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 potential trades. Industry responses revealed sharp divisions, with Susquehanna and Jane Street calling the practice unacceptable, while the European Fund and Asset Management Association said it “almost certainly” results in client “price degradation.” 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 imposing 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 electronic trading environments. The ability to pre-hedge creates a secondary revenue stream that doesn’t appear on standard commission reports. When a market maker receives an RFQ for a large block trade, they’re essentially getting free advance notice of significant upcoming market movement. By trading ahead of the client order, they capture the spread between the pre-trade price and the eventual execution price—essentially front-running their own clients while claiming risk management justification.
This practice has become particularly lucrative in ETF trading, where competitive RFQ systems have become the dominant mechanism for large institutional trades. As Peter Sleep noted, the practice is “absolutely rife” in this space. The business case is straightforward: if you know a large buyer is about to enter the market, buying ahead of them guarantees you’ll profit from the price movement your own client creates. This creates a perverse incentive where market makers benefit from moving prices against their clients rather than seeking best execution.
Strategic Implications for Market Structure
The regulatory hesitation to ban pre-hedging outright reflects deeper structural tensions in modern market making. Larger players like Jane Street and Susquehanna have taken public positions against the practice precisely because they have the balance sheet strength to compete without these tactics. Their opposition serves dual purposes: it positions them as client-friendly while potentially squeezing smaller competitors who rely more heavily on pre-hedging to manage inventory risks.
Iosco’s acknowledgment that smaller dealers might need pre-hedging to compete reveals the fundamental tension here. The practice creates an uneven playing field where informational advantages trump execution quality. Market makers who pre-hedge aggressively can show better initial quotes because they’ve already positioned themselves to profit from the subsequent price movement. This creates a race to the bottom where the most aggressive pre-hedgers win business, forcing even reluctant participants to adopt similar tactics to remain competitive.
Why Regulatory Scrutiny Is Intensifying Now
The timing of this regulatory focus coincides with several market developments that have amplified the impact of pre-hedging. The massive growth of passive investing and ETF trading has created more large, predictable institutional flows that are easier to anticipate and trade ahead of. Additionally, the electronification of fixed income and derivatives markets has expanded the scope of RFQ-based trading beyond equities, creating new opportunities for these practices.
More importantly, institutional investors have become increasingly sophisticated about measuring transaction costs. Advanced transaction cost analysis tools now make it easier to detect patterns of price degradation around large orders. As asset managers face pressure on their own fees, they’re scrutinizing every basis point of trading costs, making practices like pre-hedging more visible and less tolerable. The current high-rate environment also increases the cost of carrying inventory, creating additional pressure for market makers to use pre-hedging as a substitute for traditional risk management.
The Future of Market Making Economics
Looking forward, the resolution of this debate will reshape market maker business models significantly. If regulators follow through with stricter limitations, we’ll likely see consolidation among smaller players who relied on pre-hedging to compete. Larger firms with stronger balance sheets will gain market share, potentially reducing competition in the long run. Alternatively, if the practice continues with better disclosure and consent mechanisms, we may see the emergence of tiered service models where clients explicitly pay for “no pre-hedging” execution.
The most likely outcome is increased transparency rather than outright prohibition. Market makers will need to develop more sophisticated ways to demonstrate they’re acting in client interests while still managing their own risk. This could lead to new technologies for proving execution quality or more detailed pre-trade agreements about permitted hedging activities. Regardless of the regulatory path, the cat is out of the bag—institutional investors now understand this hidden cost and will demand better terms, squeezing market maker profitability across the board.
