Position Paper June 2016
Payment for Order Flow in the United Kingdom
Internalisation, Retail Trading, Trade-Through Protection, and Implications for Market Structure
Payment for Order Flow in the United Kingdom
View the entire article (PDF)Abstract
We investigate the 2012 clarification that banned the use of payment for order flow arrangements in the United Kingdom. We find that over the period 2010–2014, the proportion of retail-sized trades executing at the best quoted price increased from around 65% to more than 90%, suggesting that the integrity of the order book has improved. We argue that quote integrity can be maintained without trade-through protection.
Summary
In this paper, we investigate the clarification issued in 2012 by the Financial Services Authority (FSA), now the Financial Conduct Authority (FCA), in regard to the illegality of payment for order flow (PFOF) arrangements in the United Kingdom. A PFOF arrangement is one in which a broker offers to systematically route its order flow to a wholesale market maker in return for a fee. While the broker earns the fee (subsidising the commission charged to the end investor), the market maker acquires the opportunity to execute the order flow internally.
PFOF arrangements create a conflict of interest between the clients of the broker and the broking firm itself because the incentive to achieve best execution for each trade for each client may conflict with the incentive to maximise fees from selling order flow to market makers. In other words, PFOF arrangements may create a conflict of interest with a broker’s best execution obligations. It is for this reason that the FSA decided to emphasise the ban on PFOF arrangements in 2012. Agency conflicts and client best execution are important and relevant issues in the context of investor protection and market integrity. It is helpful to understand the UK market before and after the PFOF rule clarification and the effect PFOF arrangements have had on execution quality for investors. The findings may have implications for other markets that currently permit PFOF arrangements, as well as for market structure policy more generally.
We analyse the proportion of retail-sized orders executing at the best quoted price on the UK primary market—the London Stock Exchange (LSE)—before and after the FSA’s updated guidance in May 2012. We posit that the explicit removal of a potential source of revenue for brokers (and with it, a removal of potential agency conflicts) should lead to more efficient order-handling practices and a more competitive market for retail-sized orders. In addition to the prohibition of PFOF arrangements, the coincident growth of lower-cost internet execution-only accounts and the limited profitability for brokers of servicing retail clients may cause the UK retail equity market to become a more competitive, utility-like service. We observe an increase in the proportion of retail-sized trades executing at best quoted prices between 2010 and 2014 from 65% to more than 90%, which is consistent with our hypothesis.
We believe this change is a positive one for market integrity because it implies that displayed liquidity providers are rewarded with executions at the price they quote. This reward mechanism upholds market integrity by supporting the incentive to post the displayed limit orders on which price discovery is based and should lead to more aggressive quoting and competitive pricing. By contrast, this outcome may be jeopardised in markets with PFOF arrangements where internalisers are able to step ahead of the quoted price on the order book by offering price improvement. It appears that the current best execution regime in the United Kingdom appears to be working well, despite the lack of a US-style trade-through rule that explicitly prevents executions away from the best quoted price.
References
- 2011 High Frequency Trading Firms, Order Book Participation, and Liquidity Supply during Periods of Heightened Adverse Selection Risk: Evidence from LSE, BATS and Chi-X. Working paper
- 2011 Response from the Association of Private Client Investment Managers and Stockbrokers Consultation response, Association of Private Client Investment Managers and Stockbrokers
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- 2014 Trade-At Rules in Australia and Canada: A Mixed Bag for Investors
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- 2014 Regulatory Efforts to Reduce Dark Trading in Canada and Australia: How Have They Worked? Research report, CFA Institute 02 Oct October CFA Institute
- 2014 Best Execution and Payment for Order Flow Thematic review, Financial Conduct Authority July
- 2012 Guidance on the Practice of Payment for Order Flow Finalised guidance, Financial Services Authority May
- 2010 Retail Off-Book Share Trading in the UK White paper, Intelligent Financial Systems 20 May May
- 2012 Dark Pools, Internalization, and Equity Market Quality. October CFA Institute
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- 2014 Dark Trading and Equity Market Quality Financial Analysts Journal, Vol. 70 No. 6 November/December CFA Institute
About the Author(s)
Sviatoslav Rosov, PhD, CFA, is director, capital markets policy, EMEA, at CFA Institute. He is responsible for developing research projects, policy papers, articles, and regulatory consultations that advance CFA Institute policy positions, focusing on market structure and wider financial market integrity issues.