Introduction

Pre-hedging is a murky liquidity provider practice that currently lacks uniform interpretation and regulatory oversight. The practice, which has been labelled frontrunning in some cases, is the process where liquidity providers hedge inventory risk in anticipation of a potential transaction. 

The anticipation of a trade is what separates it from regular hedging. While this is the general definition understood by market participants, the definition of pre-hedging is yet to be enshrined in EU law which creates uncertainty for investors. 

Pre-hedging in the European ETF market

In its 2022 call for evidence, the European Securities and Markets Authority (ESMA) defined pre-hedging as any trading activity undertaken by an investment firm where: 

• The investment firm is dealing on its own account, and the trading activity is undertaken 

• To mitigate an inventory risk which is foreseen due to a possible incoming transaction 

• Before that foreseeable transaction has been executed 

• At least partially in the interest and benefit of the client or to facilitate the trade 

The practice can be used by liquidity providers as a tool for mitigating unwanted risks on their balance sheet if a trade has been pre-agreed with the investor.

However, pre-hedging is particularly important for the European ETF market where over 50% of trades are executed via request-for-quote (RFQ) platforms. 

Strategies for buyside traders

When buyside traders want to buy or sell a block of ETF shares via platforms such as Tradeweb and Bloomberg, they will send an RFQ to multiple liquidity providers that are competing to win the trade by showing the best price. Dealers will then select which price they want and the liquidity provider is responsible for executing the trade. 

However, because dealers send the quote to multiple liquidity providers, any of them can ‘pre-hedge’ the position which causes information leakage and risks moving the market before the execution of the trade. 

Therefore, RFQs could be seen to contain price-sensitive information – not publicly available – that a liquidity provider has used to ‘pre-hedge’ a position, even without the knowledge of winning that specific trade. 

This example of what has been described as pre-hedging evidently can lead to swings in price before the execution of a large ETF trade, a negative outcome for end investors. 

As a result, buyside traders need to understand the pre-hedging behaviours of individual liquidity providers, show two-sided RFQs – a buy and a sell order – and only show quotes to providers that have a history of filling orders in the asset class they are looking to execute.