A row has been going on in the exchange-traded options market – Liffe (owned by NYSE Euronext) – where such derivative products as interest-rate options are traded. Apparently, brokers have been charging fees to market makers when executing orders for their clients – both institutional and retail – in effect making the market makers ‘pay for orders’.
This practice is well established in the US where it is known as payment for order flow. There, it was originally pioneered by Bernie Madoff who built one of the largest market-maker businesses by dealing with retail brokers directly and paying for orders submitted by brokers. “It was the Securities and Exchange Commission’s decision in the 1990s not to take a stand on the controversial issue of ‘payment for order flow’ that helped fuel the rise of Bernard Madoff”, reported The FT at the time of the Madoff scandal.
The NYSE consistently opposed payment for order flow as they lost business to Madoff’s market-making business. The NYSE described the practice of paying for orders as an inducement.
But payments for orders can also arise when exchanges pay market makers for orders. In some cases, exchanges can incentivise exchange members to submit orders or to provide liquidity. These incentives can take the form of paying for orders. In 2009, after years of opposition to the practice of payment for orders, the NYSE finally accepted that it was not going to be outlawed in the US and introduced it.
In the US, the practice is dealt with through disclosure – brokers disclose to clients on the trade confirmation itself whether they receive such payments and clients, if they ask, will be told how much the payments are. Brokers are also required to achieve the best available price on their national market system so clients are protected.
In the UK, the practice appears to be limited to a subset of the derivatives traded on Liffe – mostly options and currencies. These products trade in a range of maturities and strike prices so market makers generally do not post prices in all these combinations. Instead, brokers must ring a market maker for a price. If a trade is concluded, it is then entered into the exchange settlement system and the broker can then invoice the market maker. So the broker gets two commissions – one from his client and one from the market maker.
Interestingly, the commission charged to market makers has been much larger than that charged to brokers’ clients (although, when asked, the trade body representing brokers, the Futures and Options Association, was unable to comment on this disparity – apparently they do not have ‘visibility’ on commissions).
Also, and rather concerning, these market-maker payments have not always been disclosed by the broker to their clients (the non-market maker), so these hidden payments amount to an inducement and hence fall foul of the FCA rules.
In fact, new brokerage firms have been established by offering clients zero commission – presumably on the basis that the broker would be able to generate income by making market makers pay for orders executed for clients. A good question is whether the firms’ clients understand how the broker is remunerated?