How Do Systematic Internalisers Balance Best Execution Obligations with Tick Size Constraints?

Concept

The operational framework of a Systematic Internaliser (SI) is defined by a persistent, structural tension. At its core, the SI must reconcile a fluid, principles-based regulatory mandate with the rigid, discrete mechanics of modern market structure. This involves balancing the multi-faceted obligation of best execution against the granular, fixed increments of the tick size regime. Understanding this dynamic is central to comprehending the value and function of SIs within the European market architecture established by MiFID II.

An SI operates as a principal, using its own capital to execute client orders bilaterally. This positions it as a source of dedicated liquidity, standing apart from the central limit order books (CLOBs) of traditional exchanges. Its primary regulatory duty, enshrined in MiFID II, is to deliver “best execution.” This is a comprehensive requirement that extends beyond securing the most favorable price.

It compels the SI to consider a range of factors, including costs, speed, likelihood of execution and settlement, order size, and any other pertinent execution criteria. The objective is to achieve the best possible result for the client on a consistent basis.

Systematic Internalisers must navigate the conflict between the continuous nature of theoretical best price and the discrete, step-like reality of market tick sizes.

Juxtaposed against this holistic obligation is the tick size regime. Mandated by Article 49 of MiFID II, this framework establishes the minimum price increment, or “tick,” at which an equity instrument can be traded on a regulated venue. The purpose of this regime is to promote orderly markets, prevent the chaotic “flickering” of quotes at infinitesimal price points, and protect market makers who provide liquidity on lit exchanges.

This creates a quantized pricing ladder; prices can only exist at specific, pre-determined rungs. A stock might have a tick size of €0.01, meaning its price can be €10.00 or €10.01, but never €10.005.

The fundamental conflict arises at the intersection of these two mandates. Best execution, in its purest sense, might logically lead to a price that falls between the established ticks of the primary market. For instance, if the best bid on the lit market is €10.00 and the best offer is €10.02, the true midpoint ▴ and arguably the best possible price for both a buyer and a seller ▴ is €10.01.

If the tick size for this instrument is €0.02, the price of €10.01 is impermissible on the lit exchange. The SI’s challenge, and its primary value proposition, is to legally and efficiently navigate this gap, providing price improvement within a structure that appears to forbid it.

Strategy

The strategic response of a Systematic Internaliser to the conflict between best execution and tick size constraints is centered on a core mechanism ▴ midpoint execution. By leveraging specific provisions within MiFID II, SIs can operate at price levels unavailable on lit markets, thereby offering tangible price improvement to clients while managing their own principal risk. This strategy is a carefully calibrated system designed to function within the letter of the regulation while achieving a commercially advantageous result.

The Midpoint Execution Framework

The primary tool at the SI’s disposal is the ability to execute orders at the midpoint of the current best bid and offer (BBO) displayed on the primary trading venue. This is permissible because the execution occurs on the SI’s own books and is referenced to the public quote, without being a public quote itself. For client orders that are below the Standard Market Size (SMS), this provides a direct and quantifiable form of price improvement. The client receives an execution at a price that is definitionally better than what was publicly available on either side of the order book.

By executing at the midpoint of the public bid-ask spread, SIs provide a direct and measurable form of price improvement that is compliant with regulatory frameworks.

This capability became a point of significant debate, with venue operators arguing it created an uneven playing field. The resolution, clarified through ESMA Q&As, was that such price improvement is justified when it is “meaningful,” which has been interpreted to mean it reflects at least the minimum tick size or occurs at the midpoint. This prevents SIs from offering purely marginal improvements (e.g. a fraction of a tick) that could systematically drain liquidity from lit venues without providing substantial benefit to the end client.

How Do SIs Handle Large Orders?

For orders that are designated as Large In Scale (LIS), the rules provide greater flexibility. Both trading venues and SIs may be exempt from the tick size regime for LIS trades. This recognizes that executing large blocks requires a different set of mechanics.

Forcing a large order to adhere to the standard tick size could lead to significant market impact and information leakage. The LIS waiver allows SIs to negotiate a price with a client that satisfies best execution criteria without being constrained to the public tick ladder, facilitating the transfer of large risk positions with greater efficiency.

A Comparative View of Execution Venues

The strategic value of the SI model becomes clear when comparing execution outcomes. The table below illustrates a hypothetical scenario for a standard client buy order, demonstrating the financial benefit of midpoint execution.

In this illustration, the SI’s ability to operate at the €25.45 midpoint provides the client with a saving of €0.01 per share compared to executing on the lit exchange, resulting in a total improvement of €10.00 on the transaction. This is the foundational element of the SI’s competitive strategy.

Execution

The execution of the SI’s strategy is a high-frequency, technology-driven process. It requires a sophisticated architecture capable of ingesting real-time market data, applying a complex rules engine, executing trades on a principal basis, and fulfilling post-trade reporting obligations, all within milliseconds. This operational capability is what translates strategic positioning into compliant and effective execution.

The Operational Playbook

The lifecycle of a client order within a Systematic Internaliser follows a precise, automated sequence designed to ensure compliance with best execution while maximizing the potential for price improvement. This process is a core component of the SI’s operational integrity.

1. Order Ingestion and Validation The process begins when the SI receives a client order, typically via a secure Financial Information eXchange (FIX) protocol connection. The system immediately validates the order parameters (ticker, size, side) and enriches it with client-specific handling instructions.
2. Real-Time Reference Price Check The SI’s pricing engine continuously polls the primary listing venues for the relevant financial instrument. It captures the National Best Bid and Offer (NBBO) in real time, establishing the authoritative reference price against which best execution will be measured. This requires ultra-low latency data feeds.
3. Price Improvement Logic Application The core of the system’s logic is applied here. The rules engine evaluates several factors simultaneously:
   • Is the order size below the Standard Market Size (SMS)?
   • Is the reference market spread wide enough to allow for a meaningful midpoint price?
   • What is the SI’s current inventory position in this instrument?
   • What is the real-time volatility of the instrument?
4. Execution and Confirmation Based on the logic, the system determines the execution price. If conditions are met, it prices the trade at the BBO midpoint. The execution occurs instantaneously on the SI’s own book. A trade confirmation is immediately dispatched to the client via FIX, including the execution price and time.
5. Post-Trade Reporting The SI has a regulatory obligation to make the details of the trade public. Within a prescribed timeframe (typically near-real-time), the SI reports the trade to an Approved Publication Arrangement (APA), which then disseminates the information to the market. This ensures post-trade transparency.

Quantitative Modeling and Data Analysis

The decision to offer price improvement is a quantitative risk management problem. The SI’s model must balance the revenue from capturing the spread against the risk of holding an unwanted position in a volatile market. The following table provides a simplified representation of an SI’s decision matrix, illustrating how different variables influence the execution outcome.

Effective documentation through timestamping and Transaction Cost Analysis is the mechanism by which an SI proves its adherence to the best execution mandate.

How Is Compliance Systematically Documented?

Proving adherence to best execution is a critical function. Every step in the operational playbook is timestamped to the microsecond. This data provides an auditable trail demonstrating that at the moment of execution, the price offered by the SI was superior to the prevailing quotes on the reference market.

This data is then aggregated into Transaction Cost Analysis (TCA) reports for clients. These reports benchmark the SI’s execution quality against various metrics, such as the arrival price (the market price when the order was received) and the volume-weighted average price (VWAP), providing quantitative proof of the value delivered.

System Integration and Technological Architecture

The SI model is fundamentally a technology platform. Its success depends on seamless integration with the broader market ecosystem. This involves a robust and resilient architecture built for speed and reliability.

• FIX Protocol This is the lingua franca of electronic trading. SIs use FIX messaging for order receipt, execution confirmations, and other communications with clients. Specific tags are used to convey critical information, such as LastMkt (indicating the market of execution) and LastPx (the execution price).
• OMS and EMS Connectivity Clients interact with SIs through their own Order Management Systems (OMS) or Execution Management Systems (EMS). The SI must provide stable, certified API endpoints and FIX connections that integrate flawlessly with these platforms, allowing for efficient order routing.
• Market Data Infrastructure The entire system relies on receiving accurate market data with the lowest possible latency. This necessitates co-location of servers within the same data centers as the primary exchanges and direct, high-bandwidth connections to exchange data feeds. Any delay in receiving the reference price undermines the ability to provide compliant and competitive execution.

Reflection

The architecture of the Systematic Internaliser represents a sophisticated adaptation to a complex regulatory and market environment. It is an engineered solution to a problem of conflicting constraints. Understanding its mechanics is foundational, but the strategic implications for market participants are more profound. The knowledge of how an SI balances its obligations should prompt a re-evaluation of one’s own execution protocols.

How does this understanding of the SI’s decision matrix influence your order routing logic? When is directing flow to an SI most advantageous for your specific execution objectives? Contemplating these questions moves the discussion from a passive understanding of market structure to the active design of a superior execution framework.

The data, the rules, and the technology are components within a larger system of institutional intelligence. The ultimate edge lies in assembling these components into a coherent, goal-oriented operational strategy.