How Does the Systematic Internaliser Regime for Bonds Differ from the Regime for Equities?

Concept

The architecture of the Systematic Internaliser (SI) regime under MiFID II presents a fascinating study in regulatory adaptation. At its core, the regime is designed to cast light on over-the-counter (OTC) or off-venue trading, bringing a greater degree of transparency and structure to this historically opaque area of the market. The fundamental premise is that when an investment firm deals on its own account by executing client orders outside of a regulated trading venue on an organized, frequent, systematic, and substantial basis, it functions in a manner akin to an exchange and should therefore be subject to specific transparency obligations. This principle applies to both equities and bonds, yet the practical application of the SI regime reveals a nuanced understanding of the inherent differences between these two asset classes.

For equities, the SI regime is a more mature construct, having been introduced in the original MiFID I back in 2007. The market structure for equities is characterized by a high degree of centralization, with continuous trading on lit venues and a greater volume of standardized products. This allows for a more straightforward application of pre-trade transparency rules, where SIs in liquid equities are required to provide firm quotes to their clients. The concept of a liquid market is also more easily defined and measured in the equities space, facilitating a more standardized approach to SI designation and obligations.

The Systematic Internaliser regime seeks to illuminate off-venue trading, but its application differs significantly between the highly standardized world of equities and the more bespoke, fragmented landscape of bond markets.

The extension of the SI regime to bonds under MiFID II acknowledges the significant volume of fixed-income trading that occurs off-venue. The bond market is fundamentally different from the equities market. It is more fragmented, with a vast universe of instruments, many of which trade infrequently. The concept of a “liquid market” for a specific bond is far more elusive than for a blue-chip stock.

This reality necessitates a more flexible and tailored approach to the SI regime for bonds. The pre-trade transparency obligations, for instance, are more accommodating of the request-for-quote (RFQ) market structure that predominates in bond trading.

What Are the Core Distinctions in SI Designation?

The process of becoming a Systematic Internaliser differs between equities and bonds primarily in the granularity of the assessment. For equities and equity-like instruments, the SI test is performed on an instrument-by-instrument basis. An investment firm must assess its trading activity in each individual stock to determine if it meets the “frequent, systematic, and substantial” thresholds. This granular approach is feasible due to the standardized nature of equity instruments and the availability of comprehensive trading data.

In contrast, for bonds, the SI assessment is conducted on a much broader level. The calculation is typically performed for a class of instruments rather than for each individual bond. This is a pragmatic concession to the sheer number of outstanding bond issues and the fact that many of them trade very infrequently. A bond-by-bond assessment would be impractical and would likely result in very few firms ever qualifying as SIs for specific bonds.

This distinction in the designation process has significant implications for the scope of a firm’s SI obligations. An SI in a class of bonds will have transparency requirements across a wider range of instruments than an SI in a single equity.

How Does Liquidity Determination Impact SI Obligations?

The concept of liquidity is a critical determinant of an SI’s obligations, and the methodologies for assessing liquidity differ markedly between equities and bonds. For equities, the determination of a liquid market is a relatively straightforward, data-driven process based on factors like the average daily number of trades and the average daily turnover. The European Securities and Markets Authority (ESMA) publishes data to help firms make this determination. SIs in liquid equities are subject to stringent pre-trade transparency requirements, including the obligation to make firm quotes public.

For bonds, the assessment of liquidity is a far more complex and nuanced affair. The vast and heterogeneous nature of the bond market means that a simple, one-size-fits-all approach to liquidity determination is unworkable. ESMA’s calculations for bond liquidity are based on a more sophisticated set of criteria, and the results often show that a large proportion of bonds are classified as illiquid. This has a direct impact on the SI regime’s application.

For illiquid bonds, the pre-trade transparency obligations for SIs are significantly relaxed. Instead of being required to publish firm quotes, SIs in illiquid bonds are typically only required to disclose quotes to clients upon request. This more flexible approach is designed to avoid damaging the fragile liquidity that exists in many parts of the bond market.

Strategy

The strategic implications of the Systematic Internaliser regime diverge significantly for firms operating in the equity and bond markets. For equity-focused firms, the SI regime is a well-defined component of the market structure. The decision to become an SI is often a strategic one, driven by a desire to internalize order flow and capture bid-ask spreads. The transparency obligations, while significant, are a known quantity, and firms have developed sophisticated systems and processes to manage them.

The primary strategic consideration for an equity SI is how to compete effectively with other SIs and with traditional trading venues. This often involves a focus on providing high-quality execution, tight spreads, and value-added services to clients.

For firms operating in the bond markets, the strategic landscape of the SI regime is more complex and less certain. The introduction of the SI regime for bonds under MiFID II was a more disruptive event, forcing firms to grapple with new and unfamiliar transparency requirements in a market that has traditionally valued discretion. The decision to become a bond SI is often less about actively seeking to internalize order flow and more about managing the regulatory consequences of existing business models.

Many large banks, by virtue of their market-making activities in bonds, find themselves designated as SIs by default. The key strategic challenge for these firms is how to comply with the SI obligations without undermining their ability to provide liquidity and manage risk in a complex and often illiquid market.

Strategically, equity SIs focus on competitive pricing and execution quality within a mature framework, while bond SIs navigate a more complex and nuanced environment where compliance with new transparency rules is a primary concern.

Comparative Analysis of SI Obligations

The following table provides a comparative overview of the key obligations for Systematic Internalisers in the equity and bond markets:

Strategic Responses to the SI Regime

The different characteristics of the equity and bond SI regimes have led to distinct strategic responses from market participants.

• Equity SIs have generally embraced the regime, developing sophisticated technological infrastructure to manage their quoting and reporting obligations. They often compete aggressively on price and execution speed, seeking to attract order flow from a wide range of clients. Some firms have also developed innovative solutions to provide clients with a more holistic view of liquidity across different SIs and trading venues.
• Bond SIs have adopted a more cautious and compliance-focused approach. Many firms have invested heavily in systems and controls to ensure they can meet the complex transparency requirements of the regime. However, there is also evidence that some firms have adjusted their trading behavior to avoid triggering the SI thresholds, particularly in less liquid bonds. The flexibility of the bond SI regime, such as the ability to provide quotes on request and the use of deferred publication, has been crucial in allowing firms to continue to provide liquidity in a challenging regulatory environment.

Execution

The execution of the Systematic Internaliser regime requires a deep understanding of the operational and technological challenges involved. For both equities and bonds, firms must have robust systems in place to monitor their trading activity, identify when they cross the SI thresholds, and comply with the relevant transparency obligations. However, the specific execution requirements differ significantly between the two asset classes, reflecting the underlying differences in their market structures.

For equities, the execution of the SI regime is a highly automated and data-intensive process. Firms must be able to process large volumes of market data in real-time to ensure their quotes are competitive and reflect prevailing market conditions. They also need sophisticated order management and smart order routing technology to effectively internalize order flow and manage their risk. The high degree of standardization in the equity market has facilitated the development of off-the-shelf solutions for SI compliance, although many larger firms have built their own proprietary systems.

Operationalizing the Bond SI Regime

The execution of the bond SI regime is a more manual and judgment-based process. The lack of a centralized, real-time source of pricing data for many bonds means that firms must rely on a combination of internal models, dealer quotes, and other sources of information to determine their quoting obligations. The request-for-quote nature of the bond market also requires a different set of workflows and technologies than the continuous order-driven market for equities. Firms need systems that can efficiently manage client quote requests, track their responses, and ensure compliance with the relevant transparency requirements.

The following table outlines some of the key execution considerations for firms operating as bond SIs:

What Are the Practical Challenges of Bond SI Implementation?

The implementation of the bond SI regime has presented a number of practical challenges for investment firms. One of the biggest challenges has been the interpretation of the rules themselves, which are often complex and open to different interpretations. The International Capital Market Association (ICMA) has played a key role in helping the industry to develop a common understanding of the rules and to share best practices for their implementation.

Another major challenge has been the cost and complexity of building the necessary systems and controls to comply with the regime. For many firms, this has required a significant investment in new technology and a major overhaul of existing processes. The ongoing nature of the SI assessment, which must be performed on a quarterly basis, also creates a significant operational burden for firms.

Finally, there is the ongoing challenge of managing the potential impact of the SI regime on market liquidity. While the regime is designed to increase transparency, there is a risk that it could also lead to a reduction in liquidity, particularly in less liquid bonds, if firms become reluctant to make markets due to the associated transparency obligations. The flexibility built into the bond SI regime, such as the use of deferred publication for large trades, is designed to mitigate this risk, but it remains a key concern for the industry.

Reflection

The dual application of the Systematic Internaliser regime across equities and bonds serves as a powerful illustration of a fundamental principle in market regulation ▴ the necessity of adapting standardized rules to the unique topographies of different asset classes. The differences in the SI regimes for these two markets are a direct reflection of their inherent structural dissimilarities. The equities market, with its high degree of standardization and centralized liquidity, can accommodate a more rigid and prescriptive regulatory framework. The bond market, with its vast and fragmented landscape, requires a more flexible and nuanced approach.

As you consider the implications of the SI regime for your own operations, it is worth reflecting on the broader lessons that can be drawn from this example. How does your own firm’s operational framework account for the unique characteristics of the different markets in which you operate? Do you have the necessary systems and controls in place to not only comply with the letter of the law but also to thrive in a complex and evolving regulatory environment? The answers to these questions will be critical in determining your ability to maintain a competitive edge in the years to come.