Clifford Chance

On 13 July 2021, the European Securities and Markets Authority (ESMA) warned both firms (investment firms and credit institutions providing investment services or performing investment activities) and investors about the risks arising from payment for order flow (PFOF).

PFOF

In short, PFOF is the practice of brokers receiving payments from third parties, such as execution venues for routing client order flows to an execution venue.

ESMA has called upon the National Competent Authorities (NCAs) to prioritise supervisory activities aimed at assessing the actual impact of PFOF activities on firms’ compliance with (i) best execution, (ii) conflicts of interests and (iii) inducements requirements under MiFID II, including whether firms receiving PFOF are able to demonstrate that they consistently achieve the best possible result for their clients when executing their orders. In the Netherlands, the Authority for the Financial Markets (AFM) has endorsed ESMA's warnings.

Free lunch?

When firms execute orders in financial instruments for retail clients (in this article  we will focus on retail clients), they will need to ensure that their clients will get the best possible result. This is also referred to as 'best execution'. Under MiFID II the best possible result for a retail client is to be determined in terms of 'the total consideration, representing the price of the financial instruments and the cost relating to execution'. In short, the best possible result for a retail client is determined by the total price that the client pays for buying or selling a financial instrument. This requirement does not apply where the client provides a specific instruction to execute an order in a specific way.

The PFOF model allows firms to offer commission free trading to their (retail) clients (so called 'zero-commission brokers'). Zero-commission brokers can offer their commission-free services to their clients because they are compensated for the absence of direct commissions charged to their clients through the PFOF business model. PFOF may be considered a good thing, as it could reduce the total price for buying or selling a financial instrument. However, according to ESMA, it is important to take into account investor protection risks, such as less transparency and the potential distortion of retail clients' investment incentives when looking at the activities of a zero-commission broker. As well as any other firm, a zero-commission broker is obligated to provide fair, clear, and not misleading information and will need to provide information on all costs and charges relating to its services and financial instruments (including the 'bid-ask spread', please see below). A zero-commission broker will incur costs that will need to be paid one way or another and this should be clearly communicated to the clients. ESMA emphasises that marketing services as 'cost-free' while receiving PFOF may incentivise retail clients' gaming or speculative behaviour due to the misguided perception that trading is free. This may also infringe the zero commission broker's compliance with the requirement to provide fair, clear, and not misleading information, according to ESMA.

Best execution and bid-ask spread

The determining factor for best execution for retail clients (in the absence of a specific client instruction) is price. In this regard, ESMA expects firms to pay specific attention to the risk that receiving PFOF from third parties may affect the bid-ask spread offered by such third parties and consequently would results in a worse price for the client compared to the situation in which the third party would not provide PFOF.

The bid-ask spread, in short, is the difference between the highest price of the seller (bid) and the lowest price of the buyer (ask) for a financial instrument. Bid-ask spreads (and therefore the price that is paid for the financial instrument) may differ per execution venue (depending on the supply and demand on that execution venue). On which execution venue the execution is made therefore influences the price that is paid or received for the financial instrument.

ESMA warns that, when there is an incentive for firms to route orders to a particular execution venue, it may be that the order is not executed on the best possible terms that are currently available in the market. For example, a client may not pay any commission to the firm, because the firm receives PFOF, but the execution venue to which the order is routed may not offer the most favourable bid-ask spread that is available in the market. This may lead to an order not being executed against the best possible price.

ESMA signals that certain firms try to circumvent the best execution requirement by asking clients to choose the execution venue for their trades. This specific choice for an execution venue is seen as a specific client instruction which would take the execution of the order outside the remit of the firm's best execution obligation. This raises investor protection concerns with ESMA in two way. First, the execution venues that offer PFOF are often presented more favourably by the firms then execution venues that do not pay for order flow to the clients which may induce clients to choose PFOF execution venues. Second, by presenting the execution venues providing PFOF to the firm in a prominent manner, clients are systematically induced to choose an execution venue that provides PFOF to the firm. In ESMA’s view, such a choice does not constitute a proper specific instruction from the client according to ESMA, a specific choice for an execution venue.

Conflict of interest and inducements

Under MiFID II, firms may not receive any remuneration, discount, or non-monetary benefit for routing client orders to a particular trading or execution venue that would infringe the requirements on conflicts of interest or inducement. According to ESMA, the receipt of PFOF from an execution venue causes a conflict of interest between the firm and its clients because it incentivises the firm to choose the execution venue that offers the highest PFOF, rather than the best possible outcome for its clients trades. The consideration and eventual choice for a particular third party for the execution of client orders should be solely driven by the aim of obtaining the best possible result for the client and should not be influenced by the PFOF. Therefore, firms should consider both third parties that offer PFOF and those who do not and should choose a third party strictly on the basis of factors that relate to obtaining the best possible result for the client. These factors should also be included in the firms' best execution policy and the effectiveness should be monitored on a regular basis.

PFOF received from third parties when executing client orders constitutes an inducement within the meaning of MiFID II. Under MiFID II, this inducement is only allowed if the PFOF is designed to enhance the quality of the service to the client (quality enhancement) and that PFOF does not impair compliance with the firm's duty to act in accordance with the best interest of its clients (best interest requirement). PFOF is not acceptable if it distorts or biases the provision of the relevant service to the client. ESMA emphasises that firms are required to clearly disclose the existence, nature and amount of the PFOF to the client pre and post-execution of the transaction.

Check please!

ESMA has indicated that, considering the concerns raised above it is unlikely that PFOF will be compatible with the requirements under MiFID II. Therefore, ESMA calls upon the NCAs to assess the actual impact of PFOF on firms' compliance with the best execution, conflicts of interest and inducements requirements.

In principle, if firms receiving PFOF are able to demonstrate that they consistently achieve the best possible result for their clients when executing their orders, and comply with the rules stemming from MiFID II, PFOF should be allowed. Further, it remains to be seen how the warning from ESMA will be received in countries where PFOF is currently permitted under MiFID II as implemented in local law.