Payment for order flow

Oh lord, where to start. Well, the FCA has been commendably plain in its guidance.

What is payment for order flow (PFOF)?

PFOF is the practice of an investment firm that executes client orders (typically a broker) receiving a fee/commission not only as an agent from the client originating the order but also from the counterparty with whom the trade is then executed (typically a market maker).

The FCA considers PFOF to be bad for our markets and a direct risk to all three of the FCA’s operational objectives for the following reasons:

• It creates a conflict of interest between the broker and its clients because the broker is incentivised to pursue payments from market makers rather than to provide best execution in the interests of its clients.
• It undermines the transparency and efficiency of the price formation process. This is because the prices paid by clients include hidden costs – and whilst clients may be aware of the level of commission they pay to their brokers – they might not be aware of the higher spread that they may additionally need to pay to take account of the fees paid by the market marker.
• Forcing market makers to ‘pay-to-play’ can distort competition by creating barriers to entry and expansion. Indeed, if brokers refuse to look beyond fee-paying market makers, the most obvious way for new market makers to enter the market is to offer payment for order flow that is higher than the rates paid by existing market makers – an outcome that is inconsistent with promoting effective competition in the interests of consumers. Our supervisory work indicates that, for the most part, brokers routinely exclude non-paying market makers. This approach can result in poorer price outcomes for clients because, in addition to the wider spread that the client is likely to pay to account for the fees paid by the market maker, these ‘non-paying’ market makers might otherwise provide the most competitive pricing.

As of September the FCA has concluded:

• The large integrated investment banks have largely stopped charging PFOF in respect of all client business and across all market segments. (This is as close as a regulator will ever get to saying “hooray for investment banks”!)
• Independent brokers have mainly stopped charging PFOF to professional clients.
• Some independent brokers continue to charge market makers commission in return for order flow in respect of ECP initiated business. Here, the FCA still believes purported management of inherent conflicts of interest in PFOF are inadequate in light of SYSC 10. Nor would they satisfy the expectations under MiFID II.

See also

The FCA's FCA Marketwatch 51 released on 1 September 2016 — from which the above is extracted — should give you what you need. If that isn't enough, have a look at the FCA's original Thematic Review TR 14/13 of best execution and PFOF.

• Inducements and the rule against them.