Changes to how retail flow is brought to exchange in the UK and US are currently being considered by regulators in the respective markets.
The UK’s Financial Services Authority (FSA) has launched a guidance consultation paper on the practice of payment for order flow (PFOF), whereby market makers provide incentives to retail brokers in return for ongoing business.
The FSA describes PFOF as a “serious concern” primarily because of the resulting potential conflict of interest that could impair execution quality for end-investors.
“Where brokers are routing orders to only those market makers willing to pay for order flow, then the duty of brokers to act in the best interests of clients may be compromised,” read the FSA paper. “The client also faces another potential detriment because market makers engaging in PFOF may recover these payments by incorporating them into the spreads they offer.”
Retail flow has largely remained separate from institutional orders in the UK, but recently a number of firms, including several from the US, have attempted to aggregate retail order flow, in part to provide an additional source of liquidity to institutional clients. Aggregators that rely on PFOF may struggle to source retail order flow if the FSA curtails the practice.
According to the FSA, PFOF typically takes the form of a direct payment per order but can also involve market makers paying a broker’s settlement fees or trading technology costs. Rather than an outright ban, some market participants have suggested that PFOF need not be detrimental to best execution if retail brokers use a range of market makers or if PFOF arrangements are made explicit in execution policies.
The paper, which will result in finalised guidance from the FSA in Q1 2012, questions brokers and market makers on how widespread PFOF is and its impact on best execution obligations. The deadline for responses is 9 November.
The UK watchdog is also consulting on its Retail Distribution Review, which aims to enhance the quality of advice given to retail investors by advisory firms. The FSA plans to introduce new rules by the end of 2012 that will require advisory firms – which include banks, product providers, independent financial advisers, wealth managers and stockbrokers – to explicitly disclose how they charge clients for their services and describe their services as either independent or restricted. Individual advisers will also be required to adhere to consistent professional standards, including a code of ethics.
Meanwhile in the US, where PFOF is subject to disclosures from brokers and market makers, the Securities and Exchange Commission is considering a request from exchange group NYSE Euronext that would allow retail liquidity providers to provide price improvement via a non-displayed environment.
Under the scheme, which would apply to the group’s New York Stock Exchange and NYSE Amex bourses, retail liquidity providers would be incentivised to meet performance obligations. NYSE Euronext is also seeking approval for a service that would allow retail clients to send their flow directly to the exchange.
“Offering price improvement for retail orders within an exchange environment affords individual investors new economic incentives and ensures greater transparency, liquidity and competition throughout the US cash equities marketplace,” said Joseph Mecane, executive vice president, NYSE Euronext. “The Retail Liquidity Program will be complementary to existing marketplace offerings to retail investors and will be utilised both by retail firms directly as well by as intermediaries that service retail order flow providers.”