How Did Systematic Internalisers Change the European Equity Market Structure?

Concept

Your direct experience in the market has likely confirmed that the European equity landscape operates on multiple, interconnected levels. The introduction of the Systematic Internaliser (SI) regime under the Markets in Financial Instruments Directive (MiFID) was a deliberate architectural choice to formally recognize and regulate a long-standing market reality ▴ a significant volume of order flow is executed internally by brokers against their own capital. The SI framework brought this bilateral activity into a structured, data-reportable system, fundamentally altering the pathways through which liquidity is accessed and prices are formed.

An SI is an investment firm that, on an organized, frequent, systematic, and substantial basis, deals on its own account when executing client orders outside a regulated market (RM) or a multilateral trading facility (MTF). This mechanism provides a dedicated channel for internalization, where a firm acts as the direct counterparty to its client’s trade. This model stands in direct contrast to the multilateral, all-to-all environment of a public exchange, where anonymous participants interact based on a central limit order book. The purpose of the SI designation was to create a regulatory container for this activity, imposing specific transparency and reporting obligations on firms that had previously operated in a more opaque over-the-counter (OTC) space.

The Regulatory Architecture of SIs

The genesis of the SI can be traced to MiFID I, which first introduced the concept and ended the monopoly of traditional exchanges. MiFID II, implemented in 2018, vastly expanded the regime’s scope and impact. It established quantitative thresholds that, once crossed, mandated a firm to register as an SI for specific instruments.

This shift from a voluntary to a compulsory framework was a primary catalyst for change. It forced a large number of investment banks and high-frequency trading firms to formalize their internalization activities, bringing a substantial portion of off-exchange trading into a more monitored environment.

Systematic Internalisers function as private liquidity nodes, architecturally integrated into the broader public market network through a specific set of regulatory protocols.

This new architecture created a tripartite structure for European equity trading. The system now consists of:

• Regulated Markets (RMs) ▴ Traditional stock exchanges like Euronext or Deutsche Börse, offering the highest levels of pre- and post-trade transparency through a central limit order book.
• Multilateral Trading Facilities (MTFs) ▴ These platforms, such as those operated by Cboe Europe, also use multilateral systems to bring multiple third-party buying and selling interests together, operating with similar transparency rules to RMs.
• Systematic Internalisers (SIs) ▴ Firms engaging in bilateral trading with clients, representing a distinct and significant source of liquidity that operates under its own unique transparency rules.

The critical distinction lies in the trading model. RMs and MTFs are non-discretionary venues; their rules apply equally to all participants, and the platform operator does not interfere with the trade flow. An SI, conversely, operates on a discretionary basis.

It chooses which clients to face and at what price, executing orders using its own capital. This fundamental difference in design is the source of both the SI’s utility and the controversy surrounding its role in the market.

Strategy

The integration of Systematic Internalisers into the European market framework compelled all participants to re-evaluate their execution strategies. For institutional investors and brokerage firms alike, the rise of the SI presented a new set of opportunities and challenges centered on liquidity sourcing, cost management, and information control. The core strategic shift was from a model focused on a central, lit marketplace to a more complex, fragmented ecosystem where success depends on intelligently navigating multiple liquidity sources.

Strategic Imperatives for Market Participants

For large investment banks, the strategy of operating an SI is clear. It provides a mechanism to capture the bid-ask spread on client order flow, a primary revenue stream. It also allows the bank to offer potential price improvement to its clients, executing their orders at a price better than the current European Best Bid and Offer (EBBO) on lit markets.

This capability is a powerful competitive tool for retaining and attracting client business. High-frequency trading firms also operate as SIs, leveraging their technological speed and quantitative models to provide liquidity and profit from small price discrepancies, further diversifying the types of liquidity available through the SI channel.

For the buy-side, such as asset managers, the strategic use of SIs is primarily a tool for risk management. Executing a large order on a lit exchange risks significant market impact; the visible demand can cause the price to move adversely before the full order is filled. This is a form of information leakage. By routing portions of a large order to one or more SIs, an asset manager can execute in size without publicly signaling its intentions.

The bilateral nature of the SI trade contains the information, protecting the parent order from adverse price movements. This strategic routing is typically handled by a Smart Order Router (SOR), a sophisticated algorithm designed to parse an order and find the optimal execution path across the entire fragmented landscape of RMs, MTFs, and SIs.

What Is the Main Tradeoff When Using an SI?

The primary strategic tradeoff is between the potential for reduced market impact and a reduction in public price discovery. Every trade executed within an SI is a trade that does not contribute to the formation of prices on a public exchange. While SIs are required to publish post-trade reports, this information arrives after the fact. The pre-trade quoting obligations for SIs are also limited.

They must provide firm quotes, but only up to a “standard market size” (SMS), which is often a small fraction of the liquidity available on a lit exchange’s order book. A significant portion of SI trading occurs in sizes above the SMS, executed without any pre-trade transparency. This creates a system where a large volume of trading activity is semi-opaque, leading regulators and some market participants to question the overall impact on the health and efficiency of the price formation process.

The strategic deployment of SIs reconfigured European equity trading into a complex optimization problem, balancing the benefits of private liquidity access against the systemic need for transparent price discovery.

A Comparative View of Trading Architectures

Understanding the strategic choices requires a clear view of how these different market structures function. Each venue type offers a distinct set of attributes that an execution strategy must account for.

Execution

The execution of trades in a market populated by Systematic Internalisers is a technologically intensive process. The fragmentation of liquidity across dozens of venues, including RMs, MTFs, and a network of SIs, makes sophisticated execution algorithms and connectivity essential. For institutional traders, mastering this environment means moving beyond a single-venue mindset and adopting a holistic, system-wide approach to sourcing liquidity and managing execution costs.

The Operational Playbook for Modern Execution

The central tool in this playbook is the Smart Order Router (SOR). An SOR is an automated system that makes real-time decisions about where to route an order, or pieces of an order, to achieve the best possible result according to a predefined strategy. When a trader initiates a large order, the SOR undertakes a complex analysis:

1. Liquidity Scanning ▴ The SOR continuously scans the order books of all connected lit venues (RMs and MTFs) to understand the available depth at various price points.
2. SI Interrogation ▴ Concurrently, the SOR sends out indications of interest or quote requests to its network of connected SIs. This process probes for the non-displayed liquidity that SIs can provide.
3. Optimal Slicing and Routing ▴ Based on the responses and the state of the lit markets, the SOR’s algorithm determines the optimal execution plan. This may involve sending small “child” orders to lit markets to capture available liquidity without causing price impact, while simultaneously executing larger blocks with SIs that offer price improvement or size.
4. Continuous Re-evaluation ▴ The market is dynamic. The SOR constantly re-evaluates its strategy as fills are received and market conditions change, adjusting the routing of the remaining portion of the order to adapt to new information.

This process transforms trade execution from a manual task into a complex, data-driven optimization problem, where technology is paramount to achieving the institutional goal of best execution.

Quantitative Impact on Market Structure

The introduction of the SI regime had a measurable and significant impact on the distribution of trading volumes. Data from market authorities provides a clear picture of this structural shift. A pivotal event that further reshaped the landscape was Brexit, as a large number of the most active SIs were domiciled in the United Kingdom.

This data, inspired by reports from ESMA and national regulators, illustrates the SI’s significant role pre-Brexit and how regulatory and political events can drastically alter market architecture. The drop in the EEA’s SI market share post-2021 shows how much of that activity was concentrated in the UK, and its subsequent relocation or reclassification within the remaining EEA member states.

How Is SI Execution Quality Measured?

For an asset manager, the decision to use an SI is validated by quantitative analysis of execution quality. The key metric is Price Improvement. This measures the frequency and magnitude with which an SI provides an execution price that is better than the best bid (for a sell order) or best offer (for a buy order) available on any public exchange at the time of the trade. For example, if the EBBO for a stock is €10.00 / €10.02, an SI that fills a client’s buy order at €10.015 is providing €0.005 of price improvement per share.

This tangible cost saving is a primary justification for routing flow to an SI. Other metrics include fill rates (the probability of an order being executed) and analyses of post-trade price movements to assess any residual information leakage.

Reflection

The architectural integration of Systematic Internalisers provides a powerful case study in the evolution of market regulation. It demonstrates a move toward acknowledging and structuring existing market behaviors rather than attempting to eliminate them. The result is a more complex, technologically demanding, and fragmented system. This reality prompts a deeper consideration of your own operational framework.

Is your firm’s technology stack built to navigate this fragmented liquidity landscape effectively? How does your definition of best execution adapt to a world where the best price and the best size may exist in separate, non-public venues?

The knowledge of the SI’s function is one component in a larger system of institutional intelligence. The true strategic advantage lies in architecting an execution process that can dynamically access all liquidity sources, measure performance with precision, and adapt to the next inevitable shift in market structure. The European market is not a static entity; it is a system in perpetual motion, and mastering it requires a framework built for that reality.