Regulatory authorities within the EU are now focusing their scrutiny on neobrokers.
In the world of online trading, neobrokers have gained popularity due to their low fees, but they face criticism, especially those offering services for free or claiming to. One of the methods neobrokers use to boost revenue is through rebates, a practice known as Payment for Order Flow (PFOF).
The European Securities and Markets Authority (ESMA) has taken notice of the financial challenges faced by neobrokers and the potential conflicts of interest regarding rebates. The MiFID II framework, which governs financial markets in Europe, does not explicitly ban or prohibit PFOF arrangements; however, it imposes stringent requirements to ensure investor protection and market transparency.
MiFID II mandates investment firms, including neobrokers, to take all sufficient steps to obtain the best possible result for their clients when executing orders. This implies that when brokers receive payments for routing client orders to certain market makers or venues, they must ensure this arrangement does not compromise the quality of execution offered to the client. Transparency and documentation of order execution policies are thus critical.
ESMA's recent technical standards emphasize the need for investment firms to have clearly documented and effective order execution policies. These must include how orders are routed and the potential conflicts arising from PFOF arrangements. Firms have to inform clients about their execution policy and any conflicts of interest. For clients receiving investment advice or portfolio management, firms must carry out full suitability assessments ensuring investment decisions align with client profiles. For execution-only clients, appropriateness tests evaluate whether clients understand the financial instruments traded.
In 2021 and 2022, European national authorities increased scrutiny and, in some cases, imposed restrictions or bans on PFOF for neobrokers to safeguard retail investors. The German BaFin has already taken note of this issue and dedicated an article to it in their June journal. The Dutch and Belgian authorities, for example, have taken a cautious stance, requiring neobrokers to disclose and carefully handle any PFOF agreements and in some cases prohibiting the practice altogether.
ESMA urges national authorities to pay attention to PFOF in their supervisory activities for 2021 and 2022. ESMA warns that accepting rebates is likely not compatible with MiFID-II rules in most cases. However, no outright EU-wide ban was enacted, leaving enforcement and interpretation largely at the national level.
Investors are advised to be vigilant when trading through neobrokers. Understanding how your broker earns revenue and the potential conflicts of interest can help protect your investments. As always, it's essential to do your research and make informed decisions.
- The insurance sector may find it prudent to closely monitor the finance business of neobrokers, particularly as the European Securities and Markets Authority (ESMA) has emphasized the need for clear and effective order execution policies, which includes the disclosure of any Payment for Order Flow (PFOF) arrangements and the potential conflicts of interest.
- The finance industry might witness a shift in the neobroker business model, as some European national authorities have imposed restrictions or bans on PFOF in an effort to safeguard retail investors, signifying a growing concern about business practices within this sector.
