Topics: Derivatives / Execution / Regulation
Executing a hedge adds the finishing touches to a financing or acquisition operation, and is often the conclusion of a lengthy structuring and negotiation process.
It is during the transaction’s execution that the contract’s final financial characteristics – such as the interest rate for a swap, the premium for an option or the applicable exchange rate – are fixed on the basis of market conditions.
When the transaction is reasonably large relative to market liquidity, market conditions are an external execution parameter. The hedging bank takes note with its client of the rates and market prices, and these, plus an agreed margin, are what the borrower then pays. This is generally the case, for instance, when setting up a 20-year amortisable interest rate swap with a notional outstanding of 100 or 200 million euros or dollars, traded during normal market hours, the execution of which generally has little or no impact on market prices.
However, if the size of the envisaged transaction relative to market liquidity at the time of execution is significant, the way in which the transaction is executed can significantly affect market conditions. This is the case, for example, if the counterparty banks choose to ‘pre-hedge’ the transaction in the market – in other words, to anticipate the hedging that will be carried out in the market, even though the borrower has not yet finalised its hedging operation.
Market shift prior to the transaction causing additional costs for the borrower
If this pre-hedging is substantial or too abrupt, it can generate a market shift prior to the agreement of the transaction which will give rise to additional costs for the borrower. For instance, this could occur on a long-term interest rate trade for 1 billion euros or more, or for 500 million Polish zloty (PLN) (i.e. the equivalent of little more than 100 million euros), because the PLN swap market is less liquid than the euro swap market. It might also be the case for a large foreign exchange trade, depending on the liquidity in the currency concerned on the market at the time.
In the case of project financing or M&A transactions, it is common for there to be no explicit agreement between the borrower and its hedging banks on how the hedging transaction will be executed. Alternatively, there may be an agreement, but it may fail to take explicit account of the effects of pre-hedging; as a result, borrowers are sometimes disappointed with the final conditions obtained on hedges, because the market has shifted ‘at the wrong time’. It is therefore important to define clearly with the hedging banks how the execution will occur, transaction by transaction.
Of course, we are not just talking about project or acquisition financing here: this has much broader relevance to any transaction between an end client and its hedging counterparties. The European financial market regulator ESMA (the European Securities and Markets Authority) published a number of important recommendations on this subject in a report on market abuses[1] in September 2020.
Though provisional, we believe that these recommendations are of value to borrowers and may provide a guideline for discussions with counterparties on the choice of execution methods.
The execution of a hedging derivative – cost or risk?
Lors de l’exécution de l’opération de couverture, la banque de couverture met en place, quasi simultanément, deux opérations miroir, de sorte à ne pas porter de risque de marché net entre ces deux opérations :
A hedge between bank and borrower
A hedge in the opposite direction between bank and market
One of the important questions during execution is whether the market-facing derivative is set up by the hedging bank
a. entirely after the financial conditions have been agreed with the client (no pre-hedging),
b. or entirely or partly before the agreement of the financial conditions (total or partial pre-hedging).
The execution margin depends on the execution risk, which is itself linked to market liquidity
In case a), the borrower’s rate, or price, is taken from the market at the time of agreement and is used to set the terms of the derivative traded with the client; only then does the hedging bank set up its own hedging derivative. In this scenario, the hedging bank fully bears the execution risk, in other words the risk of the rates shifting rapidly between agreement with the client and the implementation of the market hedge by the bank. The hedging bank will therefore ask for an execution margin to cover this execution risk.
The execution risk must be priced fairly, offering the bank the prospect of making a gain that rewards it for the risk it has taken and the service it has provided (given that they are not rewarded in any other way in the transaction). The amount of the execution margin therefore depends on the execution risk, which is itself linked to market liquidity.
In theory, the market shift could be positive or negative, but where the transaction size is large relative to the underlying market liquidity, the shift is more likely to be against the bank. This is why the execution cost is generally higher when the transaction is larger and/or market liquidity is lower.
In case b), the hedging bank pre-hedges part of its future position on the market before agreeing the transaction with the client. This gives it more latitude to manage its execution risk. There is generally an execution risk prior to agreement (the risk that the trade with the client will not take place), as well as afterwards, although in principle the latter risk should be less as it relates to a smaller residual size.
The more visibility and certainty the hedging bank has about the precise timing of agreement, the more the possibility of pre-hedging enables it to limit its execution risk. This is why pre-hedging is often presented by hedging banks as a service rendered to their clients to enable them to perform large transactions or transactions in illiquid markets and to improve the prices (or execution margins) available to their clients[2] for their hedging needs.
[2] https://www.ca-cib.com/sites/default/files/2019-10/Pre-hedging%20Policy.pdf likewise: https://wholesale.banking.societegenerale.com/en/compliance-regulatory-information/general-disclosures/pre-hedging-disclosure/
Even so, while the hedging bank’s execution risk is reduced by pre-hedging, it does not completely disappear: it is merely transferred (in part at least) to the client. Transactions in an illiquid market illustrate this clearly: If the pre-hedging by the bank causes the market to shift prior to the agreement of a transaction, the additional cost is borne by the borrower, and the more illiquid the market relative to the size of the transaction, the more potentially significant this shift is.
Thus, as often in finance, the borrower’s choice is about striking the right balance between reducing its execution cost and managing its execution risk. What is certainly true is that the borrower should try to clarify its instructions to its hedging bank on this point.
In illiquid market transactions involving multiple banks, organising execution can be even more complex. There is therefore a strong temptation to simplify things by appointing a hedge coordinator to prevent the counterparties from ending up competing in the market at the same time to cover the same transaction. However, though sometimes useful, this solution does not of course resolve the pre-hedging issues – in fact it may exacerbate them in some cases[3]. The instructions given to the hedge coordinator must therefore also specify what is authorised in terms of pre-hedging.
What does ESMA say in its September 2020 report about pre-hedging ?
ESMA’s initial findings and recommendations on the practice of pre-hedging are already worthy of close attention. They usefully supplement the provisions already contained in a number of codes of conduct (particularly on the foreign exchange market) or in the MiFID regulation concerning best execution of orders.
The benefit of the pre-hedging is passed to the client
ESMA recognises the impossibility of determining a priori whether or not pre-hedging is a legitimate practice. It indicates that the question deserves thorough analysis, and that it is important to ensure that ill-judged recommendations do not legitimate harmful practices. It therefore announces that further clarifications are being prepared and that it is ready to assist the European Commission further.
However, the European regulator states that it has already identified several points that need to be considered when determining whether pre-hedging is likely to be classified as a market abuse or a breach of codes of conduct:
Whether there are clear instructions from the client explicitly requesting pre-hedging from the bank.
Whether the bank has informed the client ex ante and on a case-by-case basis of the possible pre-hedging of its position, to which the client has consented. It is not enough for the client’s agreement to be given in general through a contractual document which does not specifically relate to the envisaged transaction.
Whether the benefit of the pre-hedging is passed to the client.
Whether steps have been taken by the bank to limit the impact of pre-hedging on the market.
Whether information has been provided to the client ex post about how the pre-hedging has impacted the execution of the transaction.
In the meantime, what operational conclusions should be drawn from the report?
Borrowers should be aware that this is a sensitive matter if the envisaged transaction is significant relative to the market’s liquidity. It makes little sense to negotiate the swap or execution margin in great detail while disregarding the question of pre-hedging.
The mismanagement of a transaction execution through the market can give rise to both a substantial extra cost and significant frustrations for the borrower, which sees the price of its transaction shifting against it at the last moment without necessarily knowing if this was inevitable and whether the trade took place at the best price.
❞ pre-hedging of the execution must be based on a conscious and informed choice of the client ESMA
The matter is equally sensitive for the hedging bank in three respects: its commercial relationship with its client, its reputational risk, and compliance.
ESMA’s recommendation that there should be clear communication about what the parties want therefore makes a lot of sense: any pre-hedging of the execution must be based on a conscious and informed choice of the client which is shared with the bank or banks in charge of executing a transaction on the market. ESMA also stresses that this choice must be made on a trade by trade basis and not in general.
Further, it is important for the borrower to be able to measure the benefit of pre-hedging in terms of reducing the execution margin (which could potentially extend as far as negative execution margins), and that benefit should be weighed against the associated execution risk.
In many cases, pre-hedging the execution of a transaction is unnecessary or hazardous for the borrower. In such cases, an express agreement can be made with the hedging bank that the execution will take place without pre-hedging.
If the client specifically opts for pre-hedging, either because the market is very illiquid and the bank cannot execute without pre-hedging or because the reduction in the execution cost compensates or more than compensates for the negative effects of the pre-hedging on the market rates obtained when the transaction is agreed, the pre-hedging should be accompanied by contractual transparency on the part of the bank both in advance and retrospectively about the expected profits and actual gains from pre-hedging.
All the same, client consent and transparency from the bank (or market intermediary) will not resolve every situation.
Assessing such situations, understanding the risks for the bank (or banks where the execution of an operation is shared between several banks), negotiating a fair fee for them, clearly grasping that pre-hedging may be perfectly justified and useful in some situations but is to be avoided in others, and quantifying the difference in execution cost with and without the possibility of pre-hedging is a complex exercise which requires plenty of market experience and dialogue.
ESTER is ideally positioned as a hedge advisor to help facilitate the implementation of the principles proposed by ESMA in a spirit of constructiveness and mutual trust between our clients and their banking partners, with a view to ensuring the best possible price for the borrower at the time of execution.
ESTER can of course provide you with assistance in these areas.