New ESMA guidance less strict than the established UK position on PFOF.

By Rob Moulton, Axel Schiemann, Thomas Vogel, and Charlotte Collins

On 13 July 2021, ESMA published a statement on payment for order flow (PFOF), the practice of brokers receiving payments from third parties for directing client order flow to these third parties as execution venues.

ESMA warns that the increase in retail client activity in the past year has highlighted the use of PFOF, both in the US and in some EU jurisdictions. ESMA explains that PFOF causes an inherent conflict of interest, as it incentivises brokers to choose the execution venue offering the highest payment, rather than the venue that will achieve the best outcome for the brokers’ clients.

Therefore, ESMA is of the view that, in most cases, the receipt of PFOF is unlikely to be compatible with MiFID II. ESMA requires firms to thoroughly assess whether, by receiving PFOF, they are able to comply with relevant MiFID II requirements, in particular those on best execution, conflicts of interest, inducements, and cost transparency. Interestingly, this contrasts with the stricter UK position. The UK FCA has made clear for many years that the receipt of PFOF is not compatible with firms’ obligations regarding conflicts of interest, inducements, and best execution. This is because the FCA considers that the price quoted by the execution venue will always be influenced by the fact that any profit will be reduced by the PFOF they are paying.

However, ESMA does not believe that PFOF should be banned entirely, and explains how brokers should consider whether they are able to meet their regulatory obligations when receiving PFOF. Therefore, while the FCA has long found this to be a conflict that cannot be managed, ESMA considers that it may in fact be possible to manage in some cases. ESMA expects firms to pay specific attention to the risk that receiving PFOF from third parties may affect the bid-ask spread offered by such third parties and result in a worse price for the client. Further, ESMA expects firms to take into account implicit costs such as this when providing costs and charges information to clients.

ESMA also emphasises that when firms present clients with a list of venues to choose from, but favour in that list execution venues that offer PFOF, the choice of venue does not equate to a specific instruction from the client and so the firm would be unable to avoid its obligations regarding best execution.

ESMA asks national regulators to prioritise PFOF as a supervisory area for the remainder of 2021 and early 2022. ESMA suggests that regulators should focus on assessing whether firms receiving PFOF are meeting all of their obligations under MiFID II, rather than whether such firms can demonstrate that they have consistently achieved the best possible results for their clients. It will be interesting to see whether this leads to a clampdown on this practice in the EU.