The UK Financial Services Authority (FSA) has recently issued guidance restricting the use of payment for order flow (PFOF) arrangements (the Guidance). PFOF for this purpose refers to arrangements under which brokers receive payment from market makers in exchange for sending orders to them
The FSA states in the Guidance that it considers that in principle PFOF arrangements create a clear conflict of interest between brokers and their clients. Brokers have an incentive to direct order flow to market makers offering PFOF, potentially compromising clients’ best interests. PFOF payments from a market maker to a broker are permissible only where the relevant FSA rules on best execution, inducements and conflicts of interest are satisfied. Brokers receiving PFOF will need to demonstrate that they have implemented and maintain effective conflicts of interest management policies, procedures and organizational arrangements designed to avoid any disadvantage to clients.
Further, in order to be permissible under the FSA’s rules on inducements, PFOF payments must satisfy all three of the following tests:
- Test 1: The PFOF payment must “not impair the compliance with the firm’s duty to act in the best interests of the client;”
- Test 2: Details of PFOF payments must be disclosed to clients “in a manner that is comprehensive, accurate and understandable, before the provision of the service;” and
- Test 3: The PFOF payment must be “designed to enhance the quality of the service to the client.”
To satisfy Test 1, the broker will need to demonstrate that it has obtained the best possible price by complying with applicable best execution obligations. In order to do so it will need to compare PFOF market maker prices with prices from market makers that do not pay for order flow.
Test 2 requires the broker to disclose details of the payment ahead of the provision of the relevant services. The disclosure will need to specify the amount of the payment and to be given to the client before execution of any transaction. If the amount of the payment changes, such change will need to be communicated to the client before any further transactions are executed for that client.
To satisfy Test 3, the broker will need to provide a justification as to how the relevant payment is designed to enhance the quality of service to the client. In making this assessment the broker must also consider the nature and extent of the benefit (and any expected benefit) to the broker. It will be challenging to satisfy Test 3, since the FSA states in the Guidance that: “It is difficult to see how a firm could provide any justification that PFOF benefits the client directly. There are no obvious benefits save the one that the firm receives more remuneration from the provision of the execution services. However, this may be at the expense of the client so that in effect this may amount to no more than simply charging the client additional fees.”
The Guidance notes that in the inter-dealer broker market (which is predominantly OTC), where neither party relies on the broker or has the expectation that the broker will be acting on its behalf, the broker charges both parties a commission. This payment arrangement will not amount to payment for order flow.
The Guidance also states that the FSA’s specific concerns are unlikely to apply to liquidity incentive schemes operated by trading venues.
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