How Do SIs Manage Conflicts of Interest in Principal Trading under MiFID II?

Concept

Under the Markets in Financial Instruments Directive II (MiFID II), a Systematic Internaliser (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 organised trading facility (OTF). This principal trading activity, where the firm acts as the counterparty to its clients’ trades, is central to the SI model. While this can provide clients with a valuable source of liquidity, it also creates inherent conflicts of interest. The primary conflict arises from the fact that the SI’s financial interests are directly opposed to those of its clients.

When a client buys a financial instrument, the SI is selling it, and vice versa. This creates a situation where the SI could potentially profit from offering less favorable prices to its clients.

The Inherent Conflict in Principal Trading

Principal trading is the practice of a firm trading for its own account, rather than on behalf of its clients. In the context of an SI, this means that when a client wishes to execute a trade, the SI may choose to fill that order from its own inventory of financial instruments. This presents a clear conflict of interest, as the SI’s desire to maximize its own profits may not align with the client’s desire to obtain the best possible price. For example, an SI might be tempted to widen the bid-ask spread to increase its profit margin on a trade, to the detriment of the client.

MiFID II’s Approach to Conflicts of Interest

MiFID II recognizes the potential for conflicts of interest within the SI model and establishes a framework to manage them. The directive moves beyond the previous “reasonable steps” standard of MiFID I, requiring firms to take all “appropriate steps” to identify, prevent, and manage conflicts of interest. This higher standard necessitates a more proactive and comprehensive approach to conflict management. MiFID II also emphasizes that disclosure of conflicts of interest is a measure of last resort, to be used only when organizational and administrative arrangements are insufficient to prevent risks of damage to client interests.

• Systematic Internaliser (SI) ▴ An investment firm that executes client orders against its own book on a frequent and systematic basis.
• Principal Trading ▴ The practice of a firm trading for its own account.
• Conflict of Interest ▴ A situation in which the interests of the SI are in opposition to the interests of its clients.

Strategy

To manage the conflicts of interest inherent in principal trading, SIs must develop and implement a comprehensive strategy that is embedded in their organizational culture and daily operations. This strategy revolves around three key pillars ▴ a robust conflicts of interest policy, a commitment to best execution, and adherence to stringent transparency requirements.

Developing a Robust Conflicts of Interest Policy

Under MiFID II, SIs are required to establish, implement, and maintain an effective conflicts of interest policy. This policy must be appropriate to the size and organization of the firm and the nature, scale, and complexity of its business. The policy should identify, with reference to the specific services and activities of the SI, the circumstances which constitute or may give rise to a conflict of interest entailing a material risk of damage to the interests of one or more clients. It must also specify the procedures to be followed and measures to be adopted in order to manage such conflicts.

The Role of the Management Body

The management body of the SI has overall responsibility for ensuring that the firm complies with its obligations under MiFID II, including those related to conflicts of interest. The management body must approve the conflicts of interest policy and is responsible for its implementation and ongoing effectiveness. This includes ensuring that all relevant staff are aware of the policy and receive appropriate training.

The Centrality of Best Execution

The obligation to provide best execution is a cornerstone of investor protection under MiFID II and a key tool for managing conflicts of interest in principal trading. SIs must take all sufficient steps to obtain the best possible result for their clients, taking into account a range of execution factors, including price, costs, speed, likelihood of execution and settlement, size, and nature of the order. When an SI executes a client order against its own book, it must be able to demonstrate that the price offered to the client is fair and in line with the best execution obligation.

The best execution obligation requires firms to take all sufficient steps to obtain the best possible result for their clients on a continuous basis.

Order Execution Policy

To ensure compliance with the best execution obligation, SIs must establish and implement an order execution policy. This policy must include, for each class of financial instruments, information on the different venues where the SI executes its client orders and the factors affecting the choice of execution venue. When an SI executes orders against its own book, it is considered an execution venue for the purposes of the order execution policy.

Transparency as a Conflict Management Tool

MiFID II’s transparency requirements are designed to shed light on the prices at which financial instruments are traded, thereby empowering investors and helping to ensure a level playing field between different trading venues. For SIs, these requirements are a crucial element of their conflict management strategy. By making their quotes public, SIs provide clients with a benchmark against which to assess the fairness of the prices they are offered.

Pre-Trade and Post-Trade Transparency

SIs are subject to both pre-trade and post-trade transparency obligations. Pre-trade transparency requires SIs to make public their firm quotes in liquid instruments up to a certain size. Post-trade transparency requires SIs to make public the price, volume, and time of the trades they have executed as close to real-time as is technically possible.

Execution

The effective execution of a conflict of interest management strategy requires a combination of robust systems, clear procedures, and a culture of compliance. For SIs, this means translating the principles of their conflicts of interest policy, best execution obligation, and transparency requirements into concrete operational processes.

Implementing the Conflicts of Interest Policy

The implementation of the conflicts of interest policy begins with the identification of potential conflicts. SIs must maintain a record of the kinds of services or activities carried out by or on behalf of the firm in which a conflict of interest entailing a material risk of damage to the interests of one or more clients has arisen or, in the case of an ongoing service or activity, may arise. This record should be regularly updated.

Managing Identified Conflicts

Once a conflict of interest has been identified, the SI must take appropriate steps to manage it. These steps may include:

1. Information barriers ▴ Establishing “Chinese walls” to prevent the flow of confidential information between different parts of the business.
2. Segregation of duties ▴ Ensuring that the individuals responsible for executing client orders are separate from those who manage the firm’s own proprietary trading activities.
3. Remuneration policies ▴ Designing remuneration structures that do not create incentives for staff to act against the interests of clients.

Ensuring Best Execution in Practice

To ensure best execution, SIs must have in place a process for monitoring the effectiveness of their order execution arrangements and policy. This includes regularly assessing the quality of execution offered by the different execution venues listed in their order execution policy, including their own internal execution facility. SIs must be able to demonstrate to their clients, upon request, that they have executed their orders in accordance with their order execution policy.

SIs must be able to demonstrate that the price offered to the client is fair and in line with the best execution obligation.

Monitoring Execution Quality

The monitoring of execution quality should be a continuous process. SIs should use a variety of metrics to assess their execution performance, including:

• Price improvement ▴ The extent to which the execution price is better than the quoted price.
• Effective spread ▴ The difference between the price at which a security is bought and sold, taking into account any price improvement.
• Speed of execution ▴ The time it takes to execute an order from the moment it is received.

Meeting Transparency Obligations

SIs must have the necessary systems and procedures in place to meet their pre-trade and post-trade transparency obligations. This includes having the ability to publish their quotes in a manner that is easily accessible to other market participants and to report their trades to an Approved Publication Arrangement (APA) in a timely manner.

Reflection

The MiFID II framework for Systematic Internalisers represents a significant step forward in the regulation of principal trading. By placing a greater emphasis on the prevention and management of conflicts of interest, the directive seeks to ensure that SIs act in the best interests of their clients, even when their own financial interests are at stake. The effectiveness of this framework, however, will ultimately depend on the commitment of SIs to embedding a culture of compliance and integrity within their organizations. The challenge for SIs is not simply to comply with the letter of the law, but to embrace the spirit of the regulations and to build relationships with their clients that are based on trust and transparency.