Upper Tribunal Tax and Chancery Chamber

UT (Tax & Chancery) UT-2022-000134 UT-2022-000135 UT-2022-000137 - [2025] UKUT 00214 (TCC)

Fecha: 31-Ene-2025

Directional risk and remaining competitive

Directional risk and remaining competitive

564.

A cash BTP market maker is required to stand ready to purchase and sell cash BTPs and quote in both directions competitively. The most effective way to do this is to minimise (not significantly exaggerate) the directional risk of the book; this also protects from significant moves in the market, better enabling the market maker to quote whatever the current market conditions.

565.

The Tribunal finds that Mr Lopez managed the risk on his book (both directional risk and curve risk) very carefully throughout each day. Mr Lopez had described his approach in this way, but this is also borne out by his trading activity. He placed 1,139 small orders over the Relevant Period, 103 of which were for one lot and 954 of which were for one to 19 lots. If one of the Large Orders traded, this would have increased dramatically Mr Lopez’s directional risk. This would have been at times when he was placing Small Orders for curve management purposes, eg in F56 and F63 (both of which involved a Small Order to sell five lots, iceberged to three, and a Large Order to buy 200 lots) and F132 (a Small Order to buy one lot and a Large Order to sell 200 lots).

566.

Taking directional risk in this way would only have assisted him in quoting for client flows in one direction if, having put on the directional risk, the market then moved in his favour. This positioning would have served to make him significantly less competitive in the other direction. Yet Mr Lopez could not know in which direction he would be required to quote in the immediate future:

(1)

Client enquiries could come in at any time, for any size or duration, or for any amounts. This is shown by the list of all Electronic RFQs.

(2)

MHI was a lower tier market maker with little visibility over client flow and an information disadvantage. Mr Kasapis accepted that only market makers with deep institutional order books would have a good idea of client flow. Mr Lopez recognised this (sometimes using it as an explanation for ignoring the direction of client flow). Mr Creaturo’s opinion was that other factors cited by Mr Lopez in his witness statement, such as comparing the Bund/BTP Futures spread and anticipating liquidity from auctions, were “ultimately speculative”; a bank such as MHI could not reliably predict whether client orders would materialise at all, let alone of the size and direction of Mr Lopez’s Large Orders.

(3)

The list of 93 RFQs, and the repeated buying interest from Banca d’Italia, were not as predictable as Mr Jaffey submitted, and the uncertainty over timing, and indeed whether they would come at all, did not justify this directional risk. Positioning the entire book with significant directional risk for the sake of a narrow set of business and one client’s RFQs (and thereby rendering his pricing uncompetitive for other business) would be irrational for a market maker. It would not only likely result in a lower hit ratio overall (contrary to what he was trying to achieve) but if medium-sized tickets came in from clients in the other direction, Mr Lopez had effectively counted himself out of winning them. It made no sense for MHI to be able to quote an occasional good price for certain trades (if the enquiry came in for the right bond at the right time in the right size and the right direction) whilst being uncompetitive for all trades in the other direction.

(4)

Even if Mr Lopez did correctly predict the direction of client flow, it was speculation whether that would in fact enable him to quote competitively for those clients. The timing of both the market movements and any client enquiries were unpredictable. The market could well move against him, such that (for example) he could have bought at a far higher price than he needed to. This could be seen in, eg, F42, where the market moved 20 ticks against him from the time he placed the Large Order to the time the first Banca d’Italia RFQ came in, with the result that the anticipatory hedge would have cost €40,000 more than a hedge taken out at the time of the RFQ.

(5)

MHI had a very low hit ratio in respect of these medium-sized RFQs. Of the 93 RFQs, MHI responded to about half of them, and the Desk won seven of them (Mr Urra won six and Mr Sheth won one). Mr Urra did win three of the RFQs from Banca d’Italia. Mr Lopez may have been seeking to improve this position, but he would have been taking a risk for what is a speculative prospect of winning the cash trade in the situation where MHI’s record was poor, and where the timing of that cash trade was uncertain.

567.

We have found that the average size of Electronic RFQs for cash BTPs received by MHI during the Relevant Period was €5.1m. These 93 RFQs to which Mr Lopez refers, and which he relied on heavily as explaining his Anticipatory Hedging Strategy, were a very small portion of the total number of Electronic RFQs received by the Desk in the Relevant Period (of which there were 6,972 in total). There would, in addition, have been Voice and Bloomberg/Chat RFQs, which we approximated as a further 2,500 RFQs. Mr Lopez responded to 4,100 RFQs for BTPs during the Relevant Period, of which 104 were valued from €15-25m. Of these 104, 42 of them were for bonds with maturities of less than five years which would not typically be hedged with Futures. Mr Lopez only won ten of these 104 RFQs, and only three of the ten had a remaining maturity greater than five years, ie would justify being hedged by Futures.

568.

The Tribunal considers that whilst in principle an Anticipatory Hedging Strategy may help with positioning the Desk to meet expected client flow, the reality is that Mr Lopez was not regularly trading cash bonds with clients in the size that would justify anticipatory hedging in the size of the Large Orders, and the level of client demand was not sufficiently predictable to explain or justify taking this amount of directional risk.