifiable “where the dealer takes on outsized risk in the anticipated transaction and the potential for harm to the client can be minimized.” This would only include “large, bespoke trades in over-the-counter illiquid markets.”

Banks disagree. Adam Farkas, Chief Executive Officer of the Global Financial Markets Association, said pre-hedging is “as legitimate a practice in liquid markets as in illiquid ones, with dealers still needing to manage risks.”

There’s unlikely to be a solution that pleases everyone. Whatever the final result, Iosco’s proposals stand to put dealers’ pre-hedging practices under intense scrutiny. National regulators will begin adopting the findings in coming years.

“In its current form, the proposed framework would significantly impact dealers, potentially requiring changes to their risk management and compliance programs,” the Jones Day lawyers said.

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