Payment For Order Flow Singapore
Lara Preece
Capital markets (CMS) brokers have previously been able to gain commission and other forms of payment from other brokers, counterparties, and market makers for the placement and execution of customer orders. Although payment for order flow may only amount to fractions of cents per share, they can become substantial totals when aggregated.
Under the updated regulatory requirements from MAS, the PFOF ban will be effective from 1 April 2023. It will impact brokers and financial firms dealing in securities, derivatives, collective investment schemes and leveraged FX products.
The ban continues the trend from other global regulators. The UK, EU, and Canada have already banned PFOF, with Australia enacting temporary prohibitions while authorities consider a total ban. So while CMS brokers and financial firms in Singapore, the UK, EU, Canada, and Australia may be affected right now, the observed shift towards the prohibition of payment for order flow may include more jurisdictions in the future.
Conflicts of interest in financial firms can happen for a range of reasons. While regulatory requirements from authorities across the globe set out clear rules and guidance, many firms have found themselves inadequately equipped on examination.
Retail investors have their pick of brokers, many of which offer attractive perks such as sign-up bonuses, zero trading commission and waiving custodial charges. But payment for order flow (PFOF), a controversial practice used by many brokers to generate revenue, and in turn provide the aforementioned perks to their clients, has been facing regulatory scrutiny.
Our research looks particularly at how eliminating PFOF would affect market quality. By accounting for the business model of market makers, and the various factors they consider when executing trades, we show how banning PFOF could have negative, far-reaching consequences for all market participants, including retail investors.
When retail investors place orders through their brokers, many of these go through a process known as PFOF. In doing so, brokers effectively sell these orders for a fee to heavyweight market makers such as Citadel Securities or Virtu Financial. Acting as wholesale intermediaries, the market makers then execute these trades against their own balance sheets.
Much previous research into how PFOF benefits market makers has focused on its effect on their revenue. Each time a market maker executes a retail trade, they scoop up revenue from the price-improved bid-ask spread. The more trades they execute, the higher their revenue. Market makers are thus incentivised to load up their books with retail orders.
We set out to investigate how off-exchange orders such as PFOF help market makers manage the inventory aspect of their business model. We found that PFOF can in fact allow market makers to better manage their inventory risk.
For starters, different types of investors will often trade in opposite directions. A prime example would be the GameStop saga of 2021, when retail traders purchased shares of the video-game company en masse by coordinating through Reddit and Twitter. Their main objective was to short squeeze several institutional investors who attempted to short sell GameStop in the first place. More generally, for our mechanism to be at play, it suffices to have different investors, be it retail or institutional, possibly trading in different directions.
Such non-overlapping trading needs of retail investors and institutions create diversification benefits for market makers. By calibrating their inventory exposure to these two different types of investors, market makers can minimise, in expectation, their end-of-day inventory levels while maintaining their expected revenue from earning the bid-ask spreads.
PFOF therefore provides a way for market makers to diversify their order flows by scooping up additional retail orders through brokers, so they can execute the ideal proportion of retail-to-institutional orders based on their best judgement of the composition of orders originating from the exchange.
If PFOF were banned, all orders would be routed to the exchange, and market makers would be cut off from drawing on pure sources of retail orders to devise their ideal order composition. With less knowledge on the types of orders they are executing, they would essentially be trading in a blindfolded and random way. This lowers their ability to proactively select their optimal exposure to order flows running in different directions and gives them less control over their inventory.
Market makers hence experience greater inventory risk. This may make them less motivated to receive as many orders as possible, as the revenue from these trades may not be attractive enough to offset the inventory cost.
If this happens, market makers will end up providing less trading liquidity. Fewer investors will opt to trade, meaning that gains from trading may be reduced for both retail and institutional investors alike. Additionally, retail investors will be forced to trade entirely on-exchange and will not be able to access the more advantageous prices that market makers can often provide.
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In keeping with its regulatory obligations to maintain reasonable risk management controls, JPMS has no obligation to accept, execute, or cancel all or any part of an order that you seek to execute or cancel through JPMS. JPMS, in its discretion, may reject all or any part of an order, whether routed to a market center for execution via JPMS-provided or sponsored access or routed to a JPMS system, desk, or trader for handling.
JPM-X is designed to execute orders at the national best bid or offer or better based on price/tier/time priority. This means that of two equally priced orders, the one that is in the higher priority tier will take priority regardless of the time it was submitted to JPM-X. Firm/Conditional Orders in JPM-X are assigned to order flow types, which are grouped into tiers. You may participate in more than one tier, depending upon the order flow types to which your Firm/Conditional Orders are assigned by JPMS. The JPM-X order book is tiered based on order flow type in the following priority:
JPB-X is designed to execute orders at a VWAP (for orders designated as VWAP Price Match orders) or the close price (for orders designated as Close Price Match orders). Firm/Conditional Orders in JPB-X are assigned to order flow types, which are grouped into tiers. The JPB-X order book is tiered based on order flow type in the following priority (the tier and order flow designations correspond to the designations used for JPM-X to avoid confusion on the part of JPMS clients that use both JPM-X and JPB-X):
You may opt out of executing in JPM-X and/or JPB-X altogether or executing against one or more of the JPM-X or JPB-X order flow types (i.e., sub-tiers) or tiers to meet your specific trading needs. You can identify order flow type or tier restrictions (i) on an order-by-order basis in the Firm/Conditional Order instructions submitted to JPMS or (ii) by contacting your JPMS sales representative with respect to a subset of Firm/Conditional Orders or all order flow. In addition, JPMS may further limit the order flow types or tiers with which your Firm/Conditional Orders interact based on your trading objectives, consistent with your order instructions; accordingly, you may be prevented from interacting with an order flow type or tier with which you have not opted-out of interacting.
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