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The UK’s Financial Services Authority (“FSA”) recently published finalised guidance on the practice of payment for order flow (“PFOF”) arrangements. These are arrangements in which a broker receives payment from market makers, in exchange for sending order flow to them. The payments may take the form of direct payments per order or be in a softer form such as payment of the broker’s settlement fees or for trading software.
Although the FSA is not banning PFOF arrangements, it clarified that payments from a market maker to a broker can only be made where:
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both the conflicts of interest and best execution rules are complied with; and
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all three tests of the inducements rule are satisfied (see below).
The FSA also expects brokers who continue to operate PFOF arrangements “to commit additional resources” to monitor its compliance with FSA rules. It is not immediately clear how brokers can operate PFOF arrangements and comply with FSA rules in light of the guidance.
The FSA has suggested that if brokers cannot comply with the inducements rule, they could consider:
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forgoing these payments altogether; or
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changing the way they are remunerated by increasing the charges applied to clients so that commission is transferred or imposed on the end user.
Depending on how brokers react, the FSA’s initiative could mean that some brokers will seek to increase commissions charged to buy-side investment managers and funds.
Exclusion of the Inter-Dealer Market
The guidance clarified that payments made in the wholesale inter-dealer market (where neither party relies on the broker or has the expectation that the broker will be acting on its behalf and the broker charges both parties a commission) will not be PFOF payments and, therefore, do not need to satisfy the tests set out above.
Conflict of Interests and Best Execution Rules
The FSA believes that PFOF arrangements “create a clear conflict of interest between the clients of the firm and the firm itself,” as PFOF payments may incentivise a broker to put its own financial interests ahead of those of its client to the client’s detriment. Such arrangements, therefore, are unlikely to comply with the FSA’s conflict of interest rules.
The obligation to ensure best execution means that the broker must obtain the best possible price available (where all other relevant costs are equal). Where a broker is able to receive payments for order flow, the FSA said that it will be particularly important for the broker to demonstrate that it “had checked alternative execution possibilities (i.e. market makers) including those that do not pay for order flow and document that accordingly.”
Buy-side firms are indirectly affected by this because brokers owe them a duty of best execution.
Inducements
The three tests to be met before PFOF payments can be made are:
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the payment must “not impair the compliance with the firm’s duty to act in the best interests of the client.” According to the FSA, the broker would need to show that it had obtained the best possible price by complying with the best execution obligations (i.e. if best execution is not achieved there would be a breach of the FSA’s inducement rules);
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details of the inducement need to be disclosed to the client “in a manner that is comprehensive, accurate and understandable, before the provision of the service.” This means that the PFOF should be described as additional remuneration that is received by the broker in order for the client to easily understand the fees that are being charged; and
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the inducement must be “designed to enhance the quality of the service to the client.” The FSA is unconvinced that a broker could provide any justification that PFOF benefits the client directly.
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