According to Financial Times News, global securities regulators through Iosco have called for limits on market maker activities amid concerns about “front-running” asset manager clients. The report highlights how dealers trade on their own accounts before winning client orders, particularly in competitive “request for quote” systems where multiple dealers become aware of upcoming trades. Industry participants including Susquehanna and Jane Street criticized the practice, with Jane Street calling it “a form of market abuse” that should be banned. The European Fund and Asset Management Association warned pre-hedging “almost certainly” results in “price degradation” for clients, while investment director Peter Sleep noted the practice is “absolutely rife” in ETF trading. Iosco, representing regulators overseeing 95% of global securities markets across 130 jurisdictions, recommended dealers only pre-hedge for legitimate risk management with client consent, rather than calling for an outright ban.
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The Hidden Revenue Stream Driving Pre-Hedging
The economics behind pre-hedging reveal why this practice has become so widespread despite regulatory scrutiny. Market makers operate on razor-thin margins in highly competitive environments, creating pressure to extract additional basis points wherever possible. When a dealer receives an RFQ for a large block trade, they face significant inventory risk if they win the order. However, the temptation to trade ahead of that order creates a secondary revenue stream that’s essentially risk-free for the dealer. This isn’t traditional market making—it’s information arbitrage where the dealer profits from knowing about impending large orders before the broader market adjusts. The practice effectively transfers wealth from institutional investors to market makers through what amounts to an information tax on large trades.
Systemic Risks and Market Structure Concerns
Beyond the immediate client impact, pre-hedging creates concerning systemic implications for market structure. When multiple market makers simultaneously pre-hedge in anticipation of the same client order, they collectively move prices against the client before the trade even executes. This creates a coordination problem where individual rational behavior (each dealer protecting their position) leads to collectively worse outcomes for the market. The practice also distorts price discovery by creating artificial momentum that doesn’t reflect genuine supply and demand. Over time, this could reduce institutional participation in certain markets or drive trading to less transparent venues, potentially fragmenting liquidity and increasing overall market volatility.
The Regulatory Balancing Act
Iosco’s cautious approach reflects the genuine dilemma regulators face. An outright ban on pre-hedging could disadvantage smaller market makers who lack the balance sheet to warehouse large positions, potentially reducing competition and concentrating market power among the largest players. The legitimate risk management function of pre-hedging—when properly disclosed and consented to—can actually benefit clients by enabling dealers to offer better pricing. However, the line between risk management and front-running becomes dangerously blurred in competitive RFQ environments. The challenge for regulators is crafting rules that distinguish between legitimate inventory management and opportunistic trading on client information—a distinction that often depends on intent and scale rather than easily observable actions.
Competitive Pressures and Industry Hypocrisy
The public positions taken by major market makers like Jane Street and Susquehanna against pre-hedging reveal fascinating industry dynamics. While publicly condemning the practice, these firms operate in an environment where not pre-hedging could put them at a competitive disadvantage. This creates a classic prisoner’s dilemma: all market makers might prefer a world without pre-hedging, but individual incentives push them toward the practice. The fact that even critics acknowledge some legitimate uses for pre-hedging complicates enforcement, as it provides cover for abusive practices. The industry’s divided stance suggests this isn’t a simple good-versus-evil issue but rather a complex optimization problem where different market participants have conflicting interests based on their size, business model, and client relationships.
Where This Regulatory Battle Is Headed
The Iosco recommendations represent just the opening salvo in what will likely be a prolonged regulatory battle. Expect to see jurisdictional fragmentation as different regulators implement varying standards, creating arbitrage opportunities and compliance headaches for global firms. The most likely outcome is a bifurcated market where pre-hedging becomes explicitly permitted in certain contexts with full disclosure, while remaining prohibited in competitive RFQ scenarios. Technology will play a crucial role, with surveillance systems becoming increasingly sophisticated at detecting patterns that distinguish legitimate risk management from front-running. Ultimately, this regulatory attention may accelerate the shift toward more transparent trading protocols and electronic execution methods that reduce information leakage in the first place.
