Unhedged: Pre-Hedging, YouTube doesn't know what I like, SRTs and PIKs
Unhedged: Pre-Hedging, YouTube doesn't know what I like, SRTs and PIKs
A little something to help Friday get here quicker…because time flies when having fun.
Pre-Hedging: One step closer to rulemaking.
YouTube: After a recent enforcement action, Barrett and I are really scratching our heads. Why isn’t YouTube constantly suggesting some new fund or a guy in South Florida promising “guaranteed returns” on the latest foolproof FX options plan?
Synthetic Risk Transfers: The latest episode of the Odd Lots podcast dives into Synthetic Risk Transfers (SRTs). You can check it out HERE.
Synthetic PIKs: HERE is something new for you. "PIK" or "Payment in Kind" usually refers to a situation where a borrower, on the verge of defaulting on Loan X, sidesteps the issue by taking on new or additional debt (known as "PIK debt," "PIK securities," or a "PIK note"). The proceeds from this PIK debt are then used to make payments on Loan X, thus avoiding a default—assuming the PIK debt is allowed under the existing covenants on permitted indebtedness. Naturally, there’s a higher risk with this PIK debt because the borrower is already struggling, so it typically comes with a higher interest rate.
Pre-Hedging
What’s New: The Financial Markets Standards Board (FMSB) published its case studies on pre-hedging. Click here to read.
This is probably the point where 80% of you have checked out—who wouldn’t be thrilled by the sheer excitement of pre-hedging case studies, right? But for those brave souls who opened this, realized there were no GIFs or memes, and stuck around—welcome back to our regularly scheduled program.
Who/What is the FMSB?
Not a regulator. Just a private sector organization focused on market trading practice. But that doesn’t mean the FMSB should be ignored. I fully expect this report to catch the attention of IOSCO, who made it clear in their 2024 “Workplan” that they’ll be assessing pre-hedging and aiming to deliver a “Final Report” by the end of the year. And yes, IOSCO matters—a lot. Whatever comes out of IOSCO will likely set the principles that global regulators will use to implement pre-hedging laws locally. It’s worth noting that IOSCO’s committee includes representatives from the CFTC and SEC..
FX Markets recently covered IOSCO (HERE). While we didn’t spot the commitment to providing suggestion by end of the year as a “delay” – we thought the original plan was, effectively, “We got you….next year.” – I’d defer to FX Markets on this one since their coverage of pre-hedging has been top-notch.
I am not reading the report, give me the CliffsNotes (pretty sure anyone younger than 38 may not catch that reference).
The report dives into three key areas, and considers whether it’s worth suggesting industry standards for implementing policies and procedures in a follow-up report:
What exactly constitutes pre-hedging?
When is it appropriate to engage in pre-hedging?
How should pre-hedging be disclosed to clients? When in the trading relationship should this happen, and how should the approach differ based on the sophistication of the client or counterparty?
Also, while often these reports can seem repetitive, this report stands out as one of the better breakdowns of pre-hedging because, unlike many others, it clearly distinguishes between two ways a dealer or other liquidity provider manages their risk portfolio: pre-hedging and “inventory management.”
Inventory Management: Pre-Hedging?
“Inventory management” often doesn’t get much attention, but think of it as general market-making based on constantly reviewing and managing an institution’s risks. A major challenge with any pre-hedging rules will likely be distinguishing between pre-hedging and inventory management.
In our last post, we talked about how FX HedgePool can help buyside parties avoid issues associated with pre-hedging, especially for buyside clients with predictable or regular FX transactions, like a quarterly roll. Imagine a risk management team saying, “Historically, our institution’s risk has behaved like this, so we manage our risk based on those historical trends and practices.”
That sounds like solid inventory management, right? But if that activity is also helping the firm position itself to quote anticipated FX transactions in the future, then it’s also pre-hedging, which could negatively impact the buyside’s pricing. So, how do you tell the treasury risk group at a major financial institution, “Look, some aspects of historical risk that you’re supposed to manage...we need you to ignore them. Sure, there’s a good chance that risk will materialize, and you’ll have to manage it afterward...but no managing anticipated risks. Managing anticipated risks is pre-hedging.”
It doesn’t make much sense to restrict inventory management to only handling risks after they’ve happened.
And since I love charts, here’s a great one from the report:
Takeaway
If you have any training materials or policies related to pre-hedging, now would be a good time to update them in light of this new report. Some of the scenarios they cover—especially those about pre-hedging in liquid markets—are excellent starting points for active discussions.
Introducing Brokers and YouTube
Is anyone else bombarded with content about swaps and derivatives on YouTube or Google? No? Funny, isn’t it? Yet, when I Google back-to-school dresses for my kids, my entire internet feed gets flooded with jelly sandals and dresses for tiny hoomans. (Around Father’s Day, Barrett and I make sure to whisper “golf clubs…golf clubs” into our wife’s phone when it’s just sitting there on the counter.)
But you know how I’m sure swaps and derivatives content exists on YouTube?
Because the CFTC recently took action against a Texas company for failing to register as an Introducing Broker (IB). This company was busy pumping out content on YouTube (and other platforms), soliciting clients and taking orders for swap and options transactions. Their IB activities included identifying counterparties, price discovery, negotiating trades, trade execution, and handling various back-office support functions—all of which they charged a fee for. The Order doesn’t accuse them of any fraudulent practices or wrongdoing, just a failure to register, which is now costing them a $100,000 fine plus the compliance costs to get their registration up to date.
Paul Blart Swaps Cop
Some enforcement actions are interesting to read only because of the dissent. In re Cowen and Co. is an otherwise innocuous enforcement order, until you read Commission Pham’s dissent. In this instance the CFTC was piggy-backing on an investigation and enforcement order from the SEC and when it came time to do its own investigation, the CFTC relied on statements from Cowen in the SEC investigation that the use of unapproved communication methods by its employees was widespread so surely it impacted Cowen’s CFTC related activities. But, no one really knows for certain. As Commissioner Pham’s dissent states “None of the persons in the SEC sample was a CFTC AP. Consequently, there was no evidence in the administrative record involving CFTC APs and the specific types of records that IBs are required to maintain.”
ISDAs and PIKs
Just a note—I’ve never seen any ISDA agreements specifically address PIKs. That said, ISDAs do have cross-default language, so a default on debt could trigger an Event of Default under the ISDA, depending on how the terms are negotiated.
Given that, especially with unsecured ISDAs or ISDAs not directly linked to a loan, maybe it’s worth considering adding an Additional Termination Event (ATE) tied to a PIK issuance. Many ATEs are triggered by events that:
Aren’t considered a “fault,” so they don’t qualify as an Event of Default. This means that a close-out based on a Termination Event shouldn’t trigger a cross-default elsewhere (though you should check the Loan Documents—many don’t catch this nuance).
Are good indicators of credit deterioration or could be precursors to a future payment default.
The idea behind a Termination Event is to give the non-Affected Party (usually the Dealer) the option to decide whether to continue the trading relationship. For example, if an ATE is triggered, the Dealer still has to make payments or deliveries under the ISDA until an Early Termination Date is set, which isn’t the case when an Event of Default is triggered.
If a PIK is issued, it might make sense for the Dealer to pause and reassess. However, there are challenges with including this in your ISDAs:
For Non-Public Entities: Will the Dealer realistically even know about a PIK issuance? Negotiating this ATE might not be worth the effort if it’s unlikely to have practical utility.
For Public or Rated Entities: When dealing with a Party B that has sophisticated counsel, they might see this as “off-market.” I can’t tell you how many times that alone has been the reason for rejection. So, like with non-public entities, the negotiation effort might not be justified by its potential utility.
Still, I think it’s worth considering. There could be situations where having this termination event would be helpful, and even if the counterparty isn’t a public entity, news of a PIK transaction could still leak into the market.