Introduction

In recent years, the global financial services sector has seen the emergence of a significant number of new online brokers that base their business models on a “zero-commission policy”. When operating on a zero-commission basis, brokers can offer very attractive packages to their customers that include no commission for the administration of brokerage accounts and very low order execution fees. By offering price-competitive packages, accompanied by user-friendly interfaces of mobile and desktop apps, new online brokers (commonly referred to as “neo-brokers”) have managed to attract a sizeable number of millennial and Generation Z customers, who are willing to explore new investment opportunities.

However, regulators around the globe are increasingly expressing their concerns about the rise in zero-commission trading, emphasising that a large majority of neo-brokers that facilitate this type of trading operate under a so-called "payment for order flow" model ("PFOF"), which in some cases leaves investors actually paying more for their trades.

Under PFOF, brokers route their clients’ orders to a third party for execution and receive a fee in return for such order routing. In this structure, brokers may receive both an execution fee from their customer and PFOF from a third party that executes the client’s order.

Some argue that PFOF allows brokers receiving it being able to pass the benefit to clients, by reducing the fees that clients are required to pay to the broker. This allows brokers to build profitable services, which are commission-free for clients. However, it has become clear that accepting PFOF does not necessarily mean that clients pay less for trades. In some cases, increased spread means that clients still pay more than they would with other brokers not receiving PFOF.

In addition, financial regulators are increasingly concluding that when operating under this model, brokers may well be incentivised to route their clients’ orders to a third party that offers the highest PFOF rather than to the one offering the best conditions for their clients’ order execution like the best price, short execution and settlement time etc. For example, in the US, the Securities and Exchange Commission is taking a closer look at PFOF, with some high-profile firms facing extensive fines for misleading customers.

The UK regulator (prior to 1 April 2013, the Financial Services Authority ("FSA"), and thereafter the Financial Conduct Authority ("FCA")) has led the way in taking a stand against PFOF, which has been effectively banned in the jurisdiction since 2012. This approach has been closely followed by overseas regulators and thinktanks such as the CFA, which concluded in 2016 that the UK markets were more liquid as a result of the ban, with retail investors benefiting from improved pricing.

PFOF in the UK

In 2012, the then FSA published guidance which effectively banned firms from receiving PFOF in respect of retail and professional client business. The FSA said that PFOF creates a clear conflict of interest between the clients of the firm and the firm itself: the firm would be concerned with obtaining the highest PFOF, whereas the clients' interests would be best served through executing on the best-priced venue. This conflict was at odds with the regulator's rules on inducements, and requirements for best execution. PFOF was also considered to:

• undermine the transparency and efficiency of the price formation process, with the price paid by clients including an increased spread to account for PFOF made to the broker firm; and
• inhibit competition, by forcing liquidity providers to "pay to play", thus creating a barrier to entry and expansion.

The FSA's 2012 guidance was followed by a 2014 thematic review, in which the FCA investigated best execution and PFOF, and took action to prevent a number of firms which had changed the description of their services in an attempt to continue to receive what was essentially PFOF.

The FCA reiterated its rules in its September 2016 Market Watch newsletter, and confirmed that, whilst best execution and inducement rules do not apply to brokers' dealing with eligible counterparties, brokers are still required to comply with obligations to identify and manage conflicts of interest. In the FCA's view, it is unlikely to be possible for the direct, self-created conflict inherent in PFOF arrangements to be adequately managed, and any attempt to rely on disclosure as a management option is likely to be inadequate. In that same newsletter, the FCA also noted that, in its view, the standards introduced to implement MiFID II would mean that "firms will not be able to charge PFOF without breaching the new standards."

The FCA's position was further restated in a Dear CEO letter of December 2017, in which the FCA addressed a number of "workarounds" which brokers were reportedly implementing, including:

• linking charges to market makers for non-execution services (such as research or market analysis) to the amount of business transacted, in order to replicate PFOF;
• requiring market makers to subscribe to such non-execution services in order to receive order flow;
• establishing arrangements with intermediaries or overseas affiliates to circumvent the FCA's rules; and
• only executing via market makers who have been required to send alternative order flows to the broker to generate a fee replicating PFOF (where such order flows would not normally be executed through brokers).

The FCA said it would scrutinise any arrangements that sought to circumnavigate the rules, "for example relying on contractual arrangements that do not reflect the economic reality of the relationship”.

Following the Dear CEO letter, in its 2018/2019 Business Plan the FCA prioritised supervisory work on PFOF. It undertook a multi-firm review of practices around PFOF and published its preliminary findings in its September 2018 Market Watch newsletter and a full report in April 2019. It reiterated its concern regarding ways in which firms sought to circumvent the rules (for example, by routing client orders to overseas affiliates). The FCA noted it would "… continue to prioritise and monitor compliance with our conflicts of interest rules and views on PFOF. We will consider using our full range of powers, including enforcement action, to penalise firms breaching our rules."

Treatment of the PFOF practice under existing EU framework

Under existing regulatory framework based on MiFID II, investment firms are required to comply with a number of regulatory requirements that aim to achieve high level of investor protection in the EU. Though not as widespread as it is in the United States, the rising number of brokers operating under the PFOF model has become an area of concern for European regulators who have started discussing whether this practice is in line with applicable regulatory requirements in the EU. On 13 July 2021, the European Securities Markets Authority (ESMA) published a statement, which provides some clarification on whether operating under a PFOF model is compatible with requirements under MiFID II framework.

Conflict of interest and best execution requirements

In accordance with MiFID II requirements, investment firms are required to identify, prevent or manage and disclose any conflict that may arise between their clients’ and their own interests. To that end, investment firms are expected to take all adequate measures to prevent conflicts of interest and only in cases where efficient prevention is not possible, properly disclose their existence to their clients (nevertheless, the disclosure shall be used as a measure of last resort).

Further, when executing client orders, investment firms are required to choose the trading venue that offers the highest probability of the best possible result for their clients by taking into account various factors including, the price of the financial instrument, the execution costs, the speed and the probability of execution and settlement etc.

In its statement, ESMA emphasised that investment firms shall be solely driven by the aim of obtaining a best possible result for their client when choosing a particular third party and not by the amount of PFOF that a particular third party is willing to pay for order routing.

Inducement regime and cost transparency

Ever since the MiFID II framework started to apply in January 2018, investment firms in the EU have been required to comply with strict requirements on inducements (paying and receiving of monetary as well as certain non-monetary benefits) in conjunction with the provision of financial services. Under existing rules, investment firms are generally prohibited from receiving inducements from third parties except where they can ensure that the inducement received can enhance the quality of the service provided while not harming clients’ interest in any way.

In its statement, ESMA concludes that firms can receive PFOF solely in full compliance with MiFID II rules by ensuring that the PFOF received is designed to enhance the quality of the provided service and that such practice does not impair firms’ compliance with its fiduciary duty to act in clients’ best interest. Further, ESMA has pointed out that firms are obliged to inform their clients’ about received PFOF in compliance with ex-ante and ex-post requirements on costs and charges under MiFID II.

In the light of the considerations set out above, ESMA has not surprisingly concluded that in most cases it is rather unlikely that receiving PFOF can be compatible with the main requirements under MiFID II framework. However, unlike the FCA in the UK, ESMA did not propose a complete ban of PFOF. Instead, it has outlined the ways in which firms relying on PFOF can ensure their compliance with MiFID II requirements. Nevertheless, it is fair to conclude that zero-commission brokers currently relying on PFOF will need to make substantial changes to their business models and practices to achieve compliance.

EU-wide PFOF ban on the horizon

As part of its 2021 Capital Markets Union Package published on 25 November 2021, the EU Commission ("Commission") has proposed a Regulation amending the Markets in Financial Instruments Regulation (MiFIR), which introduces some targeted amendments to the main piece of market infrastructure regulation in the EU.

The proposed Regulation echoes the points from ESMA’s statement published in July this year, by concluding that it should be incompatible with the principle of best execution that a financial intermediary receives a payment from a trading counterpart in exchange for routing client orders for execution. In accordance with the published proposal, investment firms acting on behalf of clients shall be completely prohibited from receiving any fee or commission or non-monetary benefit from any third party in exchange for forwarding client orders to such third party for execution.
It appears therefore that the Commission has decided to follow the UK's approach this time by putting an end to the rising use of PFOF by investment firms operating in the EU.

Conclusion

The proposed ban of PFOF by the Commission does not seem to come as a surprise for the financial services industry after months of long and intense discussions between regulators, lawmakers and market participants. It is also fair to conclude that, in any event, businesses relying on PFOF are unlikely to meet regulatory requirements under the MiFID II framework due to the obvious conflict of interest, the practical impossibility of ensuring compliance with inducement rules, and the requirements on the provision of fair, clear and non-misleading information to their customers. Neo-brokers for their part have expressed their concerns about the proposed ban, by stating that their zero-commission policies have provided more benefit than harm to a huge number of their customers, by granting cheap access to international capital markets for the first time.

Although the proposed ban does go some way to aligning the EU position with that of the UK, there are likely to be differences in approach. While the FCA is clear that PFOF will not be in compliance with its rules and it is clear that it will seek to close down the use of loopholes, the EU definition is somewhat vague, and may leave open the possibility for workarounds, for example in routing payments. It will be interesting to see how regulators outside the EU address PFOF in the coming years.