How Do Systematic Internalizers Interact with the DVC and LIS Frameworks under MiFID II? ▴ Question

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Concept

The relationship between Systematic Internalisers (SIs), the Double Volume Cap (DVC), and the Large-in-Scale (LIS) framework under MiFID II is a critical area of market structure. At its core, this interaction governs the flow of liquidity and the nature of price discovery in European markets. An SI is an investment firm that executes client orders on its own account, operating outside the confines of a traditional trading venue. This internalisation of order flow is subject to a specific set of transparency requirements, designed to bring a degree of light to this segment of the market.

The DVC mechanism, on the other hand, is a direct constraint on dark pool trading. It limits the volume of trading that can occur under certain pre-trade transparency waivers, specifically the reference price waiver and the negotiated transaction waiver. This cap is set at 4% of the total volume on any single trading venue and 8% across all EU venues.

When these thresholds are breached for a particular instrument, the use of those waivers is suspended for a six-month period. This forces a significant portion of trading activity into more transparent environments.

This is where the LIS framework becomes a key factor. The LIS waiver provides an exemption from pre-trade transparency for orders that are significantly larger than the average market size. This allows large, institutional orders to be executed with a reduced risk of market impact, a crucial consideration for participants needing to move significant positions. The interplay of these three elements creates a dynamic and complex environment for market participants to navigate.

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Strategy

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The Shifting Landscape of Liquidity

The introduction of the DVC has had a profound impact on the strategic decisions of market participants. With the limitations placed on dark pool trading, liquidity has been redirected towards alternative execution methods. One of the primary beneficiaries of this shift has been the SI regime.

Since SIs operate under their own distinct transparency framework, they are not subject to the DVC in the same manner as dark pools. This has made them an increasingly attractive option for firms seeking to execute trades that might have previously been handled in a dark venue.

The LIS framework provides another strategic avenue for market participants. For orders that qualify as large-in-scale, the LIS waiver offers a way to execute trades without the pre-trade transparency that could lead to adverse price movements. This has led to a rise in the use of block trading venues that specialize in facilitating these large transactions. The strategic challenge for market participants is to determine the optimal execution strategy for a given order, taking into account its size, the liquidity of the instrument, and the current status of the DVC for that instrument.

The interplay of these regulations has created a nuanced environment where the choice of execution venue is a critical component of a successful trading strategy.

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Navigating the New Market Structure

For investment firms, the decision to become an SI is a significant strategic choice. While it offers the potential to attract order flow displaced by the DVC, it also comes with a host of regulatory and operational obligations. Firms must have the necessary infrastructure to meet the pre- and post-trade transparency requirements, as well as the systems to accurately calculate whether their trading activity meets the “frequent, systematic, and substantial” criteria that trigger the SI designation.

For the buy-side, the challenge is to adapt their execution strategies to this new landscape. This involves developing a deeper understanding of the various execution venues and their respective strengths and weaknesses. It also requires a more sophisticated approach to order routing, with a greater emphasis on identifying the most appropriate venue for each individual trade. The ability to effectively navigate this complex environment is a key determinant of execution quality and overall investment performance.

The following table illustrates the key characteristics of each framework:

Framework	Primary Function	Key Feature	Impact on Market Structure
Systematic Internaliser (SI)	Internalisation of client order flow	Operates under its own transparency regime	Provides an alternative to traditional trading venues
Double Volume Cap (DVC)	Limit dark pool trading	Caps on pre-trade transparency waivers	Redirects liquidity to more transparent venues
Large-in-Scale (LIS)	Facilitate large trades	Waiver from pre-trade transparency	Supports block trading activity

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Execution

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Operationalizing the MiFID II Frameworks

The practical execution of trades within the MiFID II landscape requires a sophisticated understanding of the rules and a robust technological infrastructure. For firms operating as SIs, this means having systems in place to manage quote dissemination, order execution, and trade reporting. These systems must be able to handle a high volume of requests for quotes and ensure that all trades are reported in a timely and accurate manner. The ability to provide competitive quotes while managing risk is a key factor in the success of an SI.

For buy-side firms, the execution process has become more complex. Order routing decisions can no longer be based on simple price and liquidity considerations. Instead, firms must now take into account a wider range of factors, including the DVC status of the instrument, the availability of LIS waivers, and the specific characteristics of the various execution venues. This has led to an increased demand for sophisticated order routing technology that can help firms navigate this complex environment and achieve best execution.

The effective implementation of these frameworks is a critical determinant of a firm’s ability to compete in the modern financial markets.

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A Deeper Dive into the Execution Process

The following list outlines the key steps in the execution process for a buy-side firm under MiFID II:

Order Analysis ▴ The first step is to analyze the characteristics of the order, including its size, the liquidity of the instrument, and any specific execution instructions from the portfolio manager.
Venue Selection ▴ Based on the order analysis, the firm must then select the most appropriate execution venue. This may involve considering a range of options, including traditional exchanges, MTFs, SIs, and block trading venues.
Order Routing ▴ Once a venue has been selected, the order is routed for execution. This may be done through a direct connection to the venue or through a third-party execution provider.
Execution and Confirmation ▴ After the order is executed, the firm receives a confirmation with the details of the trade. This information is then used for settlement and reconciliation purposes.
Post-Trade Reporting ▴ Finally, the firm must ensure that the trade is reported in accordance with the relevant MiFID II requirements. This may involve reporting the trade to an Approved Publication Arrangement (APA) or relying on the SI to report the trade on their behalf.

The following table provides a more detailed look at the execution options available to buy-side firms:

Execution Venue	Key Characteristics	Best Suited For
Regulated Market (RM)	Central limit order book, high transparency	Small to medium-sized orders in liquid instruments
Multilateral Trading Facility (MTF)	Similar to RMs, but with more flexibility	A wide range of order types and instruments
Systematic Internaliser (SI)	Bilateral execution, own transparency regime	Orders that might have previously been executed in dark pools
Block Trading Venue	Specializes in large-in-scale (LIS) trades	Large, institutional orders

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References

European Securities and Markets Authority. (2020). MiFIR report on systematic internalisers in non-equity instruments. ESMA70-156-2756.
FlexTrade. (2018). MiFID II’s Trading Hereafter ▴ Systematic Internalizers & Block Venues.
International Capital Market Association. (2017). MiFID II SI Regime Workshops ▴ A summary report.
Nasdaq. (2018). Are Double Volume Caps Impacting the Trading Landscape?.
Norton Rose Fulbright. (2016). 10 things you should know ▴ The MiFID II / MiFIR RTS.

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Reflection

The intricate dance between Systematic Internalisers, the Double Volume Cap, and the Large-in-Scale framework is a testament to the evolving nature of financial markets. Understanding these mechanisms is not merely an exercise in regulatory compliance; it is a strategic imperative. The ability to navigate this complex landscape, to identify the optimal execution path for each and every order, is what separates the leaders from the followers.

As you consider your own operational framework, ask yourself ▴ is it designed to simply meet the requirements of the rules, or is it engineered to thrive within them? The answer to that question will determine your success in the markets of tomorrow.