In its TR 13/14 thematic review, the FCA discussed the implications of payment for order flow on best execution and the integrity of the financial markets. The regulator took a clear stance against payment for order flow and declared its active pursuit against the practice. However, the commercial impact of payment for order flow and the way it fits in the financial markets has been left largely unmentioned. In this article we explore the practice of paying for order flow in a wider context and evaluate its connection to other market practices with a particular focus on high frequency trading.
The practice of payment for order flow (“PFOF”), being pioneered by Bernie Maddoff has been subject to a great degree of attention both in the UK and overseas. While creating clear issues in regards to brokers’ fiduciary duties to their clients, payment for order flow is often part of a bigger scheme, carried out by high frequency trading (“HFT”) firms. TD Ameritrade, for example, was paid hundreds of millions of dollars each year to send their orders to a HFT firm called Citadel, which executed them on their behalf. In 1997 it was estimated that 24% of E*Trade’s transaction revenue came from PFOF.
In today’s market, brokers have the opportunity to execute their orders on a number of exchanges. There are currently over 7 specialist market makers in the US alone and over 4 in the UK, and the number of private market makers is vastly higher in both countries. Best execution rules put an obligation on brokers to use the exchange that offers them, amongst other factors, the best price order price. However, with the growing popularity of PFOF this is not always the case. PFOF is essentially a tampering of best execution rules, as market makers pay for a constant influx of orders, therefore brokers are no longer guided by the best price they can obtain for investors, but by who pays the most money. So the question is, why pay so much money to simply execute orders on someone’s behalf?
While paying for order flow could carry a number of benefits for exchanges, such as tax benefits or volume-related profits, a particularly interesting aspect of the practice is the role it plays in HFT. By using the advanced infrastructure provided by HFT firms, market makers gain access to the market before everyone else. This allows them to access information faster, to ping the market and to find better order prices, giving HFT firms and market makers an unfair advantage over other market players. In effect, HFT allows its benefactors to see other people’s orders before anyone else, without any obligation to trade against them. By paying for order flow, HFT firms and market makers secure a high volume of orders on which they profit, based on the margin they are able to gain between the expected price of execution and the price that they can obtain. While the difference in price is often nominal, it needs to be amplified by the volume of orders to assess its true scale. Some HFT firms and market makers make billions every year off of these margins.
PFOF and HFT create an issue not only for investors, but also for the functioning of the financial markets and their integrity. Exchanges are commonly perceived as providing a level playing field for investors and brokers, however, paying for order flow and teaming up with HFT firms have put doubt on this. In effect, by paying brokers a number of regulatory rules are being broken, such as the best execution rules and the duty to avoid conflicts of interest. As a result of these breaches and the common use of this practice by institutions, one can cast doubt on the fairness and integrity of the financial services industry. Investors’ trust in the system is being undermined and the markets are being used as a tool of greed in contrast to
a system where there is a balanced distribution of wealth between deficit and surplus. It is for the above reasons that the FCA are keeping PFOF under active review, as was stated in its TR 13/14 “Best execution and payment for order flow” thematic review.
It is interesting to note that while PFOF is illegal, HFT itself is not currently. Regulators seem to have different opinions in regards to the legality of the practice and they are strongly reflected in their reports and studies. In the Foresight Report into the Future of Computer Trading in Financial Markets, which was published in October 2012, the UK Government expressed its views that there are four specific benefits of HFT for the financial markets: it provides better liquidity, reduced volatility, price discovery and reduced transaction costs. In contrast to the Foresight Report, in a recent letter, Martin Wheatley, the FCA’s CEO, has noted that the FCA is taking HFT very seriously and is currently working on implementing the needed changes in the upcoming recast Markets in Financial Instruments Directive (MIFID II). In the US, the SEC is working with the FBI on identifying whether HFT could be categorised as market manipulation. The European Securities and Markets Authority has also expressed its concern with HFT, linking it to the facilitation of market abuse.
The lack of convergence by regulators regarding high frequency trading could be explained by the complexity of HFT itself. Financial journalist Michael Lewis has expressed his concern with the growing inequality between the positions of clients/investors and market makers, which has resulted from the technological advancements in the market in his bestseller “Flash Boys”. Trades are run through extremely advanced software and are executed by complex algorithms. Such arrangements are only understood by very few experts, which poses a major hurdle for regulatory bodies. Moreover, the existence of forums called dark pools, which are being used by investment banks and hedge funds to conceal orders from the public further emphasizes the technical advantage of such bodies over regulators.
While the legality of HFT is still being considered by the FCA and ESMA, the disadvantage it brings to investors could be avoided by firms ensuring they are not participating in any such arrangements. This includes participation in PFOF, which as the FCA has issued in its TR14/13 report, is an area that will be kept under active review. The regulator has warned that it will take action against any firms continuing to take part in such arrangements. Firms are under an obligation to take reasonable care in establishing and maintaining effective systems and controls for compliance with the regulatory system. Firms should ensure they are adequately monitoring their activities and that they are acting in compliance with best execution and conflict of interest rules. Avoiding participation in PFOF is essential for market transparency and integrity. Compliance would help lessen the advantage HFT firms have over the market by decreasing their access to capital and in turn this would lead to a more fluid and fair market.
Should you require any further advice or information on the above, Cleveland & Co, your external in-house counsel, are here to help.