The FCA has published its most recent edition of Market Watch (No. 51) on 27 September 2016. One of the most interesting parts of this publication is the FCA's statement on its continuing work on payment for order flow (PFOF). In short, the FCA continues to find breaches of its rules in relation to conflicts of interest and PFOF. The FCA also believes that the forthcoming rules under the Markets in Financial Instruments Directive II (MiFID II) which are due to come into force on 3 January 2018 will make even the most limited use of PFOF untenable.
The FCA has always noted that its concerns about PFOF centre on the conflict of interest that PFOF creates between the broker and its clients (as the broker is incentivised to pursue payments from market makers rather than provide best execution in the interests of their clients), the lack of transparency that PFOF leads to in the price formation process (due to the hidden costs) and the distortion of competition in the market as brokers routinely exclude non-paying market makers which affects competition in pricing.
The FCA previously published guidance in 2012 and a thematic review in 2014 on PFOF. This most recent statement in its Market Watch newsletter looks at how the market has addressed some of the regulator's key findings which the FCA has assessed through its supervisory work since those publications.
The FCA has found that large integrated investment banks have taken on board the PFOF messages and ceased charging PFOF. Independent brokers have 'mainly' stopped charging PFOF and any non-compliance has been dealt with by the FCA supervision team. However, a number of independent brokers continue to charge market maker commission for order flow in respect of eligible counterparty clients (ECPs). Here the FCA does not agree that current practices adequately manage the conflict of interest and comply with the FCA's rules. While the FCA stopped short of stating current arrangements can never comply with the relevant rules – this appears to be the message.
Best execution and inducement rules do not apply to firms' dealings with ECPs. However, the conflict of interest rules in SYSC 10 do. The FCA notes that the key issue for firms is to consider whether it is possible for a direct, self-created conflict such as PFOF to be adequately managed. The FCA concludes that it is 'yet to see a single example of an effective conflicts management arrangement for charging PFOF in the context of ECP-initiated trades'. The FCA discredits the argument that equalising payments amongst fee paying market makers is sufficient, noting in particular that this does not address the issue of hidden costs. The FCA also goes on to confirm that disclosure cannot be relied upon to manage the conflict of interest. Disclosure in this context, according to the FCA, is an inadequate conflicts management tool.
The FCA makes the effort to highlight that the forthcoming MiFID II will place further restrictions on charging PFOF. For professional client business, MiFID II reinforces the ineligibility of third party payments when executing orders and will extend a number of general principles to the provision of investment services to ECPs, particularly the obligation to act honestly, fairly and professionally and communicate in a way that is fair, clear and not misleading. While the link between MiFID II and PFOF is in our view not clear, the FCA's message is.
It is therefore fair to say the regulator is making a clear statement that PFOF is not acceptable even for ECPs. Firms who continue to charge PFOF for this type of client have been warned.
