How Does the SI Regime Affect Best Execution Obligations for Buy-Side Firms?

Concept

The New Nexus of Liquidity and Obligation

The introduction of the Systematic Internaliser (SI) regime under MiFID II represents a fundamental recalibration of the European liquidity landscape. It is a structural intervention designed to cast light on previously opaque over-the-counter (OTC) trading flows, particularly in non-equity instruments. For a buy-side firm, this is not a distant regulatory nuance; it is a direct alteration of the environment in which the fiduciary duty of best execution must be met.

The regime compels certain investment firms, based on quantitative thresholds of their principal trading activity, to formalize their internalisation practices. These firms become SIs, a distinct category of execution counterparty that operates outside the traditional confines of a lit exchange or Multilateral Trading Facility (MTF), yet with newfound transparency obligations.

This development directly intersects with the buy-side’s mandate to achieve the best possible result for its clients. Best execution is a holistic concept, encompassing not just price, but also costs, speed, likelihood of execution, and any other relevant consideration. The emergence of SIs introduces a new, significant liquidity channel that cannot be ignored. A buy-side desk’s execution policy must now account for this source, integrating SIs into its venue analysis and counterparty selection framework.

The core challenge lies in understanding that SIs are not simply another broker; they are principal liquidity providers whose own business models and regulatory duties create a unique set of opportunities and challenges for the asset manager. Effectively, the SI regime forces a re-evaluation of how liquidity is sourced and how execution quality is defined and evidenced.

Defining the Systematic Internaliser Framework

A Systematic Internaliser is an investment firm that executes client orders on its own account on an “organised, frequent and systematic, and substantial basis” outside of a regulated trading venue. MiFID II replaced ambiguous definitions with quantitative thresholds to determine SI status for specific instruments, compelling many large sell-side institutions to register. The primary goal was to increase pre-trade transparency in markets, like corporate bonds, that were historically dominated by bilateral, off-venue trading. Consequently, SIs are required to publish firm quotes for liquid instruments, making their pricing accessible in a way that informal OTC trading was not.

For the buy-side, the key operational characteristics of an SI are twofold:

• Principal Liquidity ▴ When a buy-side firm trades with an SI, it is trading directly against the SI’s own capital. The SI is the counterparty, not an agent routing an order elsewhere. This can lead to benefits like access to unique inventory and the potential for reduced market impact.
• Reporting Obligation ▴ The SI is responsible for the post-trade reporting of the transaction. This alleviates a significant operational burden from the buy-side firm, simplifying its own compliance workflow and reducing the potential for reporting errors. This delegation of reporting makes transacting with an SI an attractive proposition from a purely administrative standpoint.

The SI regime transforms principal liquidity from an opaque source into a structured, transparent channel that buy-side firms are obligated to consider within their best execution framework.

Understanding this dual nature ▴ a source of principal risk transfer combined with a simplified reporting pathway ▴ is the foundational step for any buy-side firm seeking to navigate the post-MiFID II execution landscape. The decision to route an order to an SI becomes a calculated choice with direct implications for both execution quality and operational efficiency.

Strategy

Integrating SIs into the Execution Policy

The existence of Systematic Internalisers necessitates a formal update to a buy-side firm’s best execution policy. It is insufficient to simply acknowledge their presence; the policy must articulate a clear strategy for how, when, and why SI liquidity will be accessed. This requires moving beyond a static, venue-centric view of the market towards a more dynamic, counterparty-aware model. The buy-side firm must demonstrate that it has considered the full spectrum of execution factors when choosing an SI, just as it would for a lit market or an MTF.

A robust strategy involves establishing a framework for evaluating SIs based on the overarching principles of best execution. This means assessing them not only on the quoted price but also on the quality of their liquidity and the certainty of execution. The firm’s execution policy should detail the methodology for this evaluation, including the quantitative metrics and qualitative factors that will be used.

For instance, the policy might specify criteria for including a particular bank’s SI in the firm’s routing logic, based on its historical performance in specific asset classes or its specialization in certain types of instruments. This creates a defensible, evidence-based approach to counterparty selection that satisfies regulatory scrutiny.

Comparative Venue Analysis

The strategic challenge for the buy-side is to determine where SIs fit within their hierarchy of liquidity sources. This requires a comparative analysis against other available execution channels. Each venue type offers a different combination of transparency, cost, and market impact, and the optimal choice depends on the specific characteristics of the order (e.g. size, liquidity profile of the instrument, urgency).

The Strategic Use of SI Liquidity

Effectively leveraging the SI regime goes beyond mere compliance. It involves strategically directing order flow to SIs in situations where they offer a tangible advantage. For large orders in liquid instruments, an SI may provide significant price improvement over the public quote on a lit exchange, as they can internalize the flow without incurring exchange fees or creating market impact. For less liquid instruments, an SI that specializes in a particular sector may be the only reliable source of liquidity, making them an essential counterparty.

A sophisticated buy-side strategy treats SI selection not as a reporting convenience, but as a deliberate tool for optimizing execution outcomes based on order-specific needs.

This strategic approach requires a feedback loop between execution and analysis. The data gathered from trading with SIs must be rigorously analyzed through Transaction Cost Analysis (TCA) to validate their performance. This analysis should not be confined to simple price comparisons. It must also evaluate factors like rejection rates, speed of response, and the stability of quotes under different market conditions.

This data-driven process allows the firm to refine its routing logic over time, favoring SIs that consistently deliver superior execution quality and phasing out those that do not. The result is a living execution policy that adapts to the evolving liquidity landscape and continuously seeks to improve client outcomes.

Execution

Operationalizing SI Interaction

The practical execution of an SI-inclusive strategy requires significant operational and technological adjustments within the buy-side firm. The firm’s Execution Management System (EMS) and Order Management System (OMS) must be configured to properly identify, route to, and process fills from SIs. This is a non-trivial task, as SI status is instrument-specific and can change over time.

The system must have access to a reliable and up-to-date source of data identifying which counterparties are SIs for which instruments. Without this foundational data architecture, the firm cannot systematically incorporate SIs into its automated routing logic or even accurately fulfill its own oversight obligations.

The execution workflow itself must be adapted. For voice-traded orders, traders need clear protocols on when to solicit quotes from SIs. For automated flows, the firm’s Smart Order Router (SOR) logic must be enhanced.

The SOR can no longer simply prioritize lit venues; it must be capable of pinging SIs for quotes and intelligently comparing those responses against the lit market price, MTF prices, and other available liquidity sources in real-time. This comparison must account for the full range of best execution factors, including the implicit cost of potential market impact on a lit venue versus the certainty of a fill at a firm price from an SI.

A Procedural Framework for SI Onboarding and Review

A systematic process for evaluating and monitoring SI counterparties is a cornerstone of defensible best execution. This process should be formalized and documented.

1. Initial Due Diligence ▴ Before routing any order flow, the firm must conduct due diligence on the potential SI counterparty. This includes reviewing the SI’s public best execution policy (their RTS 28 report), understanding their pricing methodology, and assessing their technological capabilities for providing quotes and receiving orders.
2. Connectivity and Workflow Integration ▴ The firm must establish the necessary technical connectivity, whether through direct FIX protocol links or via a third-party network. Workflows must be tested to ensure the seamless passage of orders and execution reports between the buy-side OMS/EMS and the SI’s systems.
3. Quantitative Performance Baselining ▴ A baseline for performance must be established. For a new SI relationship, this might involve a trial period with non-critical order flow. The results are measured against the firm’s existing execution benchmarks to provide an initial assessment of the SI’s value proposition.
4. Continuous Monitoring via TCA ▴ Once onboarded, every execution with the SI must be captured and analyzed within the firm’s Transaction Cost Analysis framework. This is the most critical step for ongoing oversight and for satisfying the best execution mandate.
5. Periodic Formal Review ▴ On a regular basis (e.g. quarterly), the firm’s trading and compliance functions should conduct a formal review of each SI relationship. This review synthesizes the quantitative TCA data with qualitative feedback from traders to make a holistic assessment of the SI’s performance.

Transaction Cost Analysis in the SI Context

Transaction Cost Analysis (TCA) is the primary tool through which a buy-side firm can prove it is meeting its best execution obligations when using SIs. The analysis must be sufficiently granular to compare SI execution quality against other venues. This involves capturing a rich set of data points for every order.

By systematically tracking these metrics, a buy-side firm can build a detailed, quantitative picture of each SI’s performance. This data provides the evidence needed to justify routing decisions to regulators and clients. It also creates a powerful feedback loop, enabling the firm to dynamically adjust its execution strategy, reward high-performing SIs with more flow, and ultimately fulfill its fiduciary duty to achieve the best possible outcome for every trade. The fragmentation of liquidity caused by the SI regime is a challenge, but for the prepared firm, it is also an opportunity to leverage new data and technology to achieve a higher standard of execution.

Reflection

Beyond Compliance a New Execution Philosophy

Integrating Systematic Internalisers into a best execution framework is ultimately an exercise in systems thinking. The regulatory mandate to consider this liquidity source compels a buy-side firm to look beyond the immediate transaction and examine the architecture of its entire execution process. It requires an honest assessment of existing data capabilities, technological infrastructure, and the analytical rigor of its oversight functions. The questions raised by the SI regime ▴ how do we define execution quality, how do we measure it across disparate liquidity pools, and how do we create a defensible, data-driven process for every order ▴ are the fundamental questions of modern institutional trading.

Viewing the SI regime as merely a compliance burden is a strategic error. It is a catalyst. It forces the evolution from a static, policy-based approach to a dynamic, evidence-based system of continuous improvement.

The firm that successfully adapts is one that builds a robust feedback loop between trading, data analysis, and strategy, transforming a regulatory requirement into a source of competitive advantage. The ultimate goal is an operational framework where every execution decision is a conscious choice, optimized not just for a single trade, but for the long-term performance of the entire investment process.