On December 13, the UK Financial Conduct Authority (FCA) published a “Dear CEO” letter expressing its concerns over the practice of brokers demanding payments from counterparties in exchange for conducting client business with them, also known as payment for order flow (PFOF). The letter follows the FCA’s September 2016 update, published in their Market Watch newsletter, which reiterated the requirement of firms to continue to meet their obligation with regards to conflicts of interest management in the FCA’s Systems and Controls Handbook Rules (SYSC) (for further information, please see the Corporate & Financial Weekly Digest of September 30, 2016).
PFOF involves firms (most often brokers) executing client orders and charging and receiving fees for execution from: (1) the client initiating the order; and (2) the counterparty to the trade (often market makers). In the letter, the FCA emphasizes that such arrangements introduce a conflict of interest which ultimately can cause harm to both clients and markets. The FCA reiterates in the letter that PFOF substantially undermines a broker’s ability to act as a good agent. Similarly, it is made clear that any firms that continue to charge PFOF will ultimately breach the new standards implemented in the revised Markets in Financial Instruments Directive (MiFID II), which goes into effect on January 3, 2018 (i.e., PFOF prevents best execution from occurring).
The FCA highlights Article 27(2) of MiFID II, which relates to restrictions on third-party payments when executing orders on behalf of retail and professional clients. The FCA also notes that MiFID II will ultimately strengthen conflicts of interest requirements, which will be of particular significance for firms providing investment services to eligible counterparties, but also of relevance to professional and retail client business.
The letter also provides examples of structures which seek to avoid requirements preventing PFOF that the FCA has become aware of, specifically:
- linking charges to market makers for non-execution services, such as research products or market analysis software, to the amount of business transacted, in an attempt to replicate the PFOF previously received, or insisting that market makers subscribe to such non-essential services to continue to see the broker’s flow;
- establishing arrangements with intermediaries or overseas affiliates with a view to getting around FCA requirements on conflicts of interest, inducements and best execution in order to continue to charge PFOF from market makers; and
- only contacting market makers who have been required to send alternative order flows to brokers (which would not normally be executed through brokers, e.g., hedge trades) for the sole purpose of generating a fee to replicate PFOF.
Significantly, the letter also states that market makers who are approached by brokers with proposals that attempt to circumvent these regulations must not engage in these arrangements, and adds a new requirement that market makers should report any such attempts to the FCA.
The letter is available here.