Payment for flow – should be illegal as it’s not in a Client’s interest
An interesting article appeared in the Financial Times today, it covers the court case in United States where the brokerage firm, TD Ameritrade, has been found liable for any losses arising from diverting retail client orders towards high speed execution venues, that are repaying the brokerage firm for that order flow. This has been severely frowned upon in United Kingdom by the FCA, it comes under the heading “payment for flow” (PFOF). In spite of this, my guess is that it has not been entirely eradicated in the UK because the amounts are very small on each trade. I feel that there is the possibility of PFOF abuses still taking place particularly on electronic trading platforms.
Securities brokerage firms contractually purport to clients to act as agent or principal on contract notes. Where agency trades are directed to an execution venue that is re-paying for the broker flow, it is not simply acting as agent. It charges clients a legitimate commission for acting as agent whilst receiving a questionable payment from the execution counterparty. It is being paid on both sides of the transaction which is not in its clients interest.
There should be the only ever be one commission taken by an agent. Where there are circumstances in any forms of business where an agent purporting to act as agent is getting paid commission by the client and by the third party, conflicts of interest are certain to arise.
In the US it seems that this basic error by brokerage firms has been obfuscated by the confused and multi requirements for “best execution”. Best ex should be the best execution in the market above normal market size, not the execution a broker can get from a venue prepared to pay for that order. In simple terms both brokers and third-party execution venues have claimed that they are able to offer better execution and that payment for flow is therefore not negatively impacting the client. However the client is paying a small slice to the execution venue which may then be repaid to the broker. Therefore the client is not getting best execution from a broker with whom a contractual relationship exists if there is a PFOF arrangement.
Payment for flow also has some surreptitiously damaging aspects in that if a client order in an illiquid stock is directed towards a market maker or execution venue and the best price are not achieved ie it is available at a better pice somewhere else, as used to be the case in the UK, this means that the market price for the security is incorrect. This means that PFOF creates a disorderly market in that the security is not changing hands at the market price because effectively the broker has been bribed by an execution venue.