How Does the Si Regime Alter 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) fundamentally re-calibrated the operational environment for asset managers. It was a deliberate architectural intervention designed to bring a significant volume of over-the-counter (OTC) trading into a more transparent framework. For an asset manager, whose core fiduciary duty is to secure the best possible outcome for client orders, this was not a minor adjustment. It represented the formalization of a new type of execution venue that could not be ignored.

An SI is an investment firm that deals on its own account by executing client orders outside of a regulated market or multilateral trading facility (MTF) on an organized, frequent, and systematic basis. This process effectively brings principal trading, where the firm acts as the counterparty to its client, under a specific set of regulatory requirements.

The existence of the SI regime directly intersects with an asset manager’s best execution obligations. The directive compels firms to take all sufficient steps to obtain the best possible result for their clients, considering factors like price, cost, speed, and likelihood of execution. Prior to the SI framework, a bilateral trade with a bank’s trading desk was a purely OTC transaction. With the introduction of the SI regime, that same bank, if it meets certain quantitative thresholds for the volume of its principal trading activity, is classified as an execution venue.

This classification carries significant implications. It means an asset manager’s best execution policy must explicitly acknowledge SIs as a distinct category of venue and articulate the conditions under which trading with an SI is consistent with their overarching duty to their clients.

This shift compels the asset manager to move from a relationship-driven model of OTC trading to a data-driven, systematic evaluation of a new class of liquidity provider. The SI is not merely another counterparty; it is a formal part of the market structure. Consequently, the asset manager’s process for demonstrating compliance with best execution has to evolve.

It requires a framework for comparing the quality of execution available from an SI against the prices and liquidity available on traditional lit exchanges and MTFs. The core challenge introduced by the SI regime is the integration of this formalized, principal-trading liquidity source into a rigorous, evidence-based best execution framework that can withstand regulatory scrutiny.

Strategy

Recalibrating the Execution Policy

The primary strategic response for any asset manager to the SI regime is the comprehensive overhaul of their order execution policy. This document is the foundational text that governs how a firm achieves and demonstrates best execution. With the introduction of SIs, this policy must be updated to explicitly recognize SIs as a legitimate and distinct execution venue category. This involves more than simply adding a new definition.

The policy needs to articulate the specific circumstances under which routing an order to an SI is deemed to provide the best possible result for a client. This requires a detailed analysis of the asset classes in which the firm is active and an identification of the SIs that are relevant for those instruments.

The updated policy must detail the factors that will be considered when selecting an SI for a particular trade. These factors extend beyond the simple quoted price and must include an assessment of the likelihood of execution, the potential for price improvement, and the costs associated with the transaction. For example, for a large block trade in a corporate bond, an SI might offer a competitive price with a high certainty of execution, minimizing the market impact that would occur if the order were placed on a lit exchange. The execution policy must provide a clear rationale for making such a determination and must be supported by empirical data.

The SI regime necessitates that asset managers evolve their best execution policies from a simple venue list to a dynamic framework for evaluating principal liquidity sources.

Data and Analytics the New Foundation

A critical component of any strategy involving SIs is the enhancement of data and analytics capabilities, particularly in the realm of Transaction Cost Analysis (TCA). To satisfy the best execution obligation, an asset manager must be able to prove that the execution obtained from an SI was competitive. This requires the ability to compare the SI’s quoted price against a range of benchmarks at the time of the trade. These benchmarks could include the prevailing price on lit markets, the prices quoted by other SIs, and the prices available on various MTFs.

This necessitates a robust data infrastructure capable of capturing and analyzing high-frequency market data from multiple sources. The asset manager’s TCA process must be adapted to incorporate executions with SIs and to generate reports that clearly demonstrate the quality of execution achieved. These reports are not just for internal review; they are a key piece of evidence for demonstrating compliance to both clients and regulators. The ability to produce detailed, data-rich reports that justify the use of an SI is a cornerstone of a successful strategy in the MiFID II environment.

Comparative Analysis of Execution Venues

The decision to route an order to an SI, a lit market, or an MTF is a complex one that depends on the specific characteristics of the order and the prevailing market conditions. Asset managers must develop a systematic approach for making this decision. This often involves the use of a Smart Order Router (SOR) that is programmed with the firm’s execution policy and is capable of dynamically selecting the optimal venue for each trade. The logic underpinning the SOR must be carefully designed and regularly reviewed to ensure that it is aligned with the firm’s best execution obligations.

• Lit Markets ▴ These venues, such as traditional stock exchanges, offer a high degree of pre-trade transparency. They are generally well-suited for smaller, more liquid orders where market impact is less of a concern.
• Multilateral Trading Facilities (MTFs) ▴ MTFs provide a platform for multiple parties to interact and trade. They can offer a deep pool of liquidity and are often used for a wide range of asset classes.
• Systematic Internalisers (SIs) ▴ SIs are ideal for larger orders or for instruments that are less liquid. They can provide price improvement and reduce market impact by allowing the asset manager to trade directly with a single counterparty.

Execution

Operationalizing SI Engagement

The practical execution of a strategy that includes SIs requires significant operational adjustments for an asset manager. The first step is to establish the necessary connectivity with the relevant SI venues. This may involve direct technical integration or leveraging the services of a third-party technology provider.

Once connectivity is established, the asset manager must ensure that their order management system (OMS) and execution management system (EMS) are configured to properly handle orders routed to SIs. This includes the ability to send and receive the required data messages and to track the status of orders throughout their lifecycle.

The firm’s trading desk procedures must also be updated to reflect the new execution options. Traders need to be trained on the specific characteristics of each SI venue and on the firm’s policies for when and how to use them. This includes understanding the quoting conventions of different SIs and the process for requesting and accepting quotes. The goal is to create a seamless workflow that allows traders to efficiently access SI liquidity while adhering to the firm’s best execution policies.

Effective execution in an SI environment hinges on the seamless integration of technology, data, and trader expertise.

The Mandate for Monitoring and Review

A crucial aspect of executing trades with SIs is the ongoing monitoring and review of execution quality. MiFID II requires firms to regularly assess the effectiveness of their execution arrangements and to make changes where necessary. For SIs, this means continuously evaluating the quality of the prices and liquidity they provide.

This involves a quantitative analysis of execution data, as well as a qualitative assessment of the SI’s performance. Asset managers must be prepared to challenge their SIs on the quality of their execution and to shift their order flow to other venues if an SI is consistently failing to provide competitive outcomes.

This monitoring process should be formalized and documented, with clear metrics for what constitutes good execution. The findings of these reviews should be used to refine the firm’s execution policy and to inform decisions about which SIs to include in their list of approved venues. This continuous feedback loop is essential for ensuring that the asset manager is consistently meeting its best execution obligations in a dynamic and evolving market environment.

1. Venue Selection ▴ The process begins with the identification of an order that may be suitable for execution with an SI. This is typically a large or illiquid order where minimizing market impact is a key consideration.
2. Quote Request ▴ The asset manager’s trader will then request a quote from one or more SIs. This is often done through an electronic platform that allows for the simultaneous solicitation of quotes from multiple venues.
3. Quote Evaluation ▴ Upon receiving the quotes, the trader will evaluate them against the prevailing market conditions and the firm’s best execution criteria. This includes comparing the quoted prices to the prices available on lit markets and other venues.
4. Order Execution ▴ If a quote is deemed to be competitive, the trader will accept it and the trade will be executed with the SI. The details of the trade are then captured in the asset manager’s systems for post-trade analysis.
5. Post-Trade Analysis ▴ The final step is a thorough post-trade analysis of the execution. This involves using TCA tools to measure the quality of the execution against a range of benchmarks and to generate a report that documents the findings.

Reflection

The integration of the Systematic Internaliser regime into the European market structure represents a fundamental shift in the landscape of execution. For asset managers, it has elevated the practice of best execution from a compliance exercise to a source of competitive advantage. The ability to effectively navigate this new environment, to source liquidity from SIs in a way that is both compliant and beneficial to clients, is a hallmark of a sophisticated investment operation.

The challenge is not simply to connect to these new venues, but to develop the analytical and operational capabilities to harness their potential. The question for every asset manager is whether their current framework is sufficiently robust to meet this challenge and to transform a regulatory obligation into a strategic asset.