Liffe’s problem with payment 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.

Exchanges

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?

It appears that no other group of market makers operating on a London exchange pays for orders so it is difficult to see why the arrangement arises in Liffe – and why on only certain Liffe products: there are no such payments for orders for instruments traded through the Liffe central order book.

In May 2012 the FSA published guidance on this practice setting out its interpretation of its own rulebook (which is itself derived from MiFID I, introduced in 2007) in the context of payment for order flow. The FSA concluded quite clearly that paying for orders was not a practice that complied with its rules. The FSA/FCA position was quite clear and remains clear.

Since then the brokers, represented by their trade body, have been engaged in a debate with the regulator to find a way to meet the rules, despite the FSA guidance making it clear it was unlikely brokers would be able to comply with these rules. The FOA has published its own guidance that was then withdrawn at the request of the FSA.

For brokers, the payments received from market makers represent the largest source of income from this type of business, so giving up these sums is a major problem for them and naturally they and their trade body are doing their best to resist. This is understandable but they cannot breach the rulebook.

For market makers, the payments are necessary in order to attract business. “If you don’t pay, you don’t get called”, says one market maker who was unwilling to be named as he feared the consequences. Indeed, there is a rumour that one market maker had to shut up shop when it refused to pay brokers. It simply did not get any more business. So brokers only call if the market maker pays them. This cannot be in the interests of the broker’s client.

If a market maker must pay the broker for the order, then the market maker will need to recover the cost of the payment. There is only one way the market maker can cover this cost and that is by adjusting the price offered to the broker. So, the broker’s client gets a worse price than would be available in the absence of the payment to the broker. Ultimately, the client of the broker is funding these payments without actually being aware of the arrangement.

But there is also a risk that the broker could be influenced by the market maker offering the largest payment rather than the best price – how could that conflict be managed? This could lead to a breach of the broker’s duty of best execution (which applies, depending on the classification of the client).

Since May 2012 when the FCA pointed out the risks these arrangements pose and the way they could amount to breaches of regulatory rules, 12 months have passed during which time the FOA has been in dialogue with the regulator. But what is there to debate? The FOA concedes that the FCA is not going to change its guidance. A spokesperson for the FCA said: “Following a consultation process, the FSA issued Finalised Guidance in May 2012 which we continue to stand by.”

Is the dialogue between the FOA and FCA more about whether the FCA will actually enforce its rules in this area? It is all very well publishing guidance but what is the point if the regulator does not make its rules stick?

The brokers clearly have an incentive to continue with these arrangements, as it generates substantial income and clients either tolerate the existence of payments for orders or are unaware of them. But the problem for the regulator is that it can hardly shut its eyes to this blatant practice after it has told firms to stop – otherwise what is the point of the regulator?

The regulator can hardly shut its eyes to this blatant practice after it has told firms to stop – otherwise what is the point?

Andrew Hampton is a former investment banker

Key points

■ Brokers have been charging fees to market makers when executing orders for their clients, making the market makers ‘pay for orders’.

■ This practice is well established in the US, where it is known as payment for order flow.

■ For market makers, the payments are necessary in order to attract business.