ASIC's new guidance on pre-hedging

This article explains what is best practice, going forward.

What is pre-hedging: Profiteering or sensible risk management?

Pre-hedging refers to the practice where, prior to a bank, or other intermediary, executing a derivative transaction with a client, the bank trades in the market to establish part of its hedge position in order to reduce its risk associated with the underlying transaction and enable it to offer a more favourable spread or price to the customer.

While the concept of pre-hedging has sometimes been confused with 'front-running'-a term which describes when a bank (or other intermediary), trades in the market on its own behalf ahead of executing an order as agent for its client so as to obtain a commercial benefit for itself-pre-hedging is not frontrunning. Rather, it is an important risk management tool for banks and is a legitimate and necessary, strategy, particularly for larger and more complicated transactions.

Pre-hedging transactions can result in lower execution spreads for clients and less market volatility, as it enables banks to spread their hedging trades over a longer period.

In recent times, however, pre-hedging has come under the regulatory microscope with a number of regulators concerned with how best to protect clients and foster market transparency.

Like much else, it is all about when you use it, how you use it and what you use it for.

What prompted new guidance?

Although regulators across the globe have been looking into pre-hedging, the timing of the new guidance from the Australian Securities and Investments Commission (ASIC) aligns with the recent settlement resulting from it having commenced civil proceedings against Westpac Banking Corporation in 2021.