Zero-Commission Trading: Is Payment for Order Flow consistent with local rules transposing MiFID II?

The rise of zero-commission trading has brought about a revolution in the investment services industry; contributing in part to the unprecedented number of retail investors that are now actively participating in financial markets.

On the one side, zero-commission trading has been described as a step forward in the democratisation of investing, and an opportunity for many to manage their wealth in an economic environment characterised by low interest rates and inflation risks. Others have likened this activity to “gambling”, raising alarm bells and cautioning that this might have serious repercussions to the wider economy in the future.

There is no doubt that technological advances have played a key role in this revolution. Whereas in the past, willing investors visited or called their local broker to order investments, nowadays, mobile applications provide market access in just a few simple steps without any meaningful interaction with the broker.

However, active trading would not make sense for retail investors if a commission were to be paid to the broker in respect of each trade. The solution to this problem was the creation of a revenue stream that enabled brokers to do away with commission when receiving, transmitting or executing orders.

This revenue steam is referred to as “payment for order flow” or “PFOF”.

In a recent public statement issued by the European Securities and Markets Authority (“ESMA”), PFOF was described as “the practice of brokers receiving payments from third parties for directing client order flow to them as execution venues.”

The practice of PFOF appears to be inconsistently enforced within the European Union. 

As a general rule, in accordance with the Conduct of Business Rules transposing MiFID II issued by the Malta Financial Services Authority (“MFSA”) (“Conduct of Business Rules”), investment firms are obliged to avoid conflicts of interest in so far as it is possible to do so.

Such rules further provide that a conflict of interest is deemed to arise where a fee or commission is accepted by an investment firm in connection with the provision of a service by any party except the client, unless it can be shown that such fees or commissions: (i) are designed to enhance the quality of the relevant service to the client; and (ii) do no impinge on the firm’s duty to act in the best interests of the client.

On that basis, it can be reasonably deduced that PFOF creates a conflict of interest between the investment firm and the client. This was also confirmed in the public statement issued by ESMA on the subject of PFOF, where it held that:

“The receipt of PFOF from third parties by a firm executing client orders causes a clear conflict of interest between the firm and its clients because it incentivises the firm to choose the third party offering the highest payment, rather than the best possible outcome for its clients.”

ESMA further emphasised that “the consideration and eventual choice for a particular third party for the execution of client orders should be solely driven by the aim of obtaining the best possible result for clients and should in no way be influenced by the amount of PFOF the third party is willing to provide.”

The Conduct of Business Rules on inducements provide identical qualifications to those set out above in relation to conflicts of interest, and additionally require investment firms to disclose the existence and the maximum fees (or range thereof) received through PFOF to their clients.

In this regard, ESMA stated that firms receiving PFOF “must comply with the quality enhancement and best interests requirements…Specifically, PFOF will not be acceptable if it results in distorting or biasing the provision of the relevant service to the client.”  

Finally, the Conduct of Business Rules also require investment firms to obtain the best possible result for their clients when executing their orders and this after taking into account factors such as “price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order.”

This was also reiterated in ESMA’s public statement where it clarified that “when establishing their execution arrangements firms should consider both third parties willing to provided PFOF and those unwilling to provide PFOF, and the factors used to choose one third party over another should strictly relate to obtaining the best possible result for the client…The possible execution venues and factors used for their selection shall be clearly identified in the firm’s execution policy, and the effectiveness of the firm’s order execution arrangements shall be monitored on a regular basis.” 

Based on the above, it appears that while neither the Conduct of Business Rules nor ESMA’s public statement on the subject do not expressly forbid PFOF business models, the adoption of such revenue streams need to demonstrably adhere to the existing rules related to conflicts of interest, inducements and best execution.

In addition to the above, ESMA also warned “zero-commission brokers” to refrain from marketing themselves as “cost-free” as it could breach an investment firm’s duty to provide fair, clear and not misleading information to their clients and, furthermore, “could incentivise retail investors’ gaming or speculative behaviour due to the incorrect perception that trading is free.”

ESMA further concluded that “in most cases it is unlikely that PFOF could be compatible with MiFID II and its delegated acts.”

Based on the above, investment firms adopting PFOF business models should be mindful of the potential risks to their business which may be brought about by a change in regulation that could prohibit such models altogether.

Such risks were noted in the widely anticipated S1 filing of Robinhood Markets Inc with the Securities and Exchange Commission; where the issuer noted as a material risk to the company’s profitability the eventuality of a change in laws prohibiting PFOF business models.

On the other hand, retail investors should be mindful of PFOF and its potential implications to their financial wellbeing. Above all, they should ensure that they are aware of all costs and charges associated with the service they receive.