On April 23, the Financial Conduct Authority (FCA) has published a final report on its recent supervisory work on conflicts of interest and payment for order flow (PFOF) on how wholesale broking firms manage conflicts of interest.
PFOF occurs when an investment firm (typically a broker) that sources liquidity and executes orders for its clients receives a fee/commission from both the client that originates the order and the counterparty the trade is then executed with (typically a market maker or other liquidity provider). This creates a conflict of interest between the firm and its clients, as firms are incentivised to execute clients’ orders with counterparties based on their willingness to pay commissions. Furthermore, it is more likely that extra costs are passed on to the broker’s clients, through wider bid-ask spreads from market makers and other liquidity providers that agree to pay PFOF to attract order flow from brokers. While the impact of PFOF may not be visible in bid-ask spreads for each transaction, it is likely to affect aggregate spreads as liquidity providers need to account for the payments made to brokers. These hidden costs make the price formation process less transparent and efficient. They can also distort competition by forcing liquidity providers to use a ‘pay-to-play’ model.
The supervisory work was made of information requested to 15 firms that undertake a range of activities, plus onsite visits to 12 firms, where the FCA assessed how effectively they monitored compliance with our regulatory obligations (e.g. conflicts of interests, inducements, and best execution), and examined the controls used to ensure firms correctly classify the nature of their activity in individual transactions.
The FCA found a distinction between broking activities that source exclusive liquidity for a specific client, and those that provide non-exclusive liquidity to a range of counterparties (sections 2.6-2.15 of the report). In particular, findings confirm that:
- Nearly all firms have stopped charging liquidity providers when sourcing exclusive liquidity for a specific client, regardless of client classification
- Firms found it difficult to ensure their activity was legitimately providing non-exclusive liquidity to a range of counterparties – which may allow them to manage the conflicts of charging both sides of a trade
- Firms could take further steps to improve the systems and controls they use to manage conflicts of interest for specific areas of their businesses
- Some firms routed client orders to overseas affiliates, which charged liquidity providers PFOF
Why is this important to you?
The FCA encourages firms to read this report and consider how to improve their practices, policies, systems and controls to meet their obligations under MiFID II. The report follows the recent publication of a “Dear CEO Letter” , which reminds firms in the sector to have an appropriate understanding of their obligation to act in their clients’ best interests, and to support fair and orderly markets. The FCA makes it clear that it will continue to prioritise and monitor firms’ compliance on PFOF as part of ongoing supervision, and will use enforcement actions where serious breaches of rules are identified.
Should you wish to discuss any of the points covered in this blog, and get a better understanding on how to comply with FCA expectations, please do not hesitate to contact us.