The FCA has recently completed its thematic review on best execution and payment for order flow (“PFOF”). The TR14/13 report expresses the regulator’s growing concern with PFOF arrangements and their popularity amongst firms. Firms owe a regulatory duty to their clients as agents to obtain the best possible execution (take all reasonable steps to obtain) of an order and to avoid conflict of interests. The practice of PFOF undermines both these duties as firms are offered compensation from market makers to give them their orders hence rarely acting in or, being guided by, their clients’ best interests. 

A finding of the July 2014 report, which followed FG 12/13, was that firms have started using recast arrangements to avoid the scope of restrictions on PFOF. Firms engaging in this activity argued that:

  1. it was an “arranging service”, not the execution of orders;
  2. the broker acts simply as an intermediary, connecting market makers to investors allowing each party to remunerate the broker independently;
  3. the best execution duty did not apply, as there is no execution by the broker; and
  4. conflict of interests were managed by harmonising commission rates paid by market makers.

Such arrangements were found by the FCA to serve as a mere façade for brokers and to not be consistent with the economic realities of their activities. The regulator warns brokers of its continuous pursuit against the practice of PFOF, emphasizing that such arrangements not only present risks to consumers, but damages trust and confidence in the integrity of the markets, and could also potentially undermine competition between trading venues.

“We are keeping this area under active review and will take action against any remaining firms which continue to evade our rules and requirements on PFOF. We will consider all available tools, including enforcement action.”

It is important to note that even though PFOF could be allowed where no other venue is quoting a better price on the national market system and the rules of inducement have been complied with, the FCA states that realistically there could rarely be any benefit for clients from such arrangements.

Payment for order flow is a practice commonly used by high frequency trading (“HFT”) firms in order for them to secure a steady investment flow. For “Our Thinking” in relation to PFOF and HFT please subscribe to our newsletter here.

Should you require any further advice or information on the above, Cleveland & Co, your external in-house counsel, are here to help.