Australia financial regulator ASIC has issued a consultation paper on payment-for-order-flow (PFOF) rule amendments, and in particular to the prohibition on order incentives. ASIC said that it has identified that its rules do not deal with certain payment-for-order-flow scenarios, such as arrangements between non-market participant intermediaries, and proposes to close this regulatory gap.

While the current “action” is in the form of a consultation at this stage, ASIC was clear in saying that PFOF arrangements create conflicts of interest that can lead to poor outcomes for retail trading clients. PFOF can also negatively impact market liquidity and pricing. In the regulator’s view, these harms outweigh the benefits.

Payment for order flow is not (yet) prevalent in the Australian equity market, however ASIC has observed continued growth of payment for order flow in other markets (mostly the US). There is also increasing scrutiny of payment for order flow by other regulators. We recently reported that EU regulators were getting “ahead of the curve” on banning PFOF in Europe, with ESMA warning in July that PFOF is not compatible with MiFID II rules.

Payment-for-order-flow (PFOF) is an arrangement whereby one entity (e.g. a market maker, or hedge fund) buys client order flow from another entity (e.g. a discount/retail broker), in exchange for a payment or other incentive. It is currently prohibited among Australia market participants. The arrangement has engendered a huge shift in the US brokerage market, led originally by upstart broker Robinhood (NASDAQ:HOOD), which saw virtually all retail client equity trades go “zero commission”. Brokers instead made their money by selling order flow.

Proponents of PFOF argue that retail clients do get a much better outcome than being charged commissions on trades, with the competition for PFOF trades ensuring that clients get the best price possible, even though the trades are technically concluded “off market”.

ASIC added that it has considered the application of the existing prohibition on payment-for-order-flow in the context of recent developments in Australia and aboard. ASIC seeks feedback on its proposal to amend the current prohibition, which is set out in Part 5.4B of the ASIC Market Integrity Rules (Securities Markets) 2017.

ASIC noted that the proposed amendments are a proactive measure intended to avoid the emergence of payment-for-order-flow arrangements in Australia.

The ASIC consultation period on PFOF will end on 3 November 2021, providing respondents with an extended period in recognition of the pandemic shutdowns in which to respond to ASIC’s proposals. After receiving submissions, ASIC will consider the feedback, publish a feedback report and, if ASIC chooses to proceed, submit the amended rules for Ministerial consent.

Under Rule 5.4B.1(1) a market participant must not, directly or indirectly, make a cash payment to another person for their order flow, if the cash payment leads to the net cost being less than the value of the reported price for the transaction(s). The definition of ‘net cost’ (which is set out in Rule 5.4B.1(2)) in effect means that a market participant cannot pay more for order flow than the commission received by the market participant for those orders – that is, it prohibits PFOF if it results in a ‘negative commission’.

The full ASIC consultation paper on PFOF can be seen here (pdf).