FCA to continue firm visits dedicated to payment for order flow checks

Maria Nikolova

Nearly all of the brokers the FCA has visited have now stopped charging PFOF where they consider themselves as acting in an agency-like capacity.

The UK Financial Conduct Authority (FCA) has published an update on its work regarding Payment for Order Flow (PFOF), indicating it will continue to monitor firms to check about possible PFOF arrangements.

Let’s recall that Payment for Order Flow (PFOF) occurs when an investment firm (typically a broker) that executes orders on behalf of its client receives a fee/commission from the client that originates the order, as well as from the counterparty the trade is then executed with (typically a market maker or other liquidity provider). These payments result in a conflict of interest between the firm and its client by incentivising the firm to execute its client orders with counterparties willing to pay the highest commission and so undermine the firm’s ability to act as a good agent.

In December 2017, the UK regulator published a “Dear CEO letter”, underlining its position on PFOF. The letter also set out the FCA’s expectations on the practice in the context of MiFID II, particularly its strengthened conflicts of interest regime.

Subsequently, the FCA Business Plan 2018/2019 outlined supervisory work on PFOF as one of the FCA’s priorities to address conflicts of interest in the wholesale sector. The FCA said this work would focus on ensuring that firms are complying with the strengthened standards in MiFID II.

Before the implementation of MiFID II, the FCA found that most firms had stopped charging PFOF for retail and professional client business. However, market intelligence suggested that some firms were still charging PFOF for ECP business. Intelligence also suggested that some brokers were considering various avoidance tactics so they could continue to charge PFOF after MiFID II implementation. This was the context for the ‘Dear CEO’ letter on PFOF in December last year.

As a result, the FCA current supervisory work has focused on PFOF charged by firms for ECP business, following the implementation of MiFID II.

The FCA supervisory work to date suggests that there have been several developments in the market since January 2018.

Nearly all of the brokers the FCA has visited have now stopped charging PFOF where they consider themselves as acting in an agency-like capacity, regardless of the client’s categorisation.

Many of the brokers the FCA has visited still charge both sides of a transaction for what they characterise as interdealer-broking business, where they do not consider themselves to be acting in an agency capacity. These instances are now the vast majority of transactions where brokers charge both sides of a transaction. The regulator is currently gathering more information about brokers’ activities for this type of business. This is set to enable the FCA to assess whether firms are applying consistent judgements across the market that align with the rules on managing conflicts of interest.

The regulator has also identified isolated evidence of behaviour, in the context of providing an agency-like service to clients, whereby a broker seeking liquidity from liquidity providers has been wrongly defined as a service to those counterparties, with a corresponding charge being levied on the liquidity provider. The FCA will take action against firms who characterise their relationship with liquidity providers in a way that does not reflect economic reality and which are PFOF arrangements.

Furthermore, the FCA has received reports of some brokers booking transactions to overseas offices so they could argue that they were allowed to charge PFOF. The regulator says it will continue to examine brokers’ order routing to overseas entities for any evidence of circumventing behaviour that breaches the FCA rules; for instance, when relevant orders are handled at any stage by a UK broker but are subject to two-sided charging contrary to the FCA PFOF position.

The FCA will continue its program of firm visits. These will evaluate how robust firms’ systems and controls are for monitoring adherence to all relevant rules, policies and procedures on PFOF. Firms should note that, for a given transaction, they should analyse the capacity in which they and the different counterparties involved act, rather than look to their or these counterparties’ general business models.

The UK regulator notes that its work will include scrutiny of the specific controls for correctly classifying individual transactions, such as what a firm classifies as interdealer broking activities. The FCA will also look at the policies applied by firms, focusing particularly on how they manage potential conflicts, and the extent of their compliance monitoring and oversight activity.

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