Client’s best interest rule

The FCA’s much-talked-about, seldom understood, TCF provision. To be read in conjunction with the FCA’s “PRIN” general principles and, for those of you, my pretties, who like to dive deeper, the FCA’s discussion paper on conflicts of interest published in April 2019.

The JC’s Reg and Leg resource™ UK Edition →Go uptown Taking care of business — I mean treating customers fairly — in Memphis Tennessee COBS 2.1.1: The client's best interests rule (1) A firm must act honestly, fairly and professionally in accordance with the best interests of its client (the client's best interests rule). (2) This rule applies in relation to designated investment business carried on: (a) for a retail client; and (b) in relation to MiFID or equivalent third country business, for any other client. (3) For a management company, this rule applies in relation to any UCITS scheme or EEA UCITS scheme the firm manages. Note: article 19(1) of MiFID and article 14(1)(a) and (b) of the UCITS Directive. Index: Click ᐅ to expand: Regulation Tell me more Sign up for our newsletter — or just get in touch: for ½ a weekly 🍺 you get to consult JC. Ask about it here.

The general principles in play here are:

• Principle 2 Skill, care and diligence – A firm must conduct its business with due skill, care and diligence.
• Principle 6 Customers’ interests – A firm must pay due regard to the interests of its customers and treat them fairly.
• Principle 7 Communications with clients – A firm must pay due regard to the information needs of its clients, and communicate information to them in a way which is clear, fair and not misleading.
• Principle 8 Conflicts of interest – A firm must manage conflicts of interest fairly, both between itself and its customers and between a customer and another client.
• Principle 9 Customers: relationships of trust – A firm must take reasonable care to ensure the suitability of its advice and discretionary decisions for any customer who is entitled to rely upon its judgment.

There is much general lofty aspiration here, but not much by way of flesh on the bones. This, generally, is how the JC likes regulations — self explanatory, and demanding the application of common sense — but it does lead nervous compliance officers, who, having been beaten and bloodied in the foregoing decade don’t always have much of a conceptualisation of common sense — to adopt a bunker mentality. So a few remarks about what the fairness requirement should not mean. You know how we like disclaimers, folks, and this being turf into which the better angels of the professional advisorate tend not to rush — consider our disclaimer absolute. Take the following as you find it, and don’t blame me if you wind up in jail.

It doesn’t mean you have to offer the same product, on the same terms, to everyone.

That would be madness. But you see this argument advanced:

“If we offer this groundbreaking product — tranched synthetic collateralised emissions credit derivatives, denominated in bitcoin — to one special client, then we will have to offer it to everyone. We have to treat all our customers fairly, you see”.

This cannot be right.

Firstly, treating customers fairly rules generally tilt towards not offering customers flakey products, rather than being forced to.

Secondly, where a dealer has offered a product — flakey or otherwise — TCF is about then ensuring that the dealer exercises its rights against clients in that product (ceteris paribus) fairly. So, if you have 100 clients long the same delta-one equity swap and there is a market disruption affecting half your hedge, you close out all positions pro rata, rather than closing out the small clients in full and keeping the juicy platinum client open and therefore happy, however much that is better to your long term revenue profile.

Thirdly, trading any products necessarily involves taking on risk. Dealers do not have an unlimited tolerance for this stuff. It is axiomatic that dealers don’t, without good reason and comprehensive verbiage, grant their clients committed trading facilities. It might attract a capital charge for one thing. Suggesting that, because you have traded with one client means you are obliged to trade with another, obliges you, effectively to write the whole world a committed trading facility.

So let’s say dealer A has put on a big trade with client X in the process maxing out its appetite for bitcoin-denominated cannabis futures. If client Y comes along and says, “well you did 5 yards with him, so you can do five yards with me too,” it puts our poor risk manager in a pickle. Must she double her exposure, in the name of treating customers fairly? Is even that the end of it? If clients P, Q, and R arrive with the same request the next day, must she quadruple her exposure to suit them? Clearly that would be madness. To take our reductio ad absurdam to the other end, we wonder, must our hapless risk manager instead keep some risk headroom open when trading with X, thereby declining to fill the client’s whole order, just so she can keep enough room to accommodate Y, P, Q, and R pari passu in case they decide they want to transact? But what of clients A, B,C all the way to n? Clearly this is madness also.

So we start to put some parameters on it: a dealer must have legitimate grounds for not trading: credit appetite, market risk, prevailing volatility, reputational and so on, as legitimate grounds. No doubt imaginative risk managers could think of others. At some point, any old fool can contrive some plausible excuse for not trading, so in practice we are at the point the JC started with: you don’t have to offer the same product, on the same terms, to everyone. But this is a bad intellectual ground for getting there. None of these putative grounds have anything to do with “fairness between clients” as such — they all speak to the dealer’s personal risk appetite. So if these reasons do trump an incoming client’s request to trade, then it stands to reason that the dealer’s own interest takes precedent over the (putative) client’s interest. If so, this is a either a transgression of the client’s best interest rule, or a situation in which the client’s interest doesn’t prevail. The JC says it is obviously the latter.

It isn’t some kind of dealer-based doctrine of precedent

The same goes for close-outs and disputes. when confronted with any practial means of sorting out a specific dispute on a settlement failure with a client,. compliance will be sore pressed not to caution against this, on grounds of treating customers fairly - the equity in question being the resolution of this specific issue, and any other settlement or trading issue that might arise in any market, with any client at any time, if putatively analogous. Again, this ought not be the purpose of the TCF rule, if for no other reason it will “chilling” effect on a dealer’s appetite for settling any dispute with any client in any circumstances short of a final judgment of a competent court. TCF does not introduce the obligation to operate some kind of internal stare decisis policy, obliging a dealer to apply a doctrine of precedent binding it for all times to any practical accommodation it might make with any of its clients at any time for any reason. The intention is surely more limited: if two clients grumble about the same valuation the dealer makes on the same product at the same time, then TCF obliges the dealer who fixes the problem for one client to offer corresponding resolution to the other. Be even handed. That is all.

And “client” means?

So, then when this rule says “client” what does it mean? At first blush you might say this means any person whom the dealer has onboarded as a client who has at any time traded any product, ever, but a better view is that is should be a live client with an actual exposure to the specific product in question. If you take the former, wider, view — and a chicken licken will be inclined to, since that’s the one least likely to get him skewered — then any onboarded entity acquires some (conditional?) right to be offered a trading line in this product over any other participant in the market who hasn’t yet been onboarded — remember “a stranger is just a client you haven’t onboarded yet” — and that inequity seems just as arbitrary qnd, really, greater, than one between an existing client who is in the product at the time of the event, and one who is not.

When you back out of that cul-de-sac, there is only one conclusion left: the dealer’s decision to deal in a product must be its own sovereign right. TCF must be about fair treatment of customers the dealer has traded with, not with randoms (whether onboarded or not) with whom it hasn’t.

But conflicts of interest

It is true, Principle 8 extends to conflicts between different clients as well as between dealer and client. But surely these conflicts must arise as a result of some kind of direct interaction between the two clients, rather than the abstract fact that both of them happen to be on the demand side of the same resource for which there is limited supply. Again, regulatory rules here — best execution — are about the price at which you do trade, if you trade, and not whether you trade at all, and the conflict is between dealer and client and not between the clients.