2.1.2.1 Transmission of orders

40. 1) Introduction - Transmission of orders entails that the investment firm acts as an intermediary1 between the investment firm’s clients and the firm actually executing the order (the executing broker).2 The European legislator states that “the business of the reception and transmission of orders also includes bringing together two or more investors thereby bringing about a transaction between those investors”.3 This recital encompasses exchange-traded transactions, with central clearing requirements, as well as OTC transactions. This distinction will not have a direct impact on the risk profile of an investment firm only providing the service of transmission of orders. For this service, it does not matter whether the investment firm transmits the order to an executing broker that processes the order on a market or to an executing broker that executes the order OTC. This distinction will have an impact for the executing broker and will be discussed further in the section on the investment service of executing orders.

41. 2) Relevant risks - An investment firm that transmits or receives orders, sends the orders it has received from its client to a bank or another investment firm which then executes the order on, for instance, a financial market. The investment firm is exposed to its clients’ credit risk for the fees it should receive from its clients. Conversely, failing to transmit the orders correctly might expose the investment firm to a liability claim4 from its client. The firm is thus exposed to a legal risk towards its clients for any misconduct and in its normal day-to-day operations, just as any firm is exposed to legal risk. This will result in the investment firm being subject to operational risks if it fails to receive or transmit orders in the correct fashion. These operational risks can lead to the liability risks described above.

42. Investment firms which only perform the service of reception and transmission of orders are exposed to limited financial risks as they would normally have limited exposures to credit and market risks since they have no exposures to financial instruments either for their own risk and account or for their clients. The service of receiving or transmitting orders can be performed without consequences for the balance sheet of the investment firm, notwithstanding balance sheet items concerning fees receivable. Due to these limited balance sheet consequences, the financial risks will also be limited. The operational risk can become significant, however, as the number of orders transmitted or received increases and thus increase the risk of operational errors by the investment firm. A liability risk or an operational risk might result in a financial consequence and thus a ‘financial’ risk. Within this study financial risks relate to credit and market risks, whereas the financial consequences of a liability or operational risk are seen as part of these liability or operational risk.

43. 3) Framework for assessing risks - The service of transmitting and receiving orders is susceptible to agency costs in Moloney’s framework. The information asymmetry between the investment firm and its client can be significant, especially when the client relies fully on its investment firm to transmit its order to the appropriate venues. The primary means of addressing these agency costs are included within the supervisory regime of MiFID II,5 for instance the best execution rules.6 The requirements of MiFID II will not prevent operational errors by the investment firm when carrying out this service; their aim is to reduce these operational errors significantly. Since there will be operational errors even in the case of full compliance with MiFID II, capital requirements are necessary to address these residual operational errors in transmitting or receiving client orders. As the investment firm will only receive or transmit an order and will not perform the execution of the transaction (and thus not “handle” the funds or securities belonging to its client), the liability risk of operational errors for the investment firm will be limited. However, a limited operational risk does not mean “no” risk. As such, also for these limited operational risks, a prudential regulatory response should be in place. In the framework proposed in section 2.1.4 of this study prudential requirements should relate to operational risk that may accrue when providing this type of investment services.