European regulator backtracks on pre-hedging ban but warns of risks

investmentweek.co.uk:

ESMA describes pre-hedging as 'a voluntary market practice which might give rise to conflicts of interest or abusive behaviours'.

Pre-hedging, which ESMA described as «a voluntary market practice which might give rise to conflicts of interest or abusive behaviours», takes place when liquidity providers aim to hedge their inventory risk in an anticipatory manner.  

As an example, a liquidity provider expecting an order from a client may want to hedge the expected future risk arising from filling that order. To that goal, the liquidity provider undertakes one or several transactions to hedge the order before it is received.

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ESMA's view was that, despite pre-hedging often being motivated by a risk management rationale, the practice might raise concerns in terms of insider dealing.

For instance, a broker may be considered to have used the information received from the client about their incoming order to trade against the client. 

ESMA issued a ‘call for evidence' last year to assess whether to ban pre-hedging.

Based on the feedback it received and the issues raised, ESMA stated no ban was necessary, but global regulatory principles applicable to pre-hedging could be beneficial to foster a common regulatory approach to this practice. 

The potential principles could serve as a basis for the development of any future ESMA guidance, it added.

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