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

Concept

The introduction of the Systematic Internaliser (SI) regime within the MiFID II framework represents a fundamental re-architecting of the European liquidity landscape. For the buy-side, this evolution transforms the best execution obligation from a compliance checklist into a continuous, data-driven analytical process. The core of this transformation lies in the need to understand and systematically integrate a new, highly structured form of bilateral liquidity into the firm’s execution operating system. The mandate is no longer simply to find the best price; it is to build and maintain a sophisticated execution framework that can demonstrably prove its effectiveness across a complex matrix of potential outcomes.

An SI is an investment firm that deals on its own account by executing client orders outside a regulated market or multilateral trading facility (MTF) on an organised, frequent, systematic, and substantial basis. The regime was designed to bring the vast, opaque world of over-the-counter (OTC) trading into a more transparent and structured framework. It requires these high-volume dealers to provide firm, pre-trade quotes for liquid instruments up to a standard market size and standardises their post-trade reporting duties. For the buy-side, this creates a new, visible, and highly reliable source of principal liquidity that must be incorporated into any credible best execution policy.

What Is the Core Shift in the Best Execution Mandate?

MiFID II extended the best execution mandate directly to the buy-side, compelling asset managers and other institutional investors to take complete ownership of their execution outcomes. This requires them to establish their own robust processes for achieving and evidencing the best possible result for their clients. The obligation is comprehensive, encompassing a range of execution factors that must be weighed and balanced based on the specific context of the order.

The SI regime compels a buy-side firm to evolve its best execution framework from a static policy into a dynamic, evidence-based system of venue analysis and selection.

The primary execution factors under MiFID II are:

• Price The price at which the transaction is executed.
• Costs All explicit and implicit expenses related to the execution, including venue fees, clearing and settlement costs, and the cost of trade reporting.
• Speed The velocity of execution, from order routing to confirmation.
• Likelihood of Execution and Settlement The certainty that the trade will be completed and settled successfully.
• Size and Nature of the Order The specific characteristics of the order, which may influence the choice of execution method to minimize market impact.
• Any other consideration A catch-all category that includes factors relevant to the order, such as counterparty risk or information leakage.

The SI regime directly impacts every one of these factors. It introduces a new set of trade-offs and opportunities that a buy-side firm must quantitatively assess. For instance, an SI quote might offer a competitive price, high certainty of execution, and low market impact, while also critically shifting the operational burden of trade reporting away from the buy-side firm.

This reporting delegation is a significant cost and operational efficiency consideration that directly feeds into the best execution calculation. Consequently, a firm’s execution policy must be sophisticated enough to model and compare these multifaceted outcomes across SIs, MTFs, regulated markets, and other liquidity sources.

Strategy

Strategically, integrating Systematic Internalisers into a buy-side execution framework requires a shift in perspective. SIs are a distinct class of execution venue, and their inclusion necessitates a formal, analytical approach to venue selection and performance monitoring. The buy-side firm must architect its strategy around two central pillars ▴ the development of a dynamic Order Execution Policy that explicitly accounts for SIs, and the implementation of a rigorous data analysis framework to justify execution decisions.

The core strategic challenge is to move beyond a static, venue-agnostic approach to one that actively differentiates between liquidity types and their inherent characteristics. This means treating SIs as a primary source of liquidity to be evaluated on a pre-trade basis for every relevant order, rather than as an alternative or secondary option. A firm’s strategy must be built on the principle that to achieve best execution, one must understand and access all material sources of liquidity, and the SI regime has made a significant portion of principal liquidity quantifiable and accessible.

Architecting the Order Execution Policy

The Order Execution Policy (OEP) is the foundational document that governs a firm’s approach. To effectively incorporate SIs, the OEP must be a living document that outlines the specific procedures for how and when SI liquidity will be accessed. This involves defining the criteria for routing orders and the analytical models used to compare potential outcomes.

Key strategic enhancements to the OEP include:

1. Formal SI Identification and Mapping The policy must detail the process for identifying which counterparties are SIs for specific asset classes or instruments. Since a firm can be an SI for one bond but not another, this requires a systematic process for tracking SI registrations and maintaining an internal map of SI capabilities.
2. Integration into Smart Order Routers (SORs) For firms utilizing automated execution, the SOR logic must be updated to include SIs as a destination. The routing strategy needs to be ableto ping SIs for quotes alongside broadcasting requests to MTFs, creating a unified view of available liquidity.
3. Pre-Trade Venue Analysis Logic The policy must specify the quantitative factors that will be used to decide the execution venue. This logic must weigh the firm quote from an SI against the indicative prices on other venues, factoring in differences in fees, the likelihood of execution, and the operational benefit of the SI assuming the trade reporting obligation.
4. RFQ Protocol Definition For larger or less liquid trades often handled via Request for Quote (RFQ), the OEP must define the protocol for including SIs in the query process. This ensures that their competitive quotes are systematically solicited and evaluated.

Data Analysis as the Engine of Best Execution

A defensible best execution strategy is built on data. The SI regime contributes to the available data pool through its pre- and post-trade transparency requirements. The buy-side’s strategy must be to harness this data to monitor execution quality and justify its choices. This involves both analyzing the data provided by execution venues (under RTS 27) and producing its own analysis of its top five venues (under RTS 28).

The strategic integration of SIs hinges on a firm’s ability to quantitatively prove, on an ongoing basis, that its venue selection process leads to superior outcomes for its clients.

The table below outlines a strategic comparison of execution venues, incorporating the unique attributes of an SI.

This comparative framework demonstrates that the decision to use an SI is a complex optimization problem. The potential for a better net price, combined with lower market impact and a significant reduction in operational overhead, makes the SI an essential component of a modern buy-side execution strategy. The firm’s ability to model these trade-offs and select the optimal venue on a case-by-case basis is the hallmark of a robust best execution process.

Execution

The execution of a best execution policy that properly incorporates Systematic Internalisers is a matter of precise operational engineering. It requires the build-out of specific workflows, quantitative models, and record-keeping systems that can withstand regulatory scrutiny. This section provides a detailed playbook for the operational implementation of an SI-aware best execution framework, focusing on the quantitative analysis required to make and defend venue selection decisions.

The Operational Playbook Integrating SIs

A buy-side firm must translate its strategy into a concrete set of operational procedures. This playbook outlines the critical steps for ensuring SIs are systematically and effectively integrated into the daily execution workflow.

1. Counterparty Management System Update The firm’s central counterparty database must be enhanced with a specific flag to identify a counterparty’s SI status for each relevant asset class. This system must be updated regularly based on notifications from sell-side partners and public registers.
2. Pre-Trade “Best Ex” Engine Development An analytical engine, either built in-house or integrated into an Execution Management System (EMS), must be configured. Before an order is routed, this engine should automatically:
   • Identify all potential execution venues, including relevant SIs from the counterparty system.
   • Send out RFQs to these SIs and other quote-based venues simultaneously.
   • Poll the order books of lit venues for comparison.
   • Normalize the prices and costs from all sources into a single “total consideration” metric.
   • Recommend the optimal execution route based on the OEP’s predefined logic.
3. Post-Trade Analysis and Monitoring A Transaction Cost Analysis (TCA) process must be established to continuously monitor the quality of executions from all venues, including SIs. This involves capturing detailed timestamps and comparing the execution price against relevant benchmarks (e.g. arrival price, VWAP). The results of this TCA must feed back into the pre-trade engine to refine its logic over time.
4. Compliance Reporting Automation The firm must develop systems to ingest RTS 27 reports from its execution venues and use this data to inform its own RTS 28 report. The system should be able to aggregate execution data by venue and demonstrate why certain venues, including SIs, were chosen.

Quantitative Modeling and Data Analysis

Demonstrating best execution is a quantitative exercise. A buy-side firm must be able to model and compare the total cost of execution across different venues. The following tables provide an example of the kind of granular analysis required.

Table 1 Quantitative Execution Quality Comparison

This table compares hypothetical execution metrics for a €5 million trade in a corporate bond across three venue types. This data is essential for the firm’s internal review processes and for its RTS 28 reporting.

Table 2 Total Cost Analysis Model

Building on the data above, a TCA model calculates the total cost, providing a single figure for comparing the venues. The formula is ▴ Total Cost = (Explicit Fees + Reporting Cost) + (Market Impact Cost + Slippage Cost).

This quantitative analysis demonstrates clearly how an SI can deliver the best possible result. While the price improvement is small, the combination of zero explicit fees and significantly lower market impact creates a superior outcome in terms of total cost. This is the level of granular, evidence-based analysis that the MiFID II regime demands from buy-side firms.

How Should a Firm Document Its SI Execution Decisions?

Rigorous record-keeping is the final pillar of a defensible execution framework. For every trade executed with an SI, especially those that are large or where the SI was chosen over a seemingly better lit-market price, the firm must be able to produce a record justifying the decision. This record should include:

• A snapshot of competing quotes Evidence of the quotes solicited from other venues at the time of the trade.
• A timestamped log of the decision process This includes the time the RFQ was sent, the time the quote was received, and the time the order was executed.
• The quantitative analysis A record of the TCA calculation or other pre-trade analysis that led to the choice of the SI.
• Qualitative justification Notes on non-price factors that were considered, such as the need to minimize market impact for a large, sensitive order, or the importance of execution certainty.

By implementing these operational procedures, quantitative models, and documentation standards, a buy-side firm can transform the challenge of the SI regime into a strategic advantage, building a best execution process that is not only compliant but also demonstrably superior.

Reflection

The integration of the Systematic Internaliser regime into the market’s architecture is more than a regulatory update; it is a catalyst for institutional evolution. It compels a firm to examine the very core of its execution operating system. The frameworks and models discussed here provide the technical specifications for compliance and optimization. The ultimate question, however, is how this new architecture integrates with the firm’s intellectual capital.

How does the data from this enhanced system inform the intuition of the trader? How does a provably superior execution framework empower the portfolio manager to take on new forms of risk? The true edge is found where quantitative rigor and human judgment connect, creating a system that is not just efficient, but intelligent.