Concept
The introduction of the Systematic Internaliser (SI) regime under MiFID II represents a fundamental redesign of the market’s data architecture. Your existing best execution framework, calibrated for a world of centralized, lit exchanges and multilateral trading facilities (MTFs), now confronts a new, parallel liquidity universe. This universe operates on a bilateral basis, where investment firms execute client orders against their own book.
The core challenge this presents is one of observation and integration. An execution policy that fails to incorporate SI quote data is, in effect, operating with a significant blind spot, unaware of potentially superior prices offered in these private channels.
The SI framework compels certain high-volume investment firms to formalize their over-the-counter (OTC) activities, bringing them into a regulated and transparent structure. For instruments they trade frequently and in substantial size, these firms must provide firm, executable quotes to their clients. This creates a stream of pre-trade data that was previously inaccessible or inconsistent. The alteration to your best execution calculation, therefore, begins before a single order is routed.
It begins with the systemic requirement to capture, analyze, and act upon this new source of pre-trade transparency. Your analytical models must now weigh the firm, bilateral quotes from an SI against the dynamic, all-to-all liquidity available on a public exchange.
A firm’s best execution capability is now directly proportional to its ability to process and compare fragmented, bilateral data streams alongside public market data.
This shift moves the point of execution analysis from a purely public-facing activity to a hybrid one. The question is no longer just “what is the best price on the public markets?” but “what is the best available price across all permissible execution venues, including the private quotes from our SI counterparties?” This necessitates a profound change in both technology and process. Your Smart Order Routers (SORs) and execution algorithms require reprogramming to ingest and intelligently rank SI quotes.
Your compliance oversight must evolve to monitor and evidence that these new venues are being fairly considered and that they are, over time, contributing positively to execution quality for your clients. The SI is a structural intervention that redefines what it means to have a complete view of the market.
Strategy
Adapting a best execution strategy to the realities of the SI regime requires a move from a static, venue-centric model to a dynamic, data-centric one. The core strategic objective is to build an analytical framework that can systematically compare heterogeneous liquidity pools ▴ the central limit order books of regulated markets and the bilateral quote streams of SIs ▴ and make an optimal routing decision in real-time. This is a considerable architectural challenge that impacts technology, compliance, and trading workflows.
Recalibrating the Execution Venue Analysis
The traditional four-fold test for best execution ▴ price, costs, speed, and likelihood of execution ▴ remains the guiding principle. However, SIs introduce new variables into each component of this test. A strategic response involves updating the firm’s execution policy to explicitly define how these variables are weighted and measured when an SI is a potential venue.
- Price ▴ An SI provides a firm quote, which can be advantageous for certainty of execution. This price may also include improvements over the prevailing public market bid-offer spread. The strategy must involve capturing these quotes and comparing them to the European Best Bid and Offer (EBBO) at the moment of execution.
- Costs ▴ Execution on an SI typically avoids exchange or clearing fees. These implicit cost savings must be quantified and factored into the total consideration calculation, which is the ultimate measure of best execution.
- Speed ▴ Bilateral execution with an SI can be faster, as it removes the latency associated with an order resting on a public book. This is particularly relevant for latency-sensitive strategies.
- Likelihood of Execution ▴ For large orders (above standard market size), an SI can offer a higher probability of full execution without market impact, as the trade occurs off-book. The strategic assessment must consider the risk of information leakage and slippage on a lit venue versus the certainty offered by an SI.
How Does Pre-Trade Transparency from SIs Change Routing Logic?
The mandate for SIs to publish pre-trade quotes for liquid instruments underpins the entire strategic shift. This data cannot remain passive. It must be actively integrated into the firm’s Smart Order Router (SOR) logic. Imagine the SOR as a GPS for your orders.
Previously, it navigated a map of public highways (exchanges, MTFs). Now, it must also see a network of private, high-speed toll roads (SIs).
The SOR’s algorithm must be enhanced to send a request-for-quote (RFQ) to relevant SIs concurrently with checking the lit market prices. The routing decision is then based on the superior result returned from all sources. This requires a technical build-out to establish and maintain FIX protocol connections to multiple SIs and a logical upgrade to the SOR to process the returned quote data within the order’s execution timeframe. The strategy here is one of technological parity; your firm’s internal systems must be able to “speak the language” of SIs to access their liquidity.
Integrating SI quote streams transforms the Smart Order Router from a passive price-taker on public markets to an active liquidity seeker across a hybrid market structure.
Integrating Bilateral and Public Data Streams
A successful strategy hinges on creating a unified view of a fragmented market. It is useful to conceptualize lit markets as a vast, open public square where all participants can see the ongoing auction. SIs, in this analogy, are a series of private, sound-proofed rooms where a firm can receive a direct, binding price from a counterparty. A robust best execution strategy ensures the trader has a window into every relevant room while still watching the main square.
This requires a data management strategy capable of normalizing and synchronizing these different data types. The public market provides a continuous stream of Level 2 data, while SIs provide discrete, on-demand quotes. The following table illustrates the strategic considerations when comparing these liquidity sources.
| Execution Factor | Lit Market (e.g. Regulated Market) | Systematic Internaliser (SI) |
|---|---|---|
| Price Discovery | Multilateral and transparent, contributing to public price formation. | Bilateral; price is based on the SI’s own risk position and the public reference price. |
| Pre-Trade Transparency | Publicly disseminated order book (e.g. Level 2 data). | Firm quotes provided upon request to clients. Public disclosure for liquid instruments. |
| Execution Certainty | Dependent on order queue priority and available depth. | High certainty up to the quoted size, as the SI is the direct counterparty. |
| Market Impact | Higher potential for information leakage and slippage, especially for large orders. | Minimal to zero market impact, as the trade is executed off-book. |
| Associated Costs | Includes exchange fees, clearing fees, and potential broker commissions. | Typically embedded in the spread; avoids explicit venue and clearing fees. |
The strategic implementation involves building a system that can weigh these factors on a trade-by-trade basis, guided by the overarching execution policy. This ensures that the choice of venue is not just compliant, but is demonstrably in the best interest of the client based on a holistic and evidence-based assessment of all available liquidity sources.
Execution
The execution of a best execution policy that properly incorporates Systematic Internalisers is a matter of precise operational engineering. It demands a granular approach to technology integration, quantitative analysis, and regulatory reporting. The abstract strategy must be translated into a concrete, auditable workflow that proves the firm is taking all sufficient steps to achieve the best possible result for its clients on a consistent basis.
The Operational Playbook for SI Integration
Integrating SIs into an existing execution framework is a multi-stage process that touches every part of the trading lifecycle. The following steps provide a high-level operational playbook for a firm seeking to systematically leverage SI liquidity.
- Venue Identification and Onboarding ▴ The firm must first identify the investment firms that have registered as SIs for the specific asset classes and instruments it trades. This involves reviewing regulatory registers and engaging directly with counterparties. An onboarding process must then be initiated, which includes due diligence on the SI’s execution quality and establishing the necessary legal and commercial agreements.
- Technological Connectivity ▴ Secure and low-latency connectivity must be established. This is typically achieved via the Financial Information eXchange (FIX) protocol. The firm’s order management system (OMS) and execution management system (EMS) must be configured with the correct FIX message specifications to request quotes from and route orders to the SI.
- Smart Order Router (SOR) Calibration ▴ The logic of the SOR is the core of the execution process. It must be recalibrated to recognize SIs as a distinct venue type. The SOR’s algorithm needs to be programmed to query SIs for quotes in parallel with scanning lit market order books and to make a routing decision based on a weighted analysis of the best execution factors defined in the firm’s policy.
- Transaction Cost Analysis (TCA) Model Enhancement ▴ Post-trade analysis is critical for demonstrating best execution. The firm’s TCA model must be enhanced to properly benchmark SI executions. This means capturing not only the execution price but also the lit market reference price (e.g. arrival price or Volume-Weighted Average Price – VWAP) at the time of the SI trade. This allows for a quantitative comparison of the execution quality provided by the SI versus other venues.
- Compliance Monitoring and Reporting ▴ The compliance function requires new tools to monitor SI-related order flow. This includes building surveillance reports to ensure that SIs are being given fair consideration and to track their performance over time. Furthermore, the data from SI executions must be fed into the annual RTS 28 reporting process, which discloses the top five execution venues used for each class of financial instrument.
Quantitative Modeling and Data Analysis
A data-driven approach is essential to validating the effectiveness of an SI-inclusive execution strategy. This requires specific quantitative models both pre-trade and post-trade. The pre-trade model, embedded within the SOR, must calculate the expected total consideration from each potential venue, while the post-trade TCA model must measure the actual outcome.
Effective execution requires a quantitative framework that can translate the abstract principles of best execution into measurable, comparable data points across all venue types.
The table below provides a simplified model of a pre-trade SOR weighting mechanism. It demonstrates how a system might quantify the decision-making process.
| Metric | Regulated Market | Systematic Internaliser | Weighting Factor |
|---|---|---|---|
| Reference Price (EUR) | 100.05 (Best Offer) | 100.04 (Firm Quote) | 60% |
| Expected Fees (bps) | 0.50 | 0.00 | 20% |
| Expected Latency (ms) | 50 | 10 | 10% |
| Expected Fill Rate (%) | 85% (for order size) | 100% (up to quote size) | 10% |
| Weighted Score | 100% |
In a post-trade context, a detailed TCA report is the primary evidence of best execution. The following table illustrates a comparative analysis of two hypothetical trades, demonstrating how the performance of an SI is measured.
| Order ID | Asset | Venue | Execution Price | Arrival Price | Slippage (bps) | Fees (EUR) | Total Cost (bps) |
|---|---|---|---|---|---|---|---|
| ORD-001 | ABC Corp | Lit Exchange | 100.10 | 100.05 | +5.0 | 5.00 | +5.5 |
| ORD-002 | ABC Corp | SI-Bank-A | 100.04 | 100.05 | -1.0 | 0.00 | -1.0 |
This quantitative analysis provides the audit trail necessary to justify execution decisions to both clients and regulators. It moves the concept of best execution from a qualitative statement of intent to a quantitative, evidence-based practice.
What Is the Consequence for Regulatory Reporting?
The inclusion of SIs has a direct and significant impact on a firm’s reporting obligations, particularly the annual RTS 28 report. This report requires a firm to publish, for each class of financial instruments, its top five execution venues in terms of trading volumes. When a firm executes a significant volume of trades with SIs, those SIs will likely feature prominently in this report. This has several consequences.
First, it increases the transparency of the firm’s execution practices, making its choice of counterparties public. Second, it requires the firm to write a detailed summary of the execution quality obtained from these venues, justifying why routing flow to a bilateral counterparty was consistent with its best execution duty. This narrative must be supported by the quantitative TCA data gathered throughout the year, creating a direct link between daily execution practice and annual regulatory disclosure.
References
- ICMA. (2018). MiFID II SI Regime Workshops A summary report. International Capital Market Association.
- Callaghan, E. (2016). MiFID II/MiFIR ▴ Transparency & Best Execution requirements in respect of bonds. International Capital Market Association.
- Swedish Securities Dealers Association. (2018). Guide for drafting/review of Execution Policy under MiFID II.
- Autorité des marchés financiers. (2020). Summary document on SPOT inspections of the best execution and best selection obligations applicable to asset management companies.
- Deutsche Bank Wealth Management. (2022). EMEA Order Execution Policy 2022.
- European Securities and Markets Authority. (2017). Questions and Answers on MiFID II and MiFIR investor protection and intermediaries topics. ESMA70-872942901-38.
- Lehalle, C. A. & Laruelle, S. (Eds.). (2013). Market Microstructure in Practice. World Scientific Publishing.
- Harris, L. (2003). Trading and Exchanges ▴ Market Microstructure for Practitioners. Oxford University Press.
Reflection
Is Your Data Architecture a Window or a Wall?
The integration of Systematic Internalisers into the European market structure was an architectural intervention designed to illuminate the OTC space. It forces a critical question upon every investment firm ▴ is your current operational framework designed to look through this new window, or does it treat it as a wall? A legacy system, calibrated only for public exchange data, cannot perceive the liquidity and pricing information that now exists beyond its narrow view.
Achieving a superior execution outcome in the current market is a function of observational capacity. The challenge is to ensure your firm’s technological and analytical architecture provides a complete, panoramic view of all available liquidity, enabling your execution strategy to be truly systematic and demonstrably optimal.
Glossary
Systematic Internaliser
Best Execution
Execution Policy
Pre-Trade Transparency
Smart Order
Execution Quality
Execution Strategy
Smart Order Router
Lit Market
Order Management System
Transaction Cost Analysis
