How Does the SI Tick Size Regime Alter Competition with Exchanges?

Concept

The architecture of modern financial markets is a system of interconnected protocols, each governing a fundamental aspect of interaction. When we analyze the competitive dynamics between Systematic Internalisers (SIs) and traditional exchanges, we are observing the direct consequence of a single, critical protocol adjustment ▴ the tick size regime. To grasp its impact, one must view tick size as more than a minimum price increment; it is the foundational quantum of price competition. It defines the smallest possible unit of price improvement a venue can offer, thereby shaping the very pathways that order flow will follow.

Initially, the Markets in Financial Instruments Directive II (MiFID II) imposed a harmonized tick size regime on lit trading venues like the major stock exchanges. This was a deliberate architectural choice designed to standardize price steps, promote orderliness, and prevent a destructive “race to the bottom” where venues would compete by offering infinitesimally small price increments, potentially degrading market stability. SIs, however, were initially positioned outside the direct application of this specific protocol.

An SI operates on a bilateral basis, using its own capital to execute client orders. Its mandate under MiFID II was to provide quotes that reflected “prevailing market conditions,” a less rigid standard than the tick size grid imposed on exchanges.

The core of the competitive alteration stems from a regulatory asymmetry where one venue type was bound to discrete price steps while the other could operate in the continuum between those steps.

This regulatory delta created a significant competitive vector. An SI could offer a price that was, for instance, a fraction of a cent better than the best bid or offer on a lit exchange. For a broker-dealer with a best execution mandate, routing an order to an SI to capture this marginal, sub-tick price improvement was not just an option; it was a fiduciary obligation. This capability allowed SIs to attract a substantial volume of order flow, particularly for liquid stocks where even fractional price improvements are meaningful when aggregated over millions of trades.

Exchanges, bound by the tick size protocol, were structurally incapable of competing on this specific dimension. They could not match the SI’s sub-tick price; they could only offer the next valid price tick, which was inherently inferior.

The Architectural Imbalance

This situation created a fundamental imbalance in the market’s architecture. Exchanges argued that this amounted to an unfair competitive advantage, allowing SIs to systematically peel off uninformed, profitable order flow while contributing less to the centralized price discovery process that occurs on a lit order book. The price discovery on an exchange is a public good, generated by the interaction of diverse orders within the constraints of price-time priority.

The SI model, by internalizing flow, benefits from this public price signal without fully contributing to its formation. The ability to price-improve at a sub-tick level was the primary mechanism enabling this internalization, fundamentally altering the competitive landscape away from the central lit venues.

Strategy

The strategic implications of the differential tick size treatment were profound, creating distinct operational playbooks for SIs, exchanges, and institutional traders. The subsequent harmonization, which subjected SIs to the same tick size constraints as exchanges, represented a system-wide recalibration, forcing a new set of strategic considerations for all participants. Understanding this shift is key to mastering modern execution.

Strategic Playbooks under Regulatory Asymmetry

Before the regime was extended to SIs, the strategies were clear and predicated on exploiting the regulatory gap.

• Systematic Internalisers ▴ The core strategy was one of regulatory arbitrage. SIs engineered their systems to ingest real-time price feeds from lit markets and offer quotes at a microscopic improvement. Their value proposition to brokers was simple and powerful ▴ send us your flow, and we will provide a better price than the public exchange, guaranteeing compliance with your best execution mandate. This allowed them to internalize the most valuable order flow ▴ non-toxic, uninformed trades ▴ while avoiding the risks associated with adverse selection on a central limit order book.
• Exchanges ▴ The strategic position of exchanges was defensive. They focused on advocating for regulatory change, arguing that the flight of volume to SIs was damaging the quality of public price discovery and creating a two-tiered market. Operationally, their strategy was to highlight other competitive advantages, such as the transparency of a central order book and the robustness of their market model, while contending with declining market share in certain segments.
• Institutional Traders and Brokers ▴ For the buy-side and their brokers, the strategy was one of optimization. Best execution frameworks were configured to systematically check SI quotes against lit market prices. Smart order routers were programmed to default to SIs for any order where sub-tick price improvement was available. This was a rational, micro-level optimization that, in aggregate, drove the macro-level shift in liquidity.

Recalibration the New Strategic Imperative

The decision by European regulators to extend the tick size regime to SIs, effective from 2020, was a direct intervention to re-level the competitive field. By mandating that SI quotes adhere to the same minimum price increments as exchanges, the primary vector of their competitive advantage was neutralized. This forced a strategic realignment across the board.

With sub-tick price improvement nullified as a competitive tool, the strategic calculus for venue selection shifted towards execution certainty, market impact, and specialized liquidity access.

The table below outlines the shift in competitive dynamics.

What Is the New Basis for SI Competition?

Post-harmonization, SIs must compete on a different set of factors. Their strategic focus has shifted towards leveraging their inherent structural advantages. They can still offer a guaranteed execution at the prevailing quote, which is valuable in fast-moving markets.

For orders larger than the standard market size, they can provide liquidity with potentially less market impact than if a similar order were placed on a lit book. The competition has moved from a simple, price-based algorithm to a more nuanced, qualitative assessment of execution quality.

Execution

The execution of an order is the final, decisive act in a trading strategy. The application of the tick size regime to Systematic Internalisers was not merely a change in regulation; it was a fundamental rewrite of the execution protocols for a significant portion of the European equity market. For an institutional trader or a best execution committee, the operational calculus for venue selection has been irrevocably altered.

The Mechanics of the Tick Size Protocol

To understand the execution shift, one must first understand the protocol itself. The MiFID II tick size regime, detailed in Regulatory Technical Standard (RTS) 11, is not a single value. It is a dynamic grid that assigns a specific minimum price increment based on a security’s price and liquidity profile. The liquidity is measured by the average daily number of transactions (ADNT) on the most relevant market, typically the primary exchange.

The system is designed so that highly liquid, low-priced stocks have very small tick sizes (e.g. €0.0001), while illiquid, high-priced stocks have much larger ticks (e.g. €0.50).

This granular, data-driven approach ensures the protocol is adapted to the specific characteristics of each instrument. When this grid was extended to SIs, it meant their quoting engines had to be re-architected to snap to these specific, pre-defined price points, eliminating the ability to quote in the spaces between.

The operational reality is that a key variable in the best execution algorithm ▴ sub-tick price improvement ▴ was set to zero, forcing other variables to the forefront of the decision-making process.

How Does This Alter the Best Execution Decision?

A best execution committee’s function is to build a systematic process for achieving the best possible result for a client, considering not just price but also costs, speed, likelihood of execution, and size. The change in the SI tick size regime directly impacts this multi-factor analysis.

The following table models the decision matrix for a best execution framework when routing a moderately sized order (e.g. above retail size but below block size) in a liquid stock, comparing the choice between a lit exchange and an SI after the tick size harmonization.

The research into the aftermath of the June 2020 implementation on Nasdaq Stockholm provides a critical data point. The study found that after SIs were forced to comply with the tick size regime, market quality on the lit exchange actually worsened, with wider spreads and a higher price impact for trades. The interpretation is that impatient, potentially more informed traders, who could no longer get sub-tick avoidance of price-time priority at SIs, may have rerouted their orders back to the lit market.

This influx of more aggressive flow, in turn, made market-making on the exchange riskier, causing liquidity providers to widen their quotes. This illustrates the deep, systemic interconnectedness of market structure; a change designed to level the playing field in one area had counterintuitive and complex effects on the broader system.

Reflection

The chronicle of the Systematic Internaliser tick size regime serves as a powerful case study in financial engineering. It demonstrates that a market is not a monolithic entity, but a complex system of interlocking protocols. A single parameter adjustment, seemingly minor, can trigger a cascade of strategic realignments and unforeseen consequences. The harmonization of tick sizes closed one avenue of competition only to intensify others, shifting the battleground from raw price to the more nuanced domains of market impact and execution certainty.

Evaluating Your Execution Architecture

This prompts a critical examination of one’s own operational framework. Is your execution logic sufficiently dynamic to adapt to such regulatory recalibrations? Does your venue analysis move beyond the surface level of price to model the deeper, more complex variables of information leakage and adverse selection? The ultimate strategic edge lies not in exploiting a temporary loophole, but in building a resilient and intelligent execution architecture that can maintain its effectiveness as the very ground rules of the market are rewritten.