How Does SI Price Improvement Affect Best Execution Obligations?

Concept

Your question regarding the interplay between Systematic Internaliser (SI) price improvement and best execution obligations cuts to the core of modern market architecture. It moves past the theoretical to the practical reality of institutional order flow. You are asking how a specific, controlled execution mechanism satisfies a broad, principles-based regulatory mandate. The answer resides in understanding the SI, not as a mere trading venue, but as a deliberate system designed for a specific purpose within the complex network of European financial markets.

A Systematic Internaliser is an investment firm that uses its own capital to execute client orders on a frequent, systematic, and substantial basis outside of a traditional lit exchange. This is a principal-based model. The SI becomes the counterparty to the client’s trade. This structure is foundational.

It allows the SI to internalise order flow, creating a contained liquidity environment. Within this environment, the SI has a unique capability ▴ the capacity to offer price improvement.

Price improvement is the execution of a client’s order at a price superior to the European Best Bid and Offer (EBBO) available on public exchanges at that moment. For a client buying a security, the execution price is lower than the best offer. For a client selling, the price is higher than the best bid. This is possible because the SI is acting as principal.

It is not routing an order to a lit market but is instead fulfilling the order from its own book, giving it discretion over the execution price within certain regulatory bounds. The prices an SI quotes must still reflect prevailing market conditions, ensuring they are tethered to the reality of the broader market.

What Is the Core Function of an SI in Market Structure?

The primary function of an SI is to provide a reliable and efficient source of liquidity for its clients, often for trades that might be challenging to execute on a lit exchange without causing market impact. By internalising orders, an SI can absorb larger trades without signaling the client’s intent to the wider market, thereby reducing the potential for adverse price movement before the order is fully executed. This function is a direct response to the institutional need for discreet and efficient execution.

The regulatory framework under MiFID II formalised the SI regime, expanding its scope beyond equities to other asset classes. This was a deliberate architectural choice by regulators. The goal was to bring more of the vast Over-the-Counter (OTC) market into a regulated and transparent framework. By creating specific obligations for SIs, such as pre-trade quote transparency for liquid instruments, regulators sought to ensure that this internalisation process did not detract from the price discovery function of public exchanges.

The SI model provides a structural advantage for executing client orders with minimal market impact by using the firm’s own capital.

Best execution, under Article 27 of MiFID II, is a comprehensive obligation. It requires firms to take all sufficient steps to obtain the best possible result for their clients. This is a multi-faceted analysis that includes not only price but also costs, speed, likelihood of execution, settlement, size, and the nature of the order.

The mandate is clear ▴ a firm must have a robust process for evaluating and selecting execution venues to achieve the optimal outcome for its clients. It is within this context that the role of SI price improvement becomes a critical component of the evidentiary trail.

Strategy

The strategic integration of a Systematic Internaliser into a firm’s execution framework is a deliberate decision centered on leveraging a controlled liquidity environment to satisfy the multi-dimensional requirements of best execution. The strategy is not simply about finding a better price. It is about constructing a defensible and superior execution process that can be empirically validated. Offering price improvement is a key tactic within this broader strategy, serving as a powerful, quantifiable data point in the best execution analysis.

For a broker-dealer operating as an SI, the primary strategic objective is to become a preferred liquidity destination for its clients. By consistently providing executions at prices better than the public market benchmark, the SI creates a compelling value proposition. This attracts order flow, which in turn allows the SI to have a more comprehensive view of market interest and to manage its own inventory more effectively.

It is a symbiotic relationship. The client receives a better execution price, and the SI benefits from the internalised flow.

How Does Price Improvement Evidence Best Execution?

The best execution obligation requires firms to demonstrate, with data, that their chosen execution method was the most appropriate for a given order. Price is a primary, though not exclusive, factor in this assessment. When an SI provides price improvement, it generates a clear, auditable record of a tangible benefit delivered to the client.

This data point can be directly compared against the prevailing EBBO at the time of the trade. This quantitative evidence is a cornerstone of the best execution defense.

However, a sophisticated best execution strategy looks beyond the price. The use of an SI can also be justified based on other execution factors:

• Likelihood of Execution ▴ For large orders or trades in less liquid instruments, routing to a lit market could result in partial fills or failed execution. An SI, by committing its own capital, can offer a higher certainty of execution for the full size of the order.
• Minimizing Market Impact ▴ Executing large orders on a public exchange can signal trading intent, leading to adverse selection and price slippage. The discreet nature of an SI execution minimizes this information leakage, preserving the quality of the execution for the remainder of the order and for future trades.
• Speed of Execution ▴ By internalising the trade, an SI can provide immediate execution without the latency involved in routing an order to an external venue, processing, and receiving a confirmation.
• Cost ▴ While the explicit commission may be one component, the total cost of execution includes implicit costs like market impact. By improving the price and reducing market impact, an SI can lower the total cost of trading for the client.

A robust best execution policy leverages SI price improvement as a key quantitative metric while also documenting qualitative benefits like reduced market impact.

The following table illustrates how different execution factors might be evaluated when choosing between an SI and a lit market for a large institutional order.

A firm’s strategy must also account for regulatory oversight. MiFID II requires firms to have a clear order execution policy that explains how they will achieve best execution for their clients. This policy must detail the different venues and factors considered. When a firm routes a significant portion of its flow to its own SI, it must be prepared to justify this decision.

The consistent delivery of price improvement, coupled with benefits across other execution quality factors, forms the foundation of this justification. The firm must also conduct regular, rigorous reviews of its execution quality, comparing the performance of its SI against other available venues. This is where Transaction Cost Analysis (TCA) becomes essential.

Execution

The operational execution of a best execution policy that incorporates a Systematic Internaliser is a data-intensive process. It requires a robust technological architecture for capturing, analyzing, and reporting on execution quality. The simple act of receiving price improvement is the outcome of a complex system of pre-trade transparency, order handling, and post-trade analysis. The focus of execution is on creating an objective, repeatable, and auditable process that proves the firm is meeting its obligations.

The Operational Playbook for SI Execution

A firm’s operational playbook for handling orders via an SI involves several distinct stages, each with its own set of procedures and controls. This ensures that the decision to use the SI and the quality of the resulting execution can be systematically evaluated.

1. Order Reception and Pre-Trade Analysis ▴ Upon receiving a client order, the firm’s smart order router (SOR) or trading desk must perform a pre-trade analysis. This involves capturing the current EBBO, assessing the liquidity on various lit markets, and considering the characteristics of the order (size, security, client instructions).
2. Venue Selection Logic ▴ The SOR logic must be programmed to evaluate the potential outcomes of routing the order to different venues, including the firm’s own SI. If the SI is quoting prices that represent an improvement over the EBBO, the SOR may prioritize routing the order to the SI. This logic must be documented and regularly reviewed.
3. Execution and Data Capture ▴ When an order is executed on the SI, a rich set of data must be captured at the moment of execution. This includes the execution price, the size, the time of the trade, and a snapshot of the EBBO on the reference market at that precise moment. This data is the raw material for the best execution analysis.
4. Post-Trade Transaction Cost Analysis (TCA) ▴ The execution data is fed into a TCA system. The primary calculation is the amount of price improvement received. This is calculated as the difference between the execution price and the relevant bid or offer, multiplied by the size of the trade. The TCA report will compare this execution against benchmarks, such as the volume-weighted average price (VWAP) for the day.
5. Monitoring and Reporting ▴ The firm must produce regular reports (often quarterly) that summarize its execution quality. These reports, mandated by RTS 27 (for venues) and RTS 28 (for firms), provide transparency on the top execution venues used and the quality of execution achieved. The data on price improvement from the SI is a critical input to these reports.

Quantitative Modeling and Data Analysis

The core of the execution process is the quantitative analysis of trade data. The following table provides a simplified example of how price improvement would be calculated and presented in a TCA report for a series of buy orders.

In this example, the firm can demonstrate that for three out of four trades, it achieved a better price for the client than was publicly available. For trade T12348, while there was no price improvement, the execution at the market price could still be justified based on other factors like speed or certainty of execution. A comprehensive TCA platform would analyze thousands of such trades, providing statistical summaries of average price improvement, the percentage of orders improved, and comparisons across different SIs and other venues.

Effective execution relies on a continuous feedback loop of data capture, quantitative analysis, and process refinement.

This quantitative rigor is what transforms the concept of best execution from a principle into a practice. It provides the firm, its clients, and its regulators with a transparent and evidence-based account of its performance. The ability of a Systematic Internaliser to consistently generate positive price improvement data is a powerful tool in demonstrating a commitment to this practice.

Reflection

The integration of Systematic Internaliser liquidity into your execution policy represents a critical architectural decision. The data clearly shows that price improvement is a powerful metric for substantiating best execution claims. The true strategic question, however, moves beyond simple validation. How does your firm’s monitoring framework actively compare the total cost of execution, including the implicit value of reduced market impact from an SI, against the explicit price improvement offered by other venues?

Is your TCA process calibrated to not only report on past performance but also to dynamically refine your smart order routing logic for the future? The regulations provide the blueprint for compliance. The ultimate competitive advantage is found in building an execution system that is not merely compliant, but intelligent.