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.