How Do SIs and OTFs Impact Best Execution Obligations under MiFID II?

Concept

The New Cartography of Liquidity

The Markets in Financial Instruments Directive II (MiFID II) redrew the map of European financial markets. It introduced two specific types of trading venues, the Systematic Internaliser (SI) and the Organised Trading Facility (OTF), which fundamentally altered how investment firms meet their best execution obligations. These obligations, elevated by MiFID II from taking all “reasonable” steps to all “sufficient” steps, compel firms to secure the most favorable terms for their clients when executing orders.

This shift in language signals a higher regulatory expectation, demanding a more demonstrable and robust execution process. The introduction of SIs and OTFs was a direct response to the increasing volume of over-the-counter (OTC) trading, aiming to bring more activity into regulated and transparent frameworks.

An SI is an investment firm that, on an organised, frequent, systematic, and substantial basis, deals on its own account by executing client orders outside of a regulated market (RM), multilateral trading facility (MTF), or OTF. In essence, it is a formalization of bilateral trading where a firm internalizes client order flow. An OTF, conversely, is a multilateral system for non-equity instruments (such as bonds, structured finance products, derivatives, and emission allowances) where multiple third-party buying and selling interests can interact. Unlike RMs and MTFs, which are governed by non-discretionary rules, an OTF operator has a degree of discretion in how it executes orders, either by matching client orders or arranging transactions through negotiation.

The core function of both SIs and OTFs is to structure and formalize liquidity that previously existed in less transparent, bilateral arrangements, thereby bringing it within the purview of MiFID II’s regulatory and transparency requirements.

The impact on best execution is direct and multifaceted. Before MiFID II, a significant portion of trading occurred in opaque, OTC markets, making it difficult to evidence that best execution was achieved. By creating the SI and OTF classifications, regulators forced more of this activity onto venues with pre- and post-trade transparency requirements.

This provides investment firms with more publicly available data to reference when making execution decisions and to demonstrate compliance to regulators and clients. The result is a more complex but also more data-rich environment for achieving and proving best execution.

Strategy

Navigating Discretion and Obligation

The strategic challenge for investment firms under MiFID II is to integrate SIs and OTFs into their order execution policies in a way that demonstrably serves the best interests of their clients. An execution policy is a formal document that outlines, for each class of financial instrument, the venues and factors a firm considers to achieve the best possible result. The inclusion of SIs and OTFs introduces new strategic considerations centered on the trade-off between price, liquidity, and transparency.

For an investment firm, routing an order to an SI can offer potential benefits in terms of price improvement and access to a deep pool of proprietary liquidity. Since the SI is dealing on its own account, it may be able to offer a better price than what is available on a public exchange, particularly for large orders that could cause significant market impact if executed on a lit venue. The strategic decision for the firm is to determine when the potential for price improvement and reduced market impact on an SI outweighs the benefits of accessing the broader, all-to-all liquidity of a traditional exchange. This requires a sophisticated understanding of the market for a specific instrument and the quality of execution offered by different SIs.

Integrating SIs and OTFs effectively into an execution policy requires a dynamic assessment of execution quality, moving beyond simple price analysis to consider a wider range of quantitative and qualitative factors.

OTFs present a different set of strategic choices, particularly for non-equity instruments. The discretionary nature of OTF execution allows for more complex, high-touch trades to be negotiated and executed within a regulated framework. This is especially valuable for illiquid bonds or complex derivatives where a simple, price-driven algorithm may fail to find a counterparty.

The operator of an OTF, unlike an MTF, has a duty to act in the client’s best interest, adding a layer of conduct-of-business protection. The strategic consideration for a firm using an OTF is to evaluate the quality of the negotiation process and the likelihood of achieving a favorable outcome in a market that may have limited price transparency.

Comparative Analysis of Execution Venues

To comply with best execution, firms must conduct a comparative analysis of the available execution venues. This analysis is not a one-time event but an ongoing process of monitoring and review. The table below outlines some of the key factors a firm would consider when choosing between different venue types.

This comparative framework must be embedded within the firm’s order handling procedures and supported by robust data analysis to justify execution decisions. The choice of venue is not static; it must adapt to changing market conditions and the specific characteristics of each client order.

Execution

The Mandate for Demonstrable Compliance

The operational execution of best execution under MiFID II, particularly with the inclusion of SIs and OTFs, hinges on a firm’s ability to monitor, report, and justify its trading decisions. This is a data-intensive process that requires significant investment in technology and compliance resources. Two key reporting requirements under MiFID II are central to this process ▴ RTS 27 and RTS 28 reports.

RTS 27 reports are published by execution venues, including SIs and OTFs, and provide detailed data on execution quality. These reports include information on price, costs, speed, and likelihood of execution for individual financial instruments. Investment firms are required to use this data to inform their choice of execution venues and to monitor the quality of execution they are receiving.

RTS 28 reports, on the other hand, are published by investment firms themselves. In these reports, firms must summarize, for each class of financial instrument, the top five execution venues where they executed client orders in the preceding year, along with information on the quality of execution obtained. This public disclosure forces firms to be transparent about their execution practices and provides clients with the information they need to assess whether their broker is acting in their best interests.

A Procedural Framework for Best Execution Monitoring

To meet these obligations, a firm must establish a systematic process for monitoring execution quality. This process should be integrated into the firm’s compliance framework and subject to regular review. The following list outlines a procedural framework for ongoing monitoring:

1. Data Ingestion and Normalization ▴ The first step is to collect and process execution data from all relevant sources. This includes the firm’s own order management system (OMS), as well as RTS 27 reports from all potential execution venues, including SIs and OTFs. The data must be normalized to allow for like-for-like comparisons.
2. Benchmarking and Analysis ▴ Once the data is collected, it must be benchmarked against relevant market data and execution quality metrics. This analysis should consider a range of factors, including:
   • Price ▴ Comparison of execution prices against the European Best Bid and Offer (EBBO) or other relevant benchmarks.
   • Costs ▴ Analysis of explicit costs (fees, commissions) and implicit costs (market impact, spread).
   • Speed ▴ Measurement of the time between order receipt and execution.
   • Likelihood of Execution ▴ Assessment of the probability that an order of a given size and type will be executed on a particular venue.
3. Policy Review and Adjustment ▴ The results of the analysis must be used to review and, if necessary, adjust the firm’s order execution policy. If a particular venue is consistently failing to provide high-quality execution, it may need to be removed from the policy. Conversely, new venues that demonstrate superior execution quality may be added.
4. Reporting and Governance ▴ The entire process must be documented and subject to internal governance and oversight. The findings of the monitoring process should be reported to senior management and used to inform the firm’s annual RTS 28 report.

The shift to “sufficient steps” under MiFID II transforms best execution from a qualitative assessment into a quantitative, data-driven discipline.

Quantitative Analysis of Execution Quality

The table below provides a simplified example of the type of quantitative analysis a firm might undertake to compare execution quality across different venues for a specific corporate bond.

This type of analysis, when conducted systematically across all relevant instruments and venues, provides the evidentiary basis for a firm’s best execution policy. It allows the firm to demonstrate to regulators and clients that it is taking sufficient steps to achieve the best possible result, leveraging the full range of execution venues available in the post-MiFID II landscape.

Reflection

Beyond Compliance a Framework for Competitive Advantage

The integration of Systematic Internalisers and Organised Trading Facilities into the MiFID II framework represents a fundamental evolution in market structure. For investment firms, the challenge extends beyond mere compliance with the expanded best execution obligations. The true opportunity lies in leveraging this new, more transparent market structure to build a superior execution framework. The data and reporting requirements, while demanding, provide the raw materials for a more sophisticated and intelligent approach to order routing and execution.

Firms that view these obligations solely as a compliance burden will miss the strategic implications. Those that invest in the technology and expertise to analyze the rich data streams now available from SIs, OTFs, and other venues can develop a nuanced understanding of liquidity and execution quality that translates into a tangible competitive advantage. This involves moving from a static, policy-based approach to a dynamic, data-driven one, where execution strategies are continuously refined based on empirical evidence. The ultimate goal is to create an operational framework that not only satisfies regulatory requirements but also consistently delivers superior execution outcomes for clients, transforming a regulatory mandate into a cornerstone of the firm’s value proposition.