1. Greenwashing risks caused by incomplete or deficient ESG data;
2. And, in parallel, over-reliance on traditional exclusions-based investing, which can cause asset inflation.

There Are Many Investment Paths to Sustainability

FIA EPTA has been clear from the start: Payment for Order Flow as it is currently practiced in the EU stifles competition and delivers a bad deal for retail investors.

Now, the Dutch Autoriteit Financiële Markten (AFM) has released a comprehensive study that proves our point. We revisit the question through this brief explainer, detailing the reasons why FIA ETPA urges the EU to ban PFOF practices in Europe.

To begin, what is payment for order flow (PFOF) and why is it detrimental to retail investors? 

PFOF as currently practiced in the EU means that a retail broker receives a monetary incentive (payment) from a market maker, in exchange for steering the broker clients’ order flow to a specific trading system. That market maker, thanks to its association with the retail broker, becomes the exclusive counterparty to the retail investors’ orders steered by the broker.

In theory, there can be benefits to this type of arrangement, notably cost savings. Some smaller brokerage firms don’t have the capacity to handle thousands of orders and may find it beneficial to route their orders via market makers to keep their costs low. Market makers, in turn, benefit from this growth in share volume and compensate the brokers financially for the ‘’routing’’. 

However, PFOF practices can often lead to conflicts of interest, and the lack of competition between liquidity providers means that retail investors risk getting a worse deal. The retail investors’ orders may trade at worse prices compared to a competitive execution market. In EU markets where PFOF is practiced there are no guarantees to ensure a transparent and objective process around it. Retail investors are oftentimes not aware of the PFOF arrangements between their broker and a specific market maker, giving them no say in an operation that could negatively impact them.

In light of these investor protection and competition risks, FIA EPTA has called upon the European Commission to ensure a harmonised approach PFOF to practices in the EU that ensures a fair outcome to investors –banning EU PFOF will be the most straightforward way of achieving this.

What is the AFM’s latest research paper on PFOF and how does it support FIA EPTA’s concerns?

In the summer of 2021, the European Securities and Markets Authority (ESMA) called upon national supervisory authorities to investigate the risks of PFOF.

Taking the lead, the Dutch AFM conducted a comprehensive study of the practice. It developed an assessment methodology, the so-called Comparative Pricing Model, which provides an indicator of a trading venue’s execution quality based on post-trade data. It then compared the execution quality of two PFOF trading venues and one non-PFOF trading venue, all three used by pan-European operating low-cost neo-brokers, as well as one low-cost investment firm.  

The study showed that execution prices a retail investor receives or pays for trading on a PFOF venue are consistently worse than on non-PFOF venues. The AFM has shared its analysis with other EU supervisory authorities to do their own analyses. This study will contribute to the ongoing discussions on PFOF in the MiFIR review.

Of note, recent research papers by the French Autorités des Marchés Financiers (AMF) and  Spain’s CNMV reached similar conclusions as the AFM. However, German regulators questioned the AFM’s and CNMV’s conclusions, stating they believed the sample size was likely too small. Germany remains a supporter of PFOF practices and claims banning them would lead to a serious setback in retail investor participation in financial markets. This perspective is disputed by a number of EU members.

What changes has the MiFIR Review yielded so far on PFOFs and why does FIA EPTA propose to go further than what is currently proposed?

Concerned by the negative impact of PFOF practices on retail investors, the European Commission, through its ongoing MiFIR Review, has decided to ban its use in the EU. However, FIA EPTA remains concerned that the proposal, as currently drafted, will be ineffective as it still leaves huge gaps regarding what is considered as PFOF, how it is practiced, and between whom.

It will be critical to close the loopholes contained in the proposal which would otherwise still allow PFOF practices that currently occur in various guises in the EU. In FIA EPTA’s view, the current practices, which are observed in some Member States, constitute an inappropriate conflict of interest which undermines fair competition between market participants as well as best execution for end-clients. These practices undercut EU investor protection standards and ultimately risk to disadvantage and, in due course drive away, the very retail investors whose participation in European capital markets will be critical to their success

As its preferred solution, FIA EPTA is advocating for a broad PFOF ban in the EU encompassing all direct and indirect monetary and non-monetary inducements, including all possible execution and routing scenarios between investment firms and all types of third-parties, including trading venues.

In Conclusion

Studies like the AFM’s come at an important time as the MiFIR review progresses and they reinforce FIA EPTA’s call to action. As the AFM reminds us, ‘’most retail investors are laypersons when it comes to order execution, let alone capable to influence the execution quality of their orders. In the current MiFID II best execution framework, the responsibility to substantiate the decision for (a) particular execution venue(s) lies primarily with the investment firm.’’[1]

It is high time to ensure a level the playing field, protecting retail investors from practices that undermine their standing in the market and potentially even their trust in the system.

[1] https://www.afm.nl/en/nieuws/2022/februari/kwaliteit-orderuitvoering-pfof

Market makers see growing demand from investors in ESG exchange-traded funds.

More than half (60%) of European market-making firms surveyed by FIA European Principal Traders Association (FIA EPTA) are providing liquidity in sustainable finance and ESG financial products, playing an important role in the global transition to sustainable investing.

FIA EPTA, which represents Europe’s largest non-bank market makers and liquidity providers, conducted the survey with its member firms last month, with 22 firms across the continent participating. The survey found two-thirds of the firms providing liquidity are looking to expand their activities in the ESG space, with the remainder planning to continue their activities at the current level.

While market making firms surveyed are most active in supplying liquidity in ESG futures (50%), they are starting to see a growing demand from both institutional and retail investors in ESG exchange-traded funds (45%).

The firms are active on a wide range of venues listing ESG products, with Eurex coming out top in the survey (50% of respondents), followed by Deutsche Börse Xetra and Euronext, including Borsa Italiana (45%). A third of the liquidity providers use the London Stock Exchange Group and a quarter is active on SIX Exchange and in bilateral trading.

Other survey findings show that since the start of the Covid pandemic, more than half of the firms surveyed (57%) have either been approached by or held discussions with exchanges on sustainable finance and ESG-related issues, and half have been asked to supply liquidity in ESG products.

The survey follows the release of FIA EPTA’s Principles on Sustainable Finance and ESG, published in June, which set out how market makers and liquidity providers can contribute to achieving Europe’s sustainable finance goals.

Market makers play a crucial role in the green transition by providing constant liquidity and making ESG products more attractive and available to other market participants. This helps minimise the cost of investing in ESG products, which can help investors reorient capital to sustainable investments.

“Our members are already putting their commitment to our sustainable finance principles into action, taking active roles in ESG products,” said Rutger Vijgen, public affairs advisor at FIA EPTA. “With market makers committed to trading these products, it gives investors the confidence they need to include ESG products into their portfolios and investment strategies.”

Interest and appetite in ESG products were not reported to be affected by the pandemic – signalling it was an emerging trend which has endured despite Covid rather than be accelerated by it.

A total of 57% of firms said sustainable finance and ESG considerations are now embedded in their processes for identifying new products, reflecting the growing demand from investors for sustainable investment strategies.

When it comes to improving their sustainability performance, nearly two-thirds of the firms surveyed (63%) said they were either carbon neutral or had started making reductions. A further 26% said they were looking at ways to reduce CO2 emissions but had not started implementation.

“To achieve the green transition, financial participants including asset managers, pension funds, and hedge-funds will want to significantly reduce or completely close their holdings in products that, over time, will be deemed ‘brown’,” the association said when it released its principles. “FIA EPTA members can play a vital role in this evolution, making sure there is still a market to sell these products while facilitating a smooth transition towards ‘green’ products.”

The survey also covered diversity, inclusion and wellbeing − a component of the “social” pillar of ESG − and found:

• • •  95% of firms have wellbeing policies and practices in place
    • 90% have Diversity policies in place
    • 85% of firms have inclusive hiring practices in place
    • More than half offer unconscious bias training to staff
    • 58% of firms are either reviewing or have finalised remuneration structures to address any possible gender pay gaps

In September, FIA EPTA launched a #WeAreMarketMakers campaign to drive greater understanding of what independent market making firms do, and their contribution to both financial markets and the wider economy.

Hands up if you want up-and-coming European companies to have sufficient access to the money they need to grow and to drive prosperity across the EU?  

It’s a no brainer – and one of the reasons why European politicians and regulators are keen to push forward the Capital Markets Union (CMU). 

Here’s a couple of details to flesh out the argument: equity finance in Europe is 67% of the eurozone GDP versus 125% in the US. More than two-thirds of lending to small and medium (SME) sized business in the EU comes from banks. 

 A simple analysis suggests it’s a lot harder for companies to raise money on the capital markets in the EU than in the US, leading to lower levels of investment and growth for the businesses and the EU as whole. 

The Capital Markets Union is essential for building up a stronger equity culture in Europe and for opening up or expanding other sources of capital for financing. And, a more diversified financial system is also more resilient and stable.  

In the words of the European Commission itself, the CMU will ‘’provide businesses with a greater choice of funding at lower costs and provide SMEs in particular with the financing they need’’. It also paves the way for deeper economic integration between member states. 

All market participants can help reach this goal of a stronger and more diverse European capital market – from long-term investors such as pension funds and asset managers, to independent  market making firms who jointly make up the FIA European Principal Traders Association (FIA EPTA). 

Market makers help to ensure end-investors get a better deal when they execute their investment decisions; they are estimated to provide up to 45% of the on-exchange liquidity in EU capital markets.  

By improving the quality of the secondary markets, market makers help to create the conditions that are key for companies looking to raise the capital that funds innovation, jobs, and growth for the European economy. 

Market makers enthusiastically support the CMU. Proportionate regulation of the financial markets is key to achieving the twin goals of strengthening economic growth and ensuring financial stability. Currently, there’s a very important piece of regulation going through the policy-making process:  

Newly launched initiatives by the European Commission, are bringing fresh energy to tackling the above points under the umbrella of a new CMU Package. European market makers strongly support these efforts, and in particular those that look to update the regulatory rulebook for the trading markets (the so-called MiFIR Review), as critical to achieving more efficient markets to support economic growth . 

European market makers see  three key areas where ambitious policy action is required to ensure European capital markets can make a greater contribution to the EU economy. These are: 

                    1. Building a truly integrated  EU single market for financial instruments – for which  a properly designed and executed pan-European Consolidated Tape is critical. Europe needs a utility-type single price ticker that offers real-time, post-trade price information enabling end-investors to have a full and democratised overview of European trading markets. 

 FIA EPTA will continue to advocate for real-time post trade Consolidated Tape that that is equally comprehensive across equities, ETF, bond and derivatives markets. 

                     2. To improve data quality and transparency in European equities, bonds and derivatives markets. This will help end investors to make better informed trading decisions as the price formation process is improved and search costs are lowered. Nowhere is this more needed than for post-trade data in the EU bonds market.  

We welcome the European Commission’s proposal to harmonise the delays by which post-trade price information is made public in the bond and derivatives markets, the so-called deferral regime – Now it’s also critical to ensure the transparency regime does not become overly complex and fragmented by applying different time deferrals. Based on market experience, we suggest a consistent 15-minute deferral as an appropriate length. Alongside, we advocate for a volume masking regime so that investors with large positions are properly protected without hampering the efficiency of the price formation process through unduly reduced transparency.

                    3. Strengthen investor protection standards, so that retail investors can have justified trust in their intermediaries not to be exposed to corrosive conflicts of interest or suboptimal order execution in non-competitive markets.  

The EC’s proposed ban on  Payment for order flow (PFOF) practices as currently allowed in some EU markets rightfully intends to address these concerns. However, the current draft is ineffective, and loopholes need to be closed to prevent unfair competition and protect retail investors. To guarantee fair competition between market participants as well as best execution for end clients. all direct and indirect monetary and non-monetary inducements and all possible execution and routing scenarios need to be included.
 

In sum: the proposed MiFID / MiFIR II review proposals are an important step forward to a CMU that benefits all Europeans. European market making firms are committed to sharing their on the ground knowledge and working with officials towards greater accessibility, transparency, and choice for end-investors  

We are resolute in our desire to see the CMU spark true integration and new momentum for capital markets activity  across all Member States, including those that are currently underserved (and underused). This will benefit economic and talent growth everywhere in the EU – not limiting it just to the leading centres as is the case today. Reforms take time, but it’s important to get it right as we level the playing field and open up a new era for European capital markets.  

Interview with Piebe Teeboom, Secretary General at FIA European Principal Traders Association (FIA EPTA)

Q. FIA EPTA’s latest thought leadership report, Liquidity in the Time of Covid explores how the Covid-19 pandemic changed the role and reputation of market makers. In your opinion, how significant has this change been?

In recent years, market makers have been playing a growing role in liquidity provision within European capital markets. But it’s fair to say that this has been an ongoing evolution, not revolution, and has been happening somewhat under the surface.

However, when the pandemic hit, all of that changed. Many more market participants needed to quickly change the way they accessed liquidity, and market makers offered a reliable and very efficient way for them to do that.

Covid-19 catalysed a paradigm shift in the way people perceived market makers’ value; and in the amount of added value market makers were able to bring. To the markets and to wider society.

The short answer is certainty. Whether you are an asset manager or a retail investor, the fact that market makers commit to being always present in the markets means you can always buy or sell when you want to, and at the best price. You’ll never have to wait to make a transaction.

You can imagine how important that certainty was during the Covid crisis, when all around there was so much uncertainty and trading was , incredibly choppy. It’s why the pandemic created a real light-bulb moment for asset managers in terms of the way they view and engage with market markers.

 Q. Now that the initial uncertainty created by Covid has passed, do you think the more central role market makers have carved out will continue?

I think we are entering an exciting new chapter for the market making community because they are now being seen more as a genuinely viable and reliable option when it comes to liquidity provision. They have shown the benefits that cutting-edge electronic trading can bring to the markets, especially in the bond space.

The buy side asset managers interviewed for the Liquidity in the Time of Covid report were clear that they are keen to have more diversity now in the way they access liquidity, with market makers emerging as new liquidity partners in the wider market mix.

I think that what the last year or so has taught market participants is that greater diversity of options makes for more resilient financial markets that can weather unexpected storms. And that is good news for market makers and good news for everyone else, from nest-egg investors to asset managers.

 
Q. Did you launch the #WeAreMarketMakers campaign as a response to the changes brought about by the pandemic?

The catalyst for the campaign was actually much closer to home. This year marks the 10th anniversary of FIA EPTA and, just as we have evolved as an organisation over the last decade, so the market making community that we are proud to represent has further matured in that time too. We wanted to do something to mark our 10 year anniversary that would also show the contributions of modern market makers to European capital markets and wider society.

One of the key aspects of the campaign will be putting a face to the innovators behind the code. You’ll see lots more of them over the coming months. We’ll be launching more thought leadership reports exploring different aspects of why liquidity matters so much to well-functioning markets. And we’ll be tackling some of the common questions those in the market making community receive about what they do, and how they do it. Perhaps addressing some myths head-on too.

While the pandemic wasn’t the reason for launching #WeAreMarketMakers, it has created a timely conversation about the market making community and its often unperceived benefits to markets and wider society. Today, the campaign feels more relevant and important than ever.

THE ‘LIQUIDITY IN THE TIME OF COVID‘ REPORT IS AVAILABLE TO DOWNLOAD HERE.