PFOF now under EU scrutiny with a retail focus

 ESMA has issued a statement warning firms and investors about risks arising from payment for order flow (PFOF) and from certain practices by “zero-commission brokers". The statement also outlines key MiFID II obligations designed to ensure firms act in their clients’ best interest when executing their orders.

PFOF

PFOF is the practice whereby brokers receive payments from third parties for directing client order flow to them as execution venues. The practice can be a contentious issue and in the UK, the FCA has indicated in the past that PFOF creates a conflict of interest between the broker and its client. In 2019, it issued guidance on PFOF (see our briefing here) in the context of wholesale markets, specifically eligible counterparty client business in listed derivatives. The FCA drew a distinction between firms sourcing exclusive liquidity for specific clients and those that disseminate more widely non-exclusive liquidity to a large number of clients. The FCA stated that firms sourcing exclusive liquidity for specific clients should not charge a liquidity provider.

ESMA's statement confirms that PFOF by firms from third parties would not be compatible with MiFID II and its delegated acts. It goes on to state that PFOF creates a clear conflict of interest between the firm and its clients because it encourages the firm to choose the third party offering the highest payment, rather than the best possible outcome for its clients. ESMA states that "firms must thus rigorously assess whether, by receiving PFOF, they are able to comply with relevant MiFID II requirements, most notably those on taking all sufficient steps to obtain the best possible result for their clients, on conflicts of interest and on inducements". Firms are reminded to be mindful of the fact that receiving PFOF from third parties may affect the bid-ask spread offered by these third parties and this may lead to increased costs for the client. Firms are reminded that so far retail clients are concerned, the best possible result is determined based on total consideration, representing the price of the financial instrument and the costs relating to execution. In light of concerns around PFOF, ESMA also asks NCAs to prioritise PFOF in their supervisory activities for 2021 or early 2022 and suggests that these should focus on the impact of PFOF on firms’ compliance with the best execution, conflicts of interest and inducements requirements.

As far as ESMA's stance is concerned, two things stand out:

• this is the first time ESMA has been so explicit in relation to PFOF (historically the FCA's position was not adopted in the EU around MiFID II time); and

• ESMA does not go as far as FCA as in it seemingly leaves the door ajar (but we can see where this is going).

The EU's concern appears to be focused on retail investors, in contrast to FCA's communications in this area. However, the FCA does share these concerns and it seems clear that there will be targeted reviews in this area.

Zero commission

In its statement, ESMA also sets out its thoughts on zero commission brokers. It notes that "zero-commission brokers” often receive PFOF from third parties and that this may offset the lack of direct commissions charged to their clients. Zero-commission brokers are reminded of the MiFID II requirement to provide fair, clear and not misleading information to their clients and to provide information on all costs and charges. ESMA states that, as clients of “zero-commission brokers” will always incur costs (e.g. implicit costs and third party payments received by the firm), the marketing of the service as “cost-free”, will inhibit compliance with requirements and could encourage speculative behaviour.

We Brexit, and ESMA follows the FCA… laugh or cry?