Quick Takes: Pre-hedging in swaps
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Ali Curi: Hi everyone and welcome to ION Markets Quick Takes. I'm Ali Curi and every week along with my guest Chris Barnes and our new guest Mark Bell, we take a quick dive into the headlines on the Clarus blog. 

Let's get started. 

Hi Chris. Welcome Mark. 

Chris Barnes: Hey Ali.

Mark Bell: Hi Ali. 

Ali Curi: Chris, let's start with you. What's your Quick Take for this week? Which headline from the Clarus FT blog would you like to discuss? 

Chris Barnes: All right, today Ali, I have to make it clear, I am absolutely not talking about front running. Okay? Definitely not. So this blog is called, "Pre-Hedging in Swaps." And I reckon because of this blog, we can get like a full house of "Quick Takes Podcast Bingo."

You know, we'll be talking about how I used to be a swaps trader, about how market participants do this, about how transparency for markets is good, et cetera, et cetera. So I read these standards and I was just like, we have to blog on this. This is going to be super fun.

The exact blog is called "Pre-Hedging in Swaps." It's a blog, a subject area I've thought about writing about over the years a few times, but it's really difficult to work out what angle to take on it actually. So it was really, really pleasing to see that the FMSB, which is the FICC Markets Standards Board, recently published a paper, which basically said, "Look, there are certain practices in markets, which we think is like a gray area." The regulations clearly state that certain behaviors are bad, but there are certain behaviors which are apparent in markets which are necessary to improve a client's experience in certain cases. And I have to salute the FMSB in kind of being brave enough to bring this to the fore. And to try and propose a structure whereby standards can be created. 

So precisely as I've said, we're not talking about front running. And so because that's an emotive term, "front running" sounds bad. It sounds like a client calls you and you do that trade and then you tell them the price.

That's definitely bad. I think it's so bad that in most cases, in most markets, you would call that illegal behavior. And then you overlay that with the idea that in derivatives markets in particular, we've now got post-trade transparency. So, in theory, in a perfect world, if everybody can only trade in one jurisdiction, and nobody's exempt from reporting, the whole market can see every trade.

And so, the ideal is that you go into a post transparency world, or the regulators do. And they can piece together the exact story of a trade. When was it hedged? Where were market prices? When was the client contacted? Et cetera, et cetera. And just by having that fabric around trading of transparency, it should put in sufficient barriers for any bad actors to ever even consider front running.

And I think what the FMSB has done a really good job of doing is saying, "Look, there have been two in particular, certain regulatory actions, one from the CFTC, one from ASIC over the past few years, which have highlighted that there continue to be certain behaviors where it's difficult to draw a line between 'that was behavior that we didn't expect to see as a result of post trade transparency,' and 'this is unequivocal better behavior from dealers with clients at the forefront of their mind.'"

And so if I just try and put a bit of flesh around it, the blog goes through the paper and looks at their comparison of what front running is and what pre-hedging is. But there's a nice paragraph, I think in there, of course, I think it because I wrote it, but the point is there's always a story with any OTC swap. 

It's not like me as a cross currency swaps trader, I'm just streaming prices anonymously to an order book, and anybody can come in and click to trade. A cross currency swap still has post trade transparency. The whole story behind a trade evolves over time. I lost count of the number of times where a market participant would call a salesperson and would say, "Can I have a two-way price in $200K DV01 of five year Eurodollar?

And you have to turn around and go, "No, you can't," like that is not how the market works at all. $200K is above market size. There are rarely two way prices, which are executable and liquid. We manage the franchise. If you tell us that we know that something is coming up, then we can leverage the franchise, look not to enter the market at all and manage that in a far more efficient way. And the number of times like you would be stressed and you're like, "This isn't the FX market. I know it's a cross currency swap, but you don't just call up and ask for a two way price in size. Like you must've heard this from other dealers as well." And so that kind of aspect varies massively depending on the size, depending on the client, sometimes depending on the direction. In particular on the time of the year as well. When you're talking about seasonal markets as well. 

And so I think it's well worth market participants reminding themselves of the nature of these markets, but also taking the time to read these standards, because this is not a document that says, "Do this, do this, do this, don't do that." It is just proposing a structure.

And I think as soon as these standards start to be consulted on, then these behaviors will get more and more rigid over time, even though it's really, really tough in this instance to kind of publish an explicit list of what you should do and what you shouldn't do, because they are so specific per market.

So, Mark, I've given an overview of what is potentially, I think, a very interesting subject here, as your first blog. Do you want to give a quick intro? 

Mark Bell: Thanks very much, Chris. Yes, I think the data on which the FMSB Spotlight on Hedging, on which the blog is based, is a very good read. I'd like to think of it as a juicy steak compared to the sort of boiled broccoli that we often get to read ourselves.

I think the first question really has to be about the impact of data transparency. So has access to the OTC data via SDRs and SEFs, has that allowed regulators to pick up on this unconscionable conduct? 

Chris Barnes: Yes, I think what's really happened is that even ahead of post-trade transparency actually being implemented, what banks and clients have looked at are typical market practices, and they've taken some very, very sensible steps to say, look, "We should explicitly acknowledge that on the face of it, some behaviors such as valid pre-hedging really should be discussed with a client before a market maker starts doing it."

And so there are now explicit acknowledgements that if a client is doing a trade that is large size and they've shared some information about it before the trade date, then they will sign pre-hedging agreements with dealers to put in a structure around that. 

Mark Bell: You used the term "information leakage" on trades that were executed on information that could have been gleaned from the market beforehand.

Has the data transparency allowed for this information leakage to take place more efficiently or more apparently in terms of the data that's available to the market? 

Chris Barnes: I use information leakage here in a very specific case in terms of before a trade has happened. And in the context of the blog, I'm typically talking about any period from a couple of days, to like a few weeks.

And so I think what's really happening with post trade transparency is that that information leakage would be more like, "has a pricing call taken place" as opposed to "an actual swap is happening." And so I think, again, with all of these things, it's really difficult to make a black and white categorization of what is information leakage.

There are different degrees of that, and there are different impacts depending on what information is gleaned. So I think it's definitely, definitely helped. I've got to say, this is your first podcast, amazing questions. Naturally, this is an interesting subject.

On that note, Ali, I think I'll have to pass back to you.

Ali Curi: Well, thank you, Chris. And please tell us again, the title of your blog post. 

Chris Barnes: The blog post is called "Pre-hedging in swaps," a subtitle would be, "This is definitely not front running, guys." 

Ali Curi: Great, that works. Mark Bell, you survived your first podcast. Thank you both for joining me on the podcast today. Let's do it again next week.

Chris Barnes: Thanks, Ali. I look forward to it.

Mark Bell: Thanks, Ali. 

Ali Curi: And that's our episode for today. You can read more about these topics on the Clarus blog, and you can follow ION Markets on X and on LinkedIn. 

Thank you for joining us.