31st July 2014
Investors risk losing out on transactions because those carrying them out on their behalf often flout rules designed to protect clients.
A new paper from the Financial Conduct Authority concludes that “best execution” – the optimum delivery of cost, speed and administrative efficiency is compromised because brokers and others are not doing enough because of inadequate management focus, poor office practices and a lack of supporting controls. This can adversely impact on investors ranging from the private buyer or seller up to the largest fund management firms. It has threatened to penalise firms which do not follow its rules.
The FCA found that “many firms do not understand key elements of our requirements and are not embedding them into business practices.”
The most contentious practice it found was “payment for order flow”, a practice first invented by convicted Ponzi fraudster Bernard Madoff but allowed until 2012 in a more benign form. This is where a broker is receives payments not from the client but from another party which wants to influence the routing of the buy or sell order. This may be where market makers and others pay brokers for the right to transact with clients, in the hope those customers will not be aware that assets may be mispriced against them. In some cases, they ensure the spread between the price at which they buy from investors and that at which they sell is biased in their favour.
The FCA found “a small number of firms” involved in equity trading continuing to receive this remuneration despite rules against this – offenders are believed to be around 10 per cent of the sample it looked at. It says this is a conflict of interest – more prevalent in futures and options trading. Some had deliberately changed their terms of business to obfuscate their practices. They had recast arrangement by changing the description of what they do. But this, the FCA charges “ is not consistent with the economic reality of their activities.”
The watchdog discovered that some firms left it up to clients to discover when something was wrong – it was the “they’ll walk if they are unhappy but as they are still with us, they must be happy” line. But this ignores that many clients are unaware of the fine points of equity trading. These customers feel they are entitled to leave that to the professionals they pay.
The FCA further found that there was a “poor level of understanding” over which activities are covered by the obligation to provide best execution. Firms use outdated conventions to hold clients in schemes which rules now forbid.
And, deliberately or otherwise, many firms lack effective monitoring that would prevent poor client outcomes or less than best execution of orders.
The FCA says it will now write to all the firms in its sample to provide individual feedback and keep “best execution” under active review.
It concludes: “Our findings not only highlight that a failure to obtain best execution on a consistent basis presents a risk of detriment to individual clients, but that it also presents risks to trust and confidence in the integrity of our markets as well as potentially undermining competition between trading venues.”