How Does the SI Regime Affect Best Execution Obligations for Asset Managers?

Concept

The introduction of the Systematic Internaliser (SI) regime under the second Markets in Financial Instruments Directive (MiFID II) represents a fundamental architectural shift in European financial markets. For an asset manager, understanding this regime is a matter of direct operational consequence, impacting the very core of the mandate to deliver best execution. The SI is a specific type of execution venue, an investment firm that, on an organised, 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 structure creates a hybrid liquidity source, combining elements of bilateral, over-the-counter (OTC) trading with the transparency obligations of a formalised market structure.

Your responsibility as an asset manager extends beyond simply achieving a good price. The mandate for best execution under MiFID II requires you to take all sufficient steps to obtain the best possible result for your clients. This is a multi-faceted obligation, determined by a range of execution factors that include price, costs, speed, likelihood of execution and settlement, size, and the nature of the order.

The SI regime directly intersects with this obligation by creating a new, distinct category of venue that must be evaluated and integrated into your execution policy and subsequent Transaction Cost Analysis (TCA). The regime compels certain high-volume trading firms to formalise their OTC activities, bringing a significant portion of previously opaque liquidity into a more structured and observable framework.

This formalisation is the central mechanism through which the SI regime affects your duties. An SI provides firm, bilateral quotes, allowing you to engage in price discovery for large or illiquid blocks of assets without signaling your intent to the wider market, a process that mitigates information leakage and potential adverse price movements. The regime mandates pre-trade transparency obligations for SIs, requiring them to publish firm quotes for liquid instruments up to a standard market size. This provides a reliable data point for your pre-trade analysis.

Concurrently, SIs are subject to post-trade transparency requirements, contributing to the overall market data landscape that you use to evaluate execution quality. Your firm’s execution architecture must be calibrated to intelligently access this liquidity source, treating it as a strategic component within a diverse ecosystem of venues that also includes lit exchanges and MTFs.

The Systematic Internaliser regime re-architects the execution landscape by formalizing a new class of venue, directly compelling asset managers to evolve their best execution frameworks.

The core challenge presented by the SI regime is one of integration and evidence. It is your responsibility to demonstrate, with robust data and clear documentation, why routing an order to an SI constituted the best possible outcome for a client in a given circumstance. This requires a sophisticated approach to data analysis and venue selection. The existence of SIs adds a layer of complexity to your decision-making matrix.

You must now systematically compare the potential outcomes of executing via an SI against those available on traditional lit markets or MTFs. This comparison is not static; it must adapt to the specific characteristics of each order and the prevailing market conditions. The SI regime, therefore, elevates the best execution obligation from a compliance exercise to a continuous, data-driven process of strategic optimization. Your execution policy becomes a living document, a blueprint for how you navigate this more complex and fragmented liquidity landscape to fulfill your fiduciary duty.

Strategy

Integrating Systematic Internalisers into an asset manager’s best execution strategy is an exercise in architectural design. It requires building a framework that can systematically evaluate and access this unique liquidity source alongside traditional venues. The objective is to construct a decision-making process that is robust, repeatable, and, most importantly, demonstrably aligned with the client’s best interests. This involves a multi-layered approach, encompassing policy design, venue analysis, and the technological infrastructure required to support intelligent order routing.

Crafting a Defensible Execution Policy

Your order execution policy is the foundational document that governs your strategic approach. Under MiFID II, this policy must be granular and specific, detailing the execution strategies for each class of financial instrument. When incorporating SIs, the policy must articulate the precise circumstances under which you will direct orders to them. This involves defining the factors that would make an SI the optimal venue.

For example, for large-in-scale orders in a specific equity, the policy might state that an SI will be considered as the primary venue to minimize market impact, provided the quoted price is within a certain tolerance of the prevailing price on the primary lit market. The policy must also disclose to clients that their orders may be executed outside a traditional trading venue, and you must obtain their prior express consent to do so.

The policy should establish a clear hierarchy of execution factors and explain how they are weighed in different scenarios. While price and cost are the primary determinants for retail clients, for institutional orders, factors like speed, likelihood of execution, and settlement finality can take on greater importance. An SI might offer a superior outcome on these non-price factors, particularly for illiquid assets or large orders where certainty of execution without information leakage is paramount. Your policy must codify this logic, creating a defensible rationale for your execution choices.

Systematic Venue Analysis and Selection

A core component of your strategy must be the continuous and systematic analysis of all available execution venues, including SIs. This goes beyond a simple pre-trade price check. It involves a holistic assessment of execution quality based on the data that venues are now required to publish under Regulatory Technical Standard (RTS) 27. SIs, like other venues, must report detailed quarterly data on price, costs, speed, and likelihood of execution for each financial instrument.

Your strategy should leverage this data to build a quantitative picture of each venue’s performance. This allows you to move from a subjective assessment to an evidence-based selection process. For instance, you can compare the average price improvement achieved on an SI versus an MTF for a particular stock, or analyze the execution speeds for different order sizes.

This analysis forms the bedrock of your obligation to monitor the effectiveness of your execution arrangements and to identify any deficiencies. If your analysis reveals that a particular SI consistently provides inferior outcomes compared to other available venues, you are obligated to adjust your execution policy and order routing logic accordingly.

Comparative Venue Characteristics

To effectively integrate SIs, it is essential to understand their distinct characteristics in relation to other venue types. The following table provides a strategic comparison:

How Does Technology Enable SI Strategy?

A sophisticated execution strategy is only as effective as the technology used to implement it. To properly integrate SIs, an asset manager’s Order Management System (OMS) and Execution Management System (EMS) must be equipped with a Smart Order Router (SOR). The SOR is the algorithmic engine that puts your execution policy into practice.

It must be configured to include SIs in its decision-making logic, capable of simultaneously requesting quotes from multiple SIs while also assessing the state of lit order books. The SOR’s algorithm should weigh the execution factors defined in your policy ▴ comparing the firm SI quote against the volume-weighted average price (VWAP) on the lit market, for example ▴ and route the order to the venue that offers the best possible outcome according to your predefined criteria.

Execution

The execution of a best execution policy that incorporates Systematic Internalisers is a continuous, data-intensive process. It moves beyond theoretical strategy into the domain of operational workflows, data analysis, and regulatory reporting. For an asset manager, this means establishing a robust operational playbook for interacting with SIs, monitoring their performance, and documenting the results to satisfy both client and regulatory obligations.

The Operational Playbook for SI Interaction

Executing orders via SIs requires a defined, step-by-step process that ensures compliance and optimal outcomes. This process should be embedded within the firm’s trading procedures.

1. Pre-Trade Analysis and Venue Selection
   • Order Assessment ▴ The portfolio manager or trader first assesses the characteristics of the order (instrument, size, liquidity profile, urgency). For orders identified as potentially suitable for SI execution (e.g. large-in-scale or illiquid), the SI interaction protocol is initiated.
   • Data-Driven Venue Shortlisting ▴ Using internal TCA data and the public RTS 27 reports, the trading desk maintains a ranked list of preferred execution venues, including SIs, for different instrument classes. The Smart Order Router (SOR) is configured with this logic.
   • Request for Quote (RFQ) Process ▴ The SOR sends out RFQs to a selection of appropriate SIs. To avoid information leakage, this is often done sequentially or to a limited number of SIs simultaneously. The system concurrently monitors the live prices on lit markets.
2. Trade Execution and Capture
   • Quote Evaluation ▴ The system aggregates the quotes received from SIs. The SOR’s algorithm compares these quotes against each other and against the prices available on lit venues, taking into account all relevant execution factors (price, size, likelihood of fill). The decision logic must be programmed to align perfectly with the firm’s execution policy.
   • Execution and Confirmation ▴ The trader or the automated system executes against the best available quote. A confirmation is received from the SI, and the trade details are captured in the Order Management System (OMS).
   • Timestamping ▴ Every step of this process, from order receipt to execution, must be timestamped with high precision. This is a critical requirement for post-trade analysis and regulatory scrutiny.
3. Post-Trade Monitoring and Reporting
   • TCA Integration ▴ The execution data is fed into the firm’s Transaction Cost Analysis system. The analysis compares the execution price against relevant benchmarks (e.g. arrival price, VWAP) to quantify the quality of the execution.
   • Regular Policy Review ▴ The aggregated TCA results are used to conduct the mandatory regular review of the execution policy and venue performance. If an SI consistently underperforms, it must be flagged, and the SOR’s logic must be adjusted.
   • RTS 28 Reporting ▴ The execution data, including trades conducted with SIs, forms the basis for the firm’s annual RTS 28 report, which discloses the top five execution venues used for each class of financial instrument.

Quantitative Modeling and Data Analysis

The obligation to monitor execution quality necessitates a quantitative approach. Asset managers must ingest and analyze the RTS 27 reports published by SIs and other venues. These reports provide a standardized dataset for comparing venue performance. The table below illustrates a simplified selection of data points an asset manager would extract from an SI’s RTS 27 report for a specific equity instrument.

Sample RTS 27 Data Analysis for an SI

This quantitative analysis feeds directly into the asset manager’s own reporting obligations. The annual RTS 28 report requires firms to summarize the quality of execution obtained from their top venues. The ability to produce a detailed, evidence-backed summary is the ultimate demonstration of compliance with the best execution obligation. It shows regulators and clients that the firm has a systematic process for making and evaluating its execution decisions, with the SI regime fully integrated into this framework.

Demonstrating best execution in the SI regime is achieved through a rigorous, data-driven feedback loop connecting policy, execution, and analysis.

What Is the Ultimate Test of the SI Framework?

The ultimate test of an asset manager’s execution framework is its ability to dynamically adapt. The market is not static, and the performance of different venues, including SIs, will change over time. A robust execution system must continuously ingest new data, re-evaluate venue rankings, and adjust order routing logic accordingly. The integration of SIs into the best execution process is therefore a commitment to building a learning system ▴ one that constantly refines its approach based on empirical evidence to fulfill its core fiduciary duty.

Reflection

The integration of the Systematic Internaliser regime into your firm’s operational architecture is a mandate for systemic evolution. The data streams from RTS 27 reports and the disclosure requirements of RTS 28 are components of a larger feedback mechanism. How does your current framework process this flow of information? Does it merely satisfy a reporting requirement, or does it actively inform and refine your execution logic in real time?

The regulations provide the raw material; the decisive edge is forged in the sophistication of the analytical engine you build to interpret it. The ultimate question is whether your firm views this landscape as a series of compliance hurdles or as an opportunity to construct a superior execution system, one that transforms regulatory data into a source of demonstrable and repeatable performance for your clients.