Concept
The question of whether a buy-side firm can anchor its execution policy exclusively to systematic internalisers (SIs) and satisfy its best execution obligations is a direct inquiry into the core logic of modern financial regulation. Your question moves past surface-level compliance and targets the system’s structural integrity. The architecture of the Markets in Financial Instruments Directive II (MiFID II) was designed to create a competitive, transparent, and resilient ecosystem for price discovery.
Relying solely on a single channel of liquidity, even a highly efficient one, requires a profound and demonstrable justification that withstands intense regulatory scrutiny. The system is designed to compel diligence, and diligence is measured by the breadth and depth of the options considered.
At its heart, the best execution mandate under MiFID II is an obligation for a firm to construct and implement a process that ensures it takes “all sufficient steps” to obtain the best possible result for its clients. This result is a multidimensional outcome, a calculated synthesis of not just price, but also costs, speed, likelihood of execution and settlement, order size, and any other relevant execution factor. It is a mandate of process and evidence, demanding a firm to prove its methodology is sound, consistent, and, above all, effective in achieving superior client outcomes.
A firm’s adherence to best execution is judged not by the outcome of a single trade, but by the demonstrable robustness of its overarching execution policy and monitoring framework.
Systematic Internalisers represent a specific and vital node within this complex market architecture. An SI is an investment firm that executes client orders on its own account on an organized, frequent, and substantial basis, operating outside the confines of a traditional regulated market or multilateral trading facility (MTF). They are, in essence, principal liquidity providers that internalize order flow.
The SI regime brings a segment of this previously opaque over-the-counter (OTC) activity into a more transparent framework, requiring pre-trade quote publication and post-trade reporting. They offer a valuable source of liquidity, potentially providing price improvement and size execution that may be unavailable on public exchanges.
The central challenge emerges from the word “solely.” While MiFID II does not explicitly forbid a firm from using a single execution venue in its policy, it places a heavy burden of proof on the firm to demonstrate that this single venue consistently delivers the best possible result. This creates an immediate operational and analytical paradox. To prove that one venue is superior, a firm must have a clear view of the alternatives. Without actively sourcing liquidity or, at a minimum, systematically ingesting and analyzing data from a representative set of other venues (Regulated Markets, MTFs, other liquidity providers), a firm’s claim of achieving the “best” result exists in a vacuum.
The assertion lacks a comparative benchmark, transforming an evidence-based obligation into a declaration of faith in a single provider. Therefore, a strategy of sole reliance on SIs is a direct confrontation with the regulatory expectation of comprehensive market assessment.
Strategy
Developing a defensible strategy that relies solely on Systematic Internalisers for best execution is an exercise in constructing a fortress of evidence. The strategic framework must be designed not just to execute trades, but to continuously prove that this limited channel is superior to all other available options. This is a high-stakes analytical endeavor that shifts the firm’s operational focus from simple execution to perpetual, rigorous self-assessment.
The Architecture of a Defensible Policy
An execution policy centered on SIs must be built upon a foundation of dynamic, data-driven justification. It cannot be a static document. Instead, it must function as a living framework that adapts to market conditions and is relentlessly tested against external benchmarks. The core components of this strategy involve a sophisticated approach to data ingestion, comparative analytics, and governance.
A firm must first define the precise conditions under which an SI provides the optimal execution outcome. This requires moving beyond generalities and codifying the specific order characteristics (e.g. size, liquidity profile of the instrument, market volatility) for which an SI is the designated venue. The policy must then articulate the methodology for proving this designation is correct on an ongoing basis. This involves establishing a system for capturing execution data from the SI and comparing it against a ‘virtual’ execution benchmark derived from the broader market.
How Do Execution Venues Compare?
The strategic choice to rely on SIs must be contextualized by understanding their distinct characteristics relative to other venues. Each venue type offers a different blend of transparency, liquidity, and execution certainty. A strategy of sole reliance on SIs inherently prioritizes certain execution factors over others, a choice that must be explicitly justified in the firm’s execution policy.
| Execution Factor | Systematic Internaliser (SI) | Multilateral Trading Facility (MTF) | Regulated Market (RM) |
|---|---|---|---|
| Price Discovery | Bilateral, based on the SI’s own quoting. Prices must be reflective of market conditions but are not formed by multilateral interaction. | Multilateral, based on a central limit order book or other transparent trading system. High degree of price discovery. | Highest level of multilateral price discovery through a central limit order book with stringent pre-trade transparency rules. |
| Potential for Price Improvement | High. SIs can offer prices better than the prevailing best bid and offer (BBO) on a lit venue, executing at the midpoint, for instance. | Moderate. Price improvement can occur through interaction with hidden or pegged orders, but the primary mechanism is the lit order book. | Low to Moderate. Price formation is based on displayed orders, though some mechanisms for improvement exist. |
| Market Impact | Low. Orders are internalized and not displayed pre-trade, minimizing information leakage for large orders. | Variable. Depends on the order size relative to market depth and the use of non-displayed order types. | High for large orders, as they are fully displayed and can move the market if they exceed available liquidity. |
| Likelihood of Execution | High, subject to the SI’s willingness to quote and deal. The SI has discretion over which clients it provides quotes to. | Dependent on finding a matching counterparty in the order book. Not guaranteed. | Dependent on market depth and available counterparties. Highly liquid instruments have a high likelihood of execution. |
The Continuous Monitoring Mandate
A strategy of sole reliance transforms the firm’s best execution committee from a periodic reviewer into a real-time analytical unit. The core of the strategy is a continuous monitoring system that validates the SI-only approach on a trade-by-trade or day-by-day basis. This system must be capable of answering a critical question at any moment ▴ “For the flow we executed today, did the SI provide a better result than what would have been achieved on the most relevant alternative venues?”
The burden of proof shifts from assuming compliance to actively demonstrating superiority through empirical data.
This requires a sophisticated Transaction Cost Analysis (TCA) framework. This framework must ingest not only the execution data from the SI but also a consolidated feed of market data from all relevant European trading venues. The TCA system must then calculate a “synthetic” execution cost for each trade, modeling what the outcome would have been if the order had been routed to an MTF or Regulated Market. This analysis must account for all dimensions of best execution, including potential market impact, exchange fees, and the probability of a complete fill.
The strategic choice to use only SIs is, therefore, a choice to invest heavily in market data infrastructure and quantitative analysis capabilities. Without this investment, the strategy is indefensible.
Execution
Executing a compliant, SI-only best execution policy is a matter of rigorous data architecture and uncompromising analytical discipline. The operational reality is that the firm must build and maintain a system that perpetually audits its own execution choices against the wider market. This system is the tangible proof of the “sufficient steps” taken to secure the best client outcomes.
Constructing the Evidentiary Framework
The core of the execution process is the creation of a robust evidentiary framework. This is not merely about storing trade tickets; it is about building a comprehensive data warehouse that allows for granular, multi-faceted analysis of execution quality. This framework must capture a wide array of data points for every single order executed.
The following table outlines the minimum data architecture required to support a defensible SI-only execution policy. This is the raw material for the continuous monitoring and periodic reporting that underpins compliance.
| Data Category | Specific Data Points | Analytical Purpose |
|---|---|---|
| Order Characteristics | Instrument Identifier (ISIN), Order Timestamp (milliseconds), Order Size, Order Type (e.g. Market, Limit), Client ID. | To categorize and filter trades for specific analysis. Allows for comparison of like-for-like orders. |
| SI Execution Data | Execution Timestamp, Execution Price, Executed Quantity, SI Identifier, Quoted Price (if applicable), Explicit Commissions/Fees. | To establish the actual execution outcome achieved through the Systematic Internaliser. |
| Comparative Market Data | Consolidated European Best Bid and Offer (EBBO) at time of order and execution, Market Depth on primary venues, Volume Weighted Average Price (VWAP) benchmarks for the day/hour. | To create a benchmark for comparison. This is the critical data set for proving the SI’s execution was superior to the public market alternative. |
| Execution Quality Metrics | Price Improvement vs. EBBO, Slippage vs. Arrival Price, Percentage of Fill, Execution Latency (Order to Execution). | To quantify the quality of execution across multiple factors and demonstrate consistent performance. |
What Is the Required Review and Validation Process?
A firm cannot simply build this data architecture and assume compliance. It must implement a formal, documented process for reviewing the data and validating the SI-only policy. This process must be executed by a designated oversight function, such as a best execution committee, on a frequent and systematic basis (e.g. quarterly).
- Data Aggregation and Cleansing. The first step in each review cycle is to aggregate all required data from the evidentiary framework. This data must be cleansed and validated to ensure accuracy and completeness. Any gaps or inconsistencies in the data must be investigated and resolved.
- Quantitative TCA Reporting. The core of the review involves generating a comprehensive TCA report. This report must compare the execution quality from the SI against the benchmarks established from the comparative market data. The analysis should be segmented by asset class, instrument liquidity, and order size to identify any areas where the SI-only policy may be underperforming.
- Qualitative Factor Analysis. The committee must analyze the qualitative aspects of best execution. For example, did the SI provide reliable liquidity during periods of market stress? Were there any issues with settlement speed or efficiency? This qualitative overlay provides essential context to the quantitative data.
- Policy Validation and Exception Reporting. Based on the quantitative and qualitative analysis, the committee must formally attest whether the SI-only policy continues to be effective in achieving the best possible results for clients. Any trades or scenarios where the SI underperformed the market benchmark must be documented in an exception report, along with an analysis of the root cause.
- Documentation and Record-Keeping. The entire review process, including the data used, the analysis performed, the conclusions reached, and any remedial actions taken, must be meticulously documented. This documentation is the primary evidence that the firm is meeting its ongoing monitoring obligations and will be the first thing regulators request in an audit.
Ultimately, executing a strategy of sole reliance on SIs means committing to a state of constant vigilance. The firm must operate under the assumption that its execution choices will be challenged and must have the data and processes in place to provide a robust, evidence-based defense at a moment’s notice. Without this operational commitment, such a policy is not just strategically risky; it is a direct violation of the principles of MiFID II.
References
- Planet Compliance. “In a nutshell ▴ Best Execution under MiFID II/MiFIR.” 2024.
- SmartStream Technologies. “SYSTEMATIC INTERNALISATION UNDER MIFID II ▴ WHAT’S NEEDED NOW.” 2018.
- European Securities and Markets Authority. “Best Execution under MiFID Questions & Answers.” 2017.
- Camilleri, Stefan. “MiFID II ▴ Are you a systematic internaliser?” 2024.
- BaFin. “Systematic internalisers ▴ Main points of the new supervisory regime under MiFID II.” 2017.
Reflection
Calibrating Your Execution Architecture
The analysis of reliance on Systematic Internalisers forces a critical examination of your firm’s own operational architecture. It moves the discussion from a checklist of regulatory requirements to a deeper consideration of your system’s design and its capacity for intelligent adaptation. Is your execution framework built merely to comply, or is it engineered to produce superior, demonstrable results? The question is how you validate your choices.
The data you collect, the benchmarks you compare against, and the frequency of your review cycle are the core components of your firm’s intelligence layer. A truly robust system does not fear scrutiny; it is designed to welcome it, using every data point as an opportunity to refine and enhance its performance. The regulations provide the blueprint, but the competitive edge is found in the quality of the construction.
Glossary
Systematic Internalisers
Financial Regulation
Best Execution
Under Mifid
Multilateral Trading Facility
Regulated Market
Price Improvement
Mifid Ii
Execution Policy
Execution Data
Best Execution Committee
Continuous Monitoring
Transaction Cost Analysis
Market Data
Data Architecture
Evidentiary Framework
Execution Quality
Si-Only Policy
