On the 13th July 2021, the European Securities and Markets Authority (ESMA) issued a statement to remind firms of their best execution requirements under MiFID II when they receive payment for order flow (PFOF), which refers to the practice of brokers receiving payments from third parties for directing client order flow to them as execution venues. ESMA also highlighted that in light of the serious investor protection concerns raised by PFOF and the multiple requirements applying to it, it is in most cases unlikely that the receipt of PFOF by firms from third parties would be compatible with MiFID II and its delegated acts.

Investor protection concerns raised by PFOF

According to ESMA’s statement, 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. For the execution of retail clients’ orders, this best possible outcome is to be determined in terms of total consideration, representing the price of the financial instruments and the costs relating to execution. ESMA also reminds firms that PFOF received from third parties when executing client orders constitutes an inducement received from third parties in connection with the investment service provided to the client.

Firms must therefore assess whether, by receiving PFOF, they are able to comply with relevant MiFID II requirements, most notably those on taking all sufficient steps to obtain the best possible result for their clients, on conflicts of interest and on inducements, as further detailed in the following paragraphs.

Conflicts of interest and best execution

ESMA emphasises 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. To this end, when establishing their execution arrangements firms should consider both third parties willing to provide 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.

ESMA reminds firms that for retail clients, the best possible result shall, in the absence of a specific client instruction, be determined based on total consideration, representing the price of the financial instrument and the costs relating to execution. 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. In particular, firms will need to regularly assess whether the execution venues included in their order execution policy provide for the best possible result for the client or whether they need to make changes to their execution arrangements.

Importantly, 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 compared to the situation in which the third party would not provide PFOF.

ESMA is aware that some firms receiving PFOF from execution venues present a list of execution venues to their clients and ask their clients to choose the specific venue to execute their orders. The execution venues providing PFOF are presented in a prominent or more appealing manner. In doing so, the order is supposedly executed according to the specific choice made by the client and thus the execution of the order would fall outside the remit of the firm’s best execution obligations.

ESMA emphasises that this practice raises investor protection concerns. By presenting the execution venues providing PFOF to the firm in a prominent manner, clients are systematically

induced to choose an execution venue that provides PFOF to the firm. In ESMA’s view, such a choice does not constitute a proper specific instruction from the client.

Inducements regime and cost transparency

Regarding the MiFID II inducements requirements, firms receiving PFOF when executing client orders must comply with the quality enhancement in that PFOF must be designed to enhance the quality of the relevant service provided. Furthermore, PFOF must not impair compliance with the firm’s duty to act in accordance with the best interest of its clients when executing client orders.

In addition, firms are required to clearly disclose the existence, nature and amount of PFOF to the client on an ex-ante and ex-post basis. In this respect, ESMA also highlights the importance of the requirement to provide information on all costs and charges to the client relating to the service and the financial instrument(s) for firms receiving PFOF from third parties. Such disclosures would include, inter alia, information on the implicit costs (e.g. those included in the bid-ask spread offered by the third party) and the third-party payments received (e.g. PFOF).

Lastly, ESMA reminds firms providing the service of portfolio management and executing their decisions to deal in the management of clients’ portfolios that a stricter inducements regime applies to them since these firms are not allowed to accept and retain inducements (other than minor non-monetary benefits) in relation to the provision of those services to clients.

Specific concerns regarding certain practices by “zero-commission brokers”

ESMA has also reminded “zero-commission brokers” of the MiFID II requirement to provide fair, clear and not misleading information to their clients and to provide information on all costs and charges to the client relating to the service and the financial instrument(s). ESMA emphasises that the marketing of the service as “cost-free” when receiving PFOF from third parties (which may compensate for the lack of direct commissions charged to their clients), will infringe the firm’s compliance with these requirements and it could incentivise retail investors’ gaming or speculative behaviour due to the incorrect perception that trading is free.

What firms should do now

In ESMA’s statement, National Competent Authorities (NCAs), especially in those Member States in which PFOF has been observed, are requested to prioritise PFOF in their supervisory activities for 2021 or early 2022.

Firms receiving PFOF should therefore start assessing the actual impact of PFOF on their compliance with the best execution, conflicts of interest and inducements requirements including whether they are able to demonstrate that they consistently achieved the best possible result for retail clients when executing their orders.

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