On 14 May 2012, the FSA issued its finalised guidance on payment for order flow (“PFOF”) arrangements following its October 2011 guidance consultation.
The FSA approached the industry back in October for feedback regarding the prevalence of PFOF practice and its effect on the allocation of order flow and market prices. The guidance appears to have been issued on substantially the same basis as the original consultation which stated that “PFOF arrangements create a clear conflict of interest between the clients of the firm and the firm itself. Therefore it is unlikely to be compatible with our inducements rule and risks compromising compliance with best execution rules”.
Particularly of relevance to brokers executing client orders and market makers, the FSA defines PFOF as “an arrangement whereby a broker receives payment from market makers, in exchange for sending order flow to them”. The broker will also receive commission directly from its client.
The FSA confirms that payments from a market maker to a broker are not prohibited but the payments can only take place where the following inducement, conflict of interest and best execution rules are satisfied.
The inducement rule
The FSA Handbook Conduct of Business (COBS) rules set out the rule on inducement at COBS 2.3 which applies to both retail and professional clients. The rule permits payment inducement payments such as PFOF provided that the payment satisfies all of the following tests:
The payment must “not impair the compliance with the firm’s duty to act in the best interests of the client”;
The details of the inducement are disclosed to the client “in a manner that is comprehensive, accurate and understandable, before the provision of the service”; and
That the inducement is “designed to enhance the quality of service to the client”.
In justifying their compliance with test 2, firms will need to disclose the details of the payment to the client ahead of the provision of the service. Any disclosure made will need to be “comprehensive, accurate and understandable”.
Satisfying the third test is likely to prove more challenging for firms. The payment must be designed to enhance the quality of the service to the client. The FSA acknowledges “that it is difficult to see how a firm could provide any justification that PFOF benefits the client directly”. It rejects the argument that the payment covers costs which would otherwise have to be passed onto the client directly. Market participants could find this particular hurdle difficult to overcome and will need to consider carefully the benefits that PFOF arrangements offer to underlying clients.
Conflicts of Interest
The FSA raises concerns about the incentives a broker receives to direct order flow to those market makers offering PFOF arrangements which in turn may compromise the broker’s duty to act in the best interests of its clients.
Under the FSA Handbook Senior Management Arrangements, Systems and Controls (SYSC) rules, a broker must take all reasonable steps to identify conflicts of interest between itself and its clients. Compliance with SYSC 10.1.3R would require a broker to identify PFOF as giving rise to a conflict of interest between the interest of the firm and its clients. Brokers who receive PFOF payments should therefore have appropriate conflict management procedures and policies in place so as to manage conflicts effectively and demonstrate that any PFOF arrangement does not compromise its client’s best interests.
The best execution rule set out in COBS 11.2.1R states that: “A firm must take all reasonable steps to obtain, when executing orders, the best possible result for its clients taking into account the execution factors”.
Wherever a professional or retail client legitimately relies on the firm to act on their behalf, a duty of best execution is owed to that client. The key factor in determining whether the best possible result has been achieved for the client is whether the best possible price has been obtained for that client. Brokers will need to demonstrate that the PFOF payment was not the key motivator in their decision to use a particular market maker. The decision must be based on that market maker providing the best possible prices available in comparison to other market makers who are not offering a PFOF.
In complying with the best execution rule, the FSA confirms that brokers will need to carry out monitoring of prices offered by market makers - comparing prices offered by market makers offering a PFOF with those not offering a PFOF. Under COBS 11.2.29, clients may legitimately request such information when asking brokers to demonstrate whether they have fulfilled their best execution duties to them.
In publishing its finalised guidance, the FSA emphasised that firms should carry out due diligence to ensure that the relevant COBS rules are being applied correctly. The FSA reiterated that the COBS rules have been in place since the introduction of MiFID in 2007 and brokers should be able to apply the rules to PFOF received from market makers wherever a client is relying on them to act on their behalf.
Firms receiving or offering PFOF arrangements should carefully consider the FSA guidance and take practical steps to ensure compliance with the rules around inducements, conflicts of interest and best execution. Firms should work with their advisers to analyse how they will meet the stated requirements. In achieving compliance, firms should have the following in place:
Conflicts of interests and Best Execution policies and procedures;
Monitoring Programme in relation to prices offered by market makers and a procedure for comparing the prices offered by market makers offering PFOF and those market makers not offering such payments;
Documentary records detailing compliance with the inducements rule and, in particular, why a PFOF improves the quality of service provided to a broker’s underlying client.
For further information, please see the FSA’s finalised guidance together with the summary of the feedback received to the October 2011 guidance consultation: