FSA releases
finalised guidance on payment for order flow arrangements
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:
1.
The payment must
“not impair the compliance with the firm’s duty to act in the best
interests of the client”;
2.
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
3.
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.
Best
Execution
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.
Practical
steps
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:
http://www.fsa.gov.uk/static/pubs/guidance/fg12-13.pdf
http://www.fsa.gov.uk/static/pubs/guidance/fg-pfof-summary.pdf
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