On September 27, the UK Financial Conduct Authority (FCA) published an update on its work in relation to payments for order flow (PFOF) in its latest Market Watch newsletter on market conduct and transaction reporting issues. Notably, the commentary on PFOF follows previous guidance on the practice (PFOF Guidance) published by the UK Financial Services Authority in May 2012, and follows findings from a thematic review of PFOF published in July 2014 (PFOF Review). In the latest Market Watch, the FCA provides a further bi-annual update on PFOF, including:
- the FCA’s findings on PFOF practices in follow-up supervisory work since the PFOF Review was published;
- a reminder for firms of their ongoing requirements to manage conflicts of interest with respect to eligible counterparties (ECPs); and
- a further reminder for firms of upcoming changes under the amended and restated Markets in Financial Instruments Directive (MiFID II) with respect to best execution, inducements and conflicts of interest.
PFOF involves firms (most often brokers) executing client orders and charging and receiving fees or commissions for execution from: (1) the client initiating the order; and (2) the counterparty to the trade (often market makers). The FCA reiterates in Market Watch that in its view, PFOF is “bad” for markets due to the conflict of interest created between firms and their clients, and also (especially for proprietary trading firms) for the distortion to the price formation process that the practice may cause. The FCA reports that since the PFOF Review, most large integrated investment banks have stopped charging PFOF across all markets and segments. The FCA notes that independent brokers have mostly ceased PFOF charges in relation to professional client business in products and markets that focus of the FCA’s supervisory work. However, it also notes that some independent brokers are continuing to charge market markers for order flow from ECP business.
The FCA emphasizes in the Market Watch that firms must continue to meet their obligations in relation to conflicts of interest management in the FCA’s Systems and Controls Handbook Rules (SYSC). Under SYSC 10, firms are required to have effective arrangements in place to identify, manage and prevent conflicts of interest, particularly any conflicts presenting a material risk of damage to the interests of clients. The FCA notes that throughout its PFOF supervisory work, it did not identify a single firm with effective arrangements to manage conflicts of interest with respect to PFOF for ECP trades. The FCA also confirmed that practices of equalizing commission paid by market makers providing quotes and relying on disclosures in relation to PFOF for ECP business does not mitigate the conflicts of interests created by PFOF and that such practices are inconsistent with the requirements in SYSC 10.
The FCA further reminds firms of upcoming changes under MiFID II that will restrict PFOF payment practices once it comes into full effect on January 3, 2018. Article 27(2) of MiFID II prohibits third-party payments and/or non-monetary benefits for routing client orders to a particular trading venue or execution venue where this might infringe conflicts of interest requirements or inducements. The FCA notes that MiFID II requires firms to act honestly, fairly and professionally in respect of services to ECPs, among other general principles. The FCA further notes that conflicts of interest requirements in MiFID II have been enhanced, and that disclosure of a conflict to a client as a means of managing the conflict should only be used as a “last resort” when the firm’s other arrangements fail to prevent a conflict.
The latest Market Watch can be read here.
The PFOF Guidance can be read here.
The PFOF Review can be read here.