How Do Systematic Internalisers Impact Best Execution Obligations in the European Union?

Concept

The introduction of Systematic Internalisers (SIs) under the Markets in Financial Instruments Directive II (MiFID II) represents a fundamental recalibration of European market structure. 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, a Multilateral Trading Facility (MTF), or an Organised Trading Facility (OTF). This framework positions SIs as a hybrid model, combining elements of bilateral, over-the-counter (OTC) trading with the transparency obligations typically associated with public exchanges.

Their primary function is to internalize client order flow, meaning they act as the direct counterparty to the trade rather than routing it to an external venue. This structure is designed to provide a deep source of liquidity, particularly for large or less liquid trades, by allowing firms to manage risk from their own books.

The Core Mechanism of a Systematic Internaliser

An investment firm qualifies as an SI for a specific financial instrument based on quantitative thresholds that measure the frequency and size of its OTC trading activities. Once a firm crosses these thresholds for a particular instrument, it is obligated to act as an SI for that instrument. This designation carries significant responsibilities, most notably the obligation to provide firm quotes to clients upon request for liquid instruments up to a certain size (Standard Market Size). These quotes must be made public and reflect prevailing market conditions.

The core operational principle is that the SI uses its own capital to complete the client’s order, absorbing the risk and providing certainty of execution. This is a departure from an agency model, where a broker would simply find a counterparty on an external market. The SI model is predicated on the firm’s ability to manage its own inventory and risk, making it a vital source of liquidity, especially in volatile or illiquid market conditions.

Systematic Internalisers are investment firms that execute client orders on their own account, providing a key source of liquidity outside traditional trading venues.

Best Execution a Mandate of Utmost Importance

Best execution is a cornerstone of investor protection in the European Union. It is not merely about achieving the lowest price but about taking all sufficient steps to obtain the best possible result for clients on a consistent basis. The obligation, enshrined in Article 27 of MiFID II, requires firms to consider a range of execution factors. While price and costs are paramount, other factors are also critical to the overall outcome for the client.

• Price The price at which the transaction is executed.
• Costs Explicit and implicit costs associated with the trade, including execution venue fees, clearing and settlement fees, and any other charges passed on to the client.
• Speed of Execution The time it takes to complete the trade, which can be critical in fast-moving markets.
• Likelihood of Execution and Settlement The certainty that the trade will be completed and settled successfully. This is particularly relevant for large or illiquid orders.
• Size and Nature of the Order The specific characteristics of the order, which may influence the choice of execution venue. A large block order, for instance, might be better suited for an SI to minimize market impact.
• Market Impact The effect the trade itself has on the prevailing market price. A key objective of best execution is to minimize adverse market impact.

To comply with this obligation, investment firms must establish and implement an order execution policy that outlines how they will achieve the best possible result for their clients. This policy must detail the different execution venues and factors the firm considers and the relative importance it places on each. The existence of SIs adds another layer to this decision-making process, providing an alternative liquidity pool that must be evaluated against traditional exchanges and MTFs.

Strategy

Integrating Systematic Internalisers into a best execution framework is a strategic imperative for investment firms operating under MiFID II. The decision to route an order to an SI is a complex one, requiring a dynamic assessment of multiple, often competing, execution factors. A firm’s execution policy must be sophisticated enough to determine when the benefits of SI execution ▴ such as price improvement, reduced market impact, and certainty of execution ▴ outweigh the potential advantages of other venues like regulated markets or MTFs. This evaluation is not a one-time decision but an ongoing process of monitoring and review to ensure that the chosen execution strategy consistently delivers the best possible results for clients.

The Strategic Calculus of SI Execution

When considering an SI as an execution venue, a firm must weigh several strategic considerations. A primary advantage of SIs is the potential for price improvement. Because SIs trade on their own account, they have the flexibility to offer prices that are better than the current public bid or offer on a regulated market. This is a significant factor in fulfilling the best execution obligation, as the total consideration for the client is a key metric.

However, price is not the only variable. For large orders, the ability to execute without causing significant market impact is a critical advantage of SIs. A large order placed on a public exchange can signal the trader’s intent to the broader market, leading to adverse price movements. By executing bilaterally with an SI, a firm can mitigate this risk, preserving the value of the trade for the client.

A firm’s strategy must dynamically assess when the certainty and reduced market impact of an SI provide a better overall result than the price on a public venue.

Furthermore, the certainty of execution offered by an SI is a powerful strategic tool. When an SI provides a firm quote, it is obligated to trade at that price up to a certain size. This removes the uncertainty inherent in order book trading, where an order may only be partially filled or may not be filled at all if the market moves away.

This is particularly valuable in volatile or illiquid markets where liquidity on public venues can be thin and unreliable. The trade-off, however, is that the firm is executing against a single counterparty, which introduces its own set of considerations, including counterparty risk and the potential for information leakage if not managed correctly.

Comparative Venue Analysis

A robust best execution strategy requires a systematic comparison of SIs against other available execution venues. This analysis must be data-driven and tailored to the specific characteristics of each order. The following table outlines some of the key comparative factors:

Execution

The execution of orders through a Systematic Internaliser requires a meticulous and evidence-based approach to satisfy best execution obligations. Investment firms must not only have a sophisticated execution policy but also the operational capabilities to implement it effectively and, crucially, to prove compliance to regulators. This involves a granular level of pre-trade analysis, real-time monitoring, and post-trade evaluation. The firm must be able to demonstrate, on a trade-by-trade basis, why the chosen execution method was the most appropriate for achieving the best possible result for the client.

Operationalizing Best Execution with SIs

The operational workflow for executing an order with an SI begins with the firm’s smart order router (SOR) or execution management system (EMS). These systems must be configured to include SIs as potential execution venues and to query them for quotes alongside other venues. When an order is received, the SOR should be able to send a request for quote (RFQ) to one or more SIs while simultaneously assessing the liquidity available on regulated markets and MTFs. The decision to route the order to an SI will then be based on a comparison of the SI’s quoted price against the prices available elsewhere, factoring in all other relevant execution criteria.

Firms must meticulously document their execution decisions, proving that the use of an SI was in the client’s best interest for that specific trade.

A critical component of this process is the firm’s ability to monitor the quality of execution provided by its chosen SIs. This is not a “set and forget” exercise. Firms are required to regularly review their execution arrangements and to make changes if they are not consistently delivering best execution.

This involves collecting and analyzing a vast amount of data, including the prices quoted by SIs, the speed of execution, the likelihood of execution, and any instances of price improvement. This data must then be compared against the execution quality data published by other venues to provide a comprehensive picture of the firm’s execution performance.

The Role of Transaction Cost Analysis

Transaction Cost Analysis (TCA) is an indispensable tool for demonstrating compliance with best execution obligations when using SIs. TCA goes beyond a simple comparison of execution prices and delves into the implicit costs of trading, such as market impact and opportunity cost. By analyzing trade data against various benchmarks, TCA can provide a quantitative assessment of execution quality.

For example, a TCA report might compare the execution price of a trade with an SI against the volume-weighted average price (VWAP) for that instrument over the same period. This can help to determine whether the SI provided a favorable execution relative to the broader market.

The following table provides a simplified example of a TCA report for a series of trades executed across different venues, including an SI:

In this example, the trade with the SI shows positive performance against both the arrival price and the VWAP, providing quantitative evidence that the firm achieved a good execution outcome. This type of analysis, conducted systematically across all trades, is essential for meeting the evidentiary burden of MiFID II’s best execution requirements.

1. Pre-Trade Analysis Before an order is executed, the firm must assess the available liquidity and pricing across all potential venues, including SIs. This analysis should be documented and should inform the routing decision.
2. Real-Time Monitoring During the execution process, the firm must monitor market conditions and the performance of its chosen venue in real-time. If conditions change, the firm must be prepared to alter its execution strategy to protect the client’s interests.
3. Post-Trade Reporting After the trade is completed, the firm must conduct a thorough post-trade analysis to assess the quality of the execution. This includes TCA, as well as a qualitative review of the execution process. The results of this analysis should be used to refine the firm’s execution policy and arrangements on an ongoing basis.

Reflection

A New Locus of Liquidity

The integration of Systematic Internalisers into the European financial landscape has created a new locus of liquidity, one that operates in parallel to traditional, multilateral trading venues. This development necessitates a re-evaluation of established execution strategies and a deeper understanding of the trade-offs inherent in different liquidity pools. The challenge for investment firms is to harness the benefits of this new market structure while remaining steadfast in their commitment to the principles of best execution. This requires a sophisticated operational framework, a data-driven approach to decision-making, and a culture of continuous improvement.

Beyond Compliance a Strategic Advantage

Ultimately, navigating the complexities of the modern market structure is not simply a matter of regulatory compliance. It is about securing a strategic advantage in an increasingly competitive environment. Firms that can effectively leverage the unique capabilities of SIs ▴ whether to minimize market impact, access deeper liquidity, or achieve price improvement ▴ will be better positioned to deliver superior results for their clients.

The journey towards mastering this new market dynamic is ongoing, but for those who are willing to invest in the necessary technology, expertise, and analytical rigor, the rewards are substantial. The question is no longer whether to engage with SIs, but how to do so in a way that maximizes value and reinforces the core tenets of best execution.