News & Views

Is Pre-hedging Considered Market Manipulation?

Is Pre-hedging Considered Market Manipulation?

By: Martin Appiah, Director of Regulatory Affairs, EMEA, Eventus


In the final report on the MAR Review, published on the 24th September 2020, ESMA acknowledged that there are fundamentally different views on pre-hedging. As a follow-up to the MAR Review, ESMA is therefore undertaking an analysis of that practice in the market and on the 29th July 2022 issues a call for evidence (CFE).

In the course of its MAR Review, ESMA alerted market participants that some national competent authorities had received suspicious transactions and order reports (STORs) on pre-hedging behaviour, a practice that is not defined in EU law. Mixed views from the market were expressed on the usefulness of pre-hedging and the risks associated with this practice. 

A significant number of respondents to the MAR Review Consultation Paper (CP) considered that pre-hedging entails market abuse risks and that it may not be beneficial for the client or the integrity of the market. These respondents considered that an RFQ may meet the MAR definition of inside information partly due to the non-public nature of the RFQs. For example, one stakeholder noted that trading venues making use of the RFQ trading system only provide the RFQs to the liquidity providers who have been asked to respond to it.

Other respondents noted that pre-hedging might have detrimental effects where the client requests quotes from two or more liquidity providers through “a first mover advantage”: 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 pre-hedging party better positioned to win the trade, but it could also impact the final price at which the trade is executed.

Several market participants asked ESMA to issue guidance on what should be considered as MAR-compliant in terms of pre-hedging and what behaviour might constitute frontrunning. Guidance was also requested on procedural aspects of pre-hedging, such as the documentation required, transparency regarding pre-hedging arrangements by brokers to their clients, and internal policies of market makers. 

The working definition for ESMA, defined in the CFE,  is that, on the one hand, pre-hedging involves a risk management aspect, as it takes place when a dealer acting as principal undertakes a trade in anticipation of a client order, in order to manage the risk associated with a possible trade stemming from that order. On the other hand, pre-hedging may fall within the scope of insider trading if a broker were to use the information received from the client to make trades for his own account, including potentially trades against the client.  

ESMA noted that pre-hedging is a frequent practice in financial markets that is not banned in other jurisdictions, provided that certain requirements are met: FINRA rule 5270 does not preclude a broker-dealer to trade for its own account to fulfill or facilitate a client’s block transaction. However, when engaging in trading activity that could affect the market for the security that is the subject of the customer block order, the broker-dealer must minimize any potential disadvantage or harm in the execution of the customer’s order, must not place its financial interests ahead of those of its customer, and must obtain the customer’s consent to such trading activity.

In Canada, front-running a client order is banned except where the principal order is submitted to hedge a position that the participant had assumed or agreed to assume before having actual knowledge of the client order, provided that the hedge is commensurate with the risk and in accordance with the ordinary practice of the participant.

Along the same line, the GFXC (Principle 1121 and guidance paper 22) and the FSMB standard for the execution of large trades in FICC markets describe the factors under which pre-hedging would be acceptable. 


ViP: The activity of pre-hedging is not new to the financial markets. Liquidity providers have been pre-hedging for a long time, and like anything else, it is something that can be abused. The ‘first mover advantage’ can impact the price of an instrument, and potentially raise the risk of front-running a client’s large order/RFQ. 

While there are many questions still outstanding in regards to pre-hedging and more regulatory guidance needed, Valdius can help in monitoring for inappropriate use of client information – front running. 

Validus has a front-running procedure where users are able to define a front-running account group, such as prop or risk books, vs target account group, such as client accounts. Users are also able to specify the front running time window and the size of a large order, allowing users to customize the parameter to meet their business needs. Potential front-running activity can be detected based on fills where orders are captured over the phone or chat or based on orders where orders are captured electronically. 


About Eventus

Eventus is a leading global provider of multi-asset class trade surveillance and market risk solutions. Its powerful, award-winning Validus platform is easy to deploy, customize and operate across equities, options, futures, foreign exchange (FX), fixed income and digital asset markets. Validus is proven in the most complex, high-volume and real-time environments of tier-1 banks, broker-dealers, futures commission merchants (FCMs), proprietary trading groups, market centers, buy-side institutions, energy and commodity trading firms, and regulators. The company’s rapidly growing client base relies on Validus and Eventus’ responsive support and product development teams to overcome its most pressing regulatory challenges. For more, visit www.eventus.com.