Regulators must be wary of going OTT on PFOF

Regulators must be wary of going OTT on PFOF

Like it or loathe it payment for order flow in its various forms was unceremoniously outlawed in no-uncertain terms on Thursday though it will have come as little surprise to most.

The Financial Conduct Authority said as long ago as 2012 that it had a serious problem with PFOF (as it has become known) and it made no secret of the fact it was running a major probe into whether banks and brokers were seeking to circumvent the rules that were in place.

FOW reported weeks ago that the FCA was preparing a damning ruling on pay for flow and this would come before the end of this month and, sure enough, the regulator duly obliged by releasing a Thematic Review that clarified its position on the last day of July.

It does not make good reading for the various banks and brokers who have for years made a nice little earner out of taking payment from market-makers for the orders they produced on behalf of their clients.

The prohibition of PFOF looks to be a done deal and that is that … but the move by the FCA does raise some interesting questions about other types of payment for orders, not least the types of incentives and rebates that exchanges offer their clients.

This has in recent years become a moot point among exchanges, some of which claim rebates create a false picture of liquidity while others argue it is standard practice for a new market.

The prohibition of payment to brokers by market-makers will hit their profits but the extension of a ban on payment for order flow by exchanges could have some more far-reaching implications.

Firstly, exchange payment for order flow is a key incentive provided by new markets to ensure the crucial backing of market-makers and brokers in their early weeks and months.

Banning it would seriously affect firms’ willingness to support nascent markets and could, ultimately, stifle innovation and competition, something that goes against some of the core principles of the European Union’s Markets in Financial Instruments Directive which is, in spirit at least, very much pro-competition.

The prohibition of exchange order flow could also force some market-makers and brokers out of the market which would mean fewer brokerage options for clients so less competition (again) and lower levels of liquidity.

The FCA may be sure that it has got it right with this iteration of PFOF (and who am I to say they are wrong?) but they should think twice about the dreaded unexpected consequences of regulation before they extend the ban to exchanges.

The PFOF ban may have marked a bad week for futures brokers but things are little better in the over-the-counter market where the world’s inter-dealer brokers are similarly having a tough time.

GFI, at least, had a good week. The $580m they got for Trayport and Fenics from CME Group looks like a big number but one has to fear for the long-time viability of the IDB.

As the tech units were being spun-off to the Merc, GFI senior management bought out the rest of GFI (namely the brokerage bits and execution platforms) for just $165m, so less than a third of what CME paid for GFI’s tech divisions.

Separately, RP Martin, a smaller IDB that hit the headlines in recent years for Libor-rigging and one of its brokers being shot in a carpark, has been forced to put itself up for sale.

Regulators, no doubt, are sure they are doing the right thing but they should perhaps bear in mind that the brokers they are seeking to bring in line are already struggling to stay afloat amid treacherous market conditions.

That said, if the regulators want a market comprising a handful of “too-big-to-fail” financial groups then they should just go right ahead.

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