How Does the SI Regime Impact Liquidity on Public Exchanges? ▴ Question

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Concept

The Systematic Internaliser (SI) regime represents a fundamental re-architecture of European market structure, introduced under the Markets in Financial Instruments Directive II (MiFID II). Its core function is to impose a regulatory framework on investment firms that deal on their own account by executing client orders outside of traditional regulated markets or multilateral trading facilities (MTFs). You have likely observed its effects directly through shifts in execution quality, counterparty availability, and the very texture of liquidity across public exchanges.

The regime was designed to formalize and increase the transparency of what was previously a vast, opaque ocean of over-the-counter (OTC) trading. It achieves this by defining a specific type of market participant, the SI, which internalizes client order flow, acting as the direct counterparty to the trade using its own capital.

This architectural intervention has a direct and systemic consequence on the public exchange model. Central limit order books (CLOBs) on public exchanges thrive on a diversity of continuous, anonymous order flow, which is the raw material for price discovery. The SI regime establishes a parallel, semi-transparent system where significant volumes of order flow, particularly from institutional clients, are diverted before they can ever reach the lit market.

An investment firm becomes an SI for a specific instrument when its dealing on own account is frequent, systematic, and substantial, crossing quantitative thresholds defined by the regulator. This creates a system where firms that were once primary contributors of flow to public venues now have a regulated, operationally distinct channel to absorb that flow internally.

The SI regime structurally alters market liquidity by sanctioning a high-volume, bilateral execution channel that operates in parallel to public exchanges, fundamentally changing order flow pathways.

The impact on liquidity is therefore a product of this systemic bifurcation. Liquidity is not necessarily destroyed, but it is displaced and its characteristics are altered. The flow that is internalized by an SI is typically less “toxic” or informed, as the SI has discretion over which clients it provides quotes to. This leaves the public exchanges to process a potentially higher concentration of aggressive, informed, or high-frequency orders, which can increase volatility and implicit trading costs for participants on the lit book.

The very nature of liquidity on public exchanges is therefore redefined by what is siphoned off into the SI ecosystem. Understanding this dynamic is the first principle in navigating the modern European execution landscape.

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Strategy

The introduction of the SI regime necessitates a deliberate and sophisticated strategic response from all market participants. For institutional investors, the primary challenge is navigating a fragmented liquidity landscape to achieve best execution. The choice of where to route an order is a complex optimization problem, balancing the benefits of potential price improvement and reduced market impact in an SI against the transparent price discovery of a public exchange. The decision-making calculus is a core element of modern trading strategy.

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Comparing Execution Venues

An institutional trader must weigh the distinct advantages and disadvantages inherent in each venue type. Public exchanges offer unparalleled pre-trade transparency through the central limit order book, while SIs provide a more curated and discreet execution environment. The strategic selection depends entirely on the specific objectives of the trade ▴ size, urgency, underlying security liquidity, and tolerance for information leakage.

Table 1 ▴ Strategic Comparison of Execution Venues
Parameter	Public Exchange (Lit CLOB)	Systematic Internaliser (SI)
Pre-Trade Transparency	High. Full depth of book is visible to all participants, facilitating public price discovery.	Limited. Only quotes up to a standard size are made public; larger quotes are disclosed bilaterally.
Price Discovery	Primary mechanism for establishing public reference prices through the interaction of diverse order flow.	Consumes reference prices from public exchanges. Contributes minimally to public price discovery.
Market Impact	High potential for market impact, especially for large orders that consume multiple levels of the order book.	Lower potential for immediate market impact, as the trade is executed off-book against the SI’s principal capital.
Information Leakage	High risk. Order details are public, signaling trading intent to all market participants.	Lower risk. Information is confined to the SI, though the SI itself gains valuable data from the client’s flow.
Execution Certainty	High for liquid securities. A marketable order will execute against the displayed liquidity.	Lower. SIs have discretion and are not obligated to trade, often retaining a “last look” option.

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The Strategic Calculus of Order Routing

A sophisticated trading desk develops a dynamic routing logic. For small, non-urgent orders in highly liquid stocks, the public exchange remains an efficient venue. For large block trades, the strategic imperative shifts toward minimizing information leakage.

Here, routing the order to a trusted Bank SI, which specializes in handling large volumes, becomes the superior strategy. Electronic Liquidity Provider (ELP) SIs, typically high-frequency trading firms, offer another strategic avenue, often providing competitive, automated quotes for smaller to medium-sized orders and contributing a different type of liquidity to the ecosystem.

Effective strategy in the SI era involves treating liquidity sourcing as a portfolio allocation problem, diversifying execution across venues to optimize for the specific risk parameters of each trade.

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What Is the Game Theory of SI Interaction?

The relationship between a client and an SI can be modeled using game theory. In a one-off transaction, the SI is incentivized to maximize its profit from that single trade, perhaps by using its ‘last look’ privilege to its advantage. The client, knowing this, may only send a small portion of the total order to test the SI’s pricing. In a repeated relationship, the incentives shift.

The SI is motivated to provide consistently good execution to ensure it continues to see the client’s valuable order flow. The client, in turn, is incentivized to concentrate more of its flow with SIs that prove to be reliable counterparties. This creates a long-term equilibrium where trust and reputation become critical components of the execution strategy.

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Execution

The execution phase is where the systemic impact of the SI regime becomes tangible. The operational mechanics of interacting with SIs and the quantitative realities of their market share reveal a complex and fragmented liquidity landscape. An examination of the data shows that while SIs have become major execution venues, their contribution to the market’s pre-trade transparency is disproportionately small, which has profound implications for how liquidity is accessed and how public price discovery functions.

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Quantitative Reality of SI Market Share

The SI regime has successfully moved a substantial portion of trading volume away from lit exchanges. Analysis of market data, for instance from the French equity market, shows a clear picture. SIs are composed of two primary groups ▴ Investment Banks (Bank SIs) and high-frequency traders (Electronic Liquidity Providers or ELP SIs). Bank SIs tend to handle larger, often voice-brokered trades and account for the majority of SI volume, while ELP SIs provide more automated, continuous quoting.

Bank SIs ▴ These entities account for the lion’s share of SI volumes, approximately 76% in the observed French market. Their model is often relationship-based, specializing in large block trades for institutional clients.
ELP SIs ▴ These high-frequency trading firms make up the remaining 24% of SI volume. Their strength lies in algorithmic pricing and execution speed, competing for more standardized order flow.

This division of volume shows that the SI regime has created distinct channels even within the off-exchange ecosystem, requiring execution desks to build relationships and technological integrations with multiple types of SIs.

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The Transparency Paradox

A core objective of MiFID II was to enhance market transparency. However, the execution data from SIs presents a paradox. While SIs are required to publish firm quotes for liquid instruments, these obligations apply only up to a certain size (Standard Market Size). A vast majority of the actual traded volume occurs under waivers that do not require pre-trade transparency.

Execution data reveals that over three-quarters of SI trading volume is not subject to pre-trade transparency requirements, limiting the regime’s contribution to public price discovery.

Studies have shown that transactions subject to pre-trade transparency rules may represent as little as 22% of the total value traded on SIs. This means that approximately 78% of the volume executed by these major market players is invisible to the public market before it trades. This opacity directly impacts liquidity on public exchanges by starving them of the order flow information that underpins robust price formation.

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How Does the Tick Size Regime Alter Execution?

The execution calculus was further altered by the extension of the MiFID II tick size regime to SIs. This rule mandates minimum price increments for quotes, harmonizing them with public exchanges. Before this, SIs could attract order flow by offering marginal price improvement ▴ quoting at a price increment smaller than the minimum tick size on the lit market. For example, they could execute a trade at a fraction of a cent better than the best bid or offer on the exchange.

The data below illustrates the significance of this practice. A substantial portion of the price improvement offered by SIs was smaller than the standard tick size.

Table 2 ▴ Impact of Tick Size Harmonization on SI Price Improvement
Metric	Value / Observation	Execution Implication
Trades with Price Improvement	Approximately 46% of SI trades within the spread offered price improvement.	SIs were a significant source of marginal price improvement for clients.
Non-Compliant Price Improvement	An estimated 43% of these improved prices would not have been compliant with the harmonized tick size regime.	The regime eliminated a key competitive advantage for SIs, forcing them to compete on other factors like size and certainty of execution.
Total Volume Affected	Nearly 40% of total SI volume was traded at prices that would become non-compliant.	This forces a significant change in SI quoting behavior and may redirect some order flow back to lit markets if price is the only consideration.

By enforcing the same tick size on SIs as on public exchanges, regulators removed a primary mechanism SIs used to attract order flow. This levels the playing field on price increments, forcing SIs to compete on other vectors like depth of liquidity and reduced market impact, and potentially making lit market quotes more attractive for certain orders.

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References

Fischer, A. & Murphy, D. (2017). MiFID II and the relationship between public markets and systematic internalisers. Journal of Securities Operations & Custody, 9(4), 334-340.
Autorité des marchés financiers (AMF). (2020). quantifying systematic internalisers’ activity ▴ their share in the equity market structure and role.
Instinet. (2017). The Impacts of a New Liquidity Paradigm.
International Financial Law Review. (2018). Mifid II ▴ how systematic internalisers threaten liquidity.
BaFin. (2017). Systematic internalisers ▴ Main points of the new supervisory regime under MiFID II.

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Reflection

The integration of the Systematic Internaliser regime into the market’s core operating system is a permanent architectural feature. The data and mechanics show a clear diversion of substantial liquidity from public venues into bilateral, semi-transparent channels. This requires a recalibration of how we define and source liquidity. The critical question for your operational framework is whether your execution protocols and technology are configured to recognize this fragmented reality.

Are your systems built to dynamically route orders based on a multi-factor analysis that includes counterparty behavior, information risk, and the quantitative realities of SI quoting? Viewing the market as a single, unified pool of liquidity is a legacy perspective. A superior operational edge is now found in mastering the complex routing logic required to navigate this bifurcated structure and access liquidity wherever it resides.