How Does the Tick Size Regime Affect the Competitiveness of Systematic Internalisers?

Concept

The architecture of modern financial markets is a system of interconnected, and often competing, execution venues. An investor’s order does not simply arrive at a single, monolithic “market”; it is routed through a complex logic system designed to seek optimal execution across a fragmented landscape. Within this ecosystem, the Systematic Internaliser (SI) operates as a distinct and powerful node.

An SI is an investment firm that executes client orders on a bilateral basis, using its own capital. It functions as a private liquidity source, standing opposite its client’s trade, rather than as a neutral intermediary matching buyers and sellers.

The competitiveness of this model is fundamentally tied to the regulatory framework governing price increments, known as the tick size regime. Under the Markets in Financial Instruments Directive II (MiFID II), a harmonized tick size regime was established for trading venues to ensure orderly markets and prevent a “race to the bottom” where venues would compete by offering infinitesimally small price improvements, creating order book noise and degrading the quality of price formation. Initially, SIs were not bound by these same tick size constraints. This exemption became the central pillar of their competitive strategy.

It allowed them to quote prices at increments smaller than those available on public exchanges, offering a marginal, yet often decisive, price improvement to their clients. This capability to provide sub-tick pricing was a direct structural advantage, attracting significant order flow from sophisticated participants whose algorithms are programmed to seek out any available price enhancement.

The subsequent extension of the tick size regime to Systematic Internalisers was a deliberate regulatory intervention designed to recalibrate the competitive dynamics between private and public liquidity venues. The core objective was to create a “level playing field,” ensuring that SIs and traditional exchanges competed on equivalent terms, at least concerning price increments for trades up to a certain size. This change strikes at the very heart of the SI value proposition, forcing a fundamental re-evaluation of their role and competitive posture within the market’s operating system. The central question becomes what an SI offers when its primary tool for attracting order flow ▴ superior pricing at the micro-level ▴ is neutralized.

The extension of the tick size regime to Systematic Internalisers directly neutralizes their primary competitive tool of sub-tick price improvement, fundamentally altering the calculus for order routing decisions.

Understanding the impact requires seeing the market not as a single entity, but as a system of liquidity pools with different characteristics. Lit markets, like Nasdaq Stockholm or Euronext, offer pre-trade transparency through a central limit order book (CLOB), governed by price-time priority. SIs, conversely, offer bilateral, non-transparent pre-trade liquidity. The tick size regime acts as a pricing protocol that governs how these different pools can interact and compete.

When SIs could quote inside the public tick, they could effectively peel off uninformed or “impatient” order flow that valued marginal price improvement over the potential for size discovery on a lit book. Research on the Swedish stock market after the regime was extended to SIs reveals that this regulatory change did not necessarily produce the intended outcome of improving the public market. Instead, it led to a deterioration in market quality on the lit exchange, with wider spreads and increased price impact. This suggests a more complex systemic interaction.

By removing the SI’s ability to filter certain types of flow through sub-tick pricing, those orders may have been rerouted to the lit market, increasing the concentration of informed or aggressive trades and thus raising the risk for market makers, who in turn widened their spreads. The competitiveness of an SI is therefore a function of its ability to segment order flow, and the tick size regime is a primary regulator of that function.

Strategy

The strategic positioning of a Systematic Internaliser within the European equity market structure is a direct consequence of the regulatory environment. The tick size regime is a critical variable in this equation, and its evolution has forced a significant strategic pivot for SIs. Their operational strategy can be understood in two distinct phases ▴ pre- and post-extension of the harmonized tick size rules.

The Pre-Extension Strategy a Focus on Price Superiority

Before the tick size regime was applied to them, the competitive strategy of SIs was elegantly simple and highly effective. It was predicated on a single, powerful capability ▴ the provision of sub-tick price improvement. This allowed them to operate as a superior execution venue for a specific, and valuable, segment of the market’s order flow.

• Marginal Price Improvement The core tactic was to quote prices at finer increments than those permitted on lit exchanges. For a stock with a tick size of €0.01 on a public venue, an SI could offer to buy at €10.005 when the best bid on the exchange was €10.00. For a Smart Order Router (SOR) managing a large institutional order, this fractional improvement, aggregated over millions of shares, represented a meaningful reduction in transaction costs. This strategy was particularly effective in attracting automated, price-sensitive flow.
• Attracting Liquidity Consumers The model was designed to appeal to “impatient” traders ▴ those who prioritize immediate execution over the potential for a better price by resting a passive order in the lit market’s queue. These participants are liquidity consumers. Research indicates that SIs became a preferred venue for this type of trader, who values the certainty of execution at a slightly improved price and wishes to avoid the complexities of order book queues and potential information leakage.
• Free-Riding on Public Price Formation A key element of this strategy involved leveraging the price discovery occurring on lit markets. SIs could use the best bid and offer on the public exchange as a reference point and simply quote a marginally better price without contributing to the underlying price formation process themselves. This allowed them to capture low-risk order flow while the broader market bore the cost and risk of price discovery.

How Does the Regulatory Shift Reshape SI Strategy?

The extension of the MiFID II tick size regime to SIs for trades up to Large-in-Scale (LIS) effectively dismantled their primary competitive weapon. This regulatory change forced a strategic realignment, compelling SIs to compete on factors other than marginal price superiority. Their new strategy is one of adaptation, focusing on a different set of value propositions.

The table below outlines the strategic shift in the operational model of Systematic Internalisers following the regulatory change.

With their price advantage neutralized, Systematic Internalisers must now pivot their strategy to emphasize execution quality, discretion, and the structural benefits of bilateral trading.

The Post-Extension Strategy a Focus on Execution Quality

With the price advantage for smaller trades largely gone, SIs must now build their competitive strategy around other attributes. This represents a maturation of their business model, moving from a simple pricing game to a more sophisticated offering centered on the quality of execution.

1. Certainty of Execution Unlike a lit market where an order may only be partially filled or may not be filled at all, an SI offers a firm quote. For a client, this provides certainty that their order will be executed in full at the quoted price, a valuable attribute when managing execution risk.
2. Reduced Market Impact Executing large orders on a lit exchange can signal intent to the market, leading to adverse price movements. By transacting bilaterally with an SI, a client can execute a significant trade with minimal information leakage, thereby reducing their market impact costs. This is a critical service for institutional asset managers.
3. Handling Large-In-Scale (LIS) Orders The tick size rules are often applied differently or not at all for trades designated as LIS. SIs can specialize in facilitating these large block trades, providing liquidity and price improvement that would be impossible to achieve on a lit order book. This positions them as a crucial venue for institutional-sized liquidity.

This strategic pivot changes the SI’s role in the market ecosystem. They function less as a simple price-beating machine and more as a specialized execution facility, offering a service that is complementary to, rather than purely competitive with, lit markets. Their competitiveness is now a function of their balance sheet, their risk management capabilities, and the sophistication of their client-facing technology.

Execution

The execution dynamics surrounding Systematic Internalisers are a direct function of the tick size protocol. Altering this protocol fundamentally rewires the decision-making logic of market participants and the technological systems they employ. Analyzing the execution process reveals the deep, mechanical impact of the regime change on market structure and competitiveness.

Operational Mechanics and Market Impact

The core of the SI execution process is the interaction between the client’s order, typically managed by a Smart Order Router (SOR), and the SI’s proprietary quoting engine. The tick size regime dictates the language of this interaction. Before the regime extension, an SI could offer a quote of €10.005 for a stock whose best bid on the lit market was €10.00 and whose tick size was €0.01. An SOR programmed for best execution would mechanically route the order to the SI to capture this price improvement.

Post-regime, the SI is obligated to quote at the same €10.00 increment. The SOR’s decision is no longer a simple price comparison. It must now weigh other factors ▴ the certainty of a full fill from the SI versus the potential for partial execution on the lit book, the risk of information leakage, and the speed of execution.

This shift has profound consequences for market quality metrics. Empirical analysis of the Swedish stock market following the June 2020 implementation of the SI tick size regime provides a clear data-driven narrative. The research found that market quality on the primary lit venue, Nasdaq Stockholm, deteriorated. This outcome points to a complex systemic rebalancing.

When SIs could no longer use sub-tick pricing to filter out certain order flows, those flows were rerouted. The data suggests that more informed or aggressive traders, who previously might have used SIs, began interacting directly with the lit order book. This increases the risk for passive liquidity providers (market makers), who must protect themselves from trading against participants with superior information. They do so by widening their bid-ask spreads. This dynamic is reflected in the quantitative data.

What Is the Quantifiable Impact on Market Quality?

The data from the post-implementation analysis on the Swedish market provides a granular view of the regime’s impact. The findings contradict the hypothesis that leveling the playing field would inherently improve the primary market. Instead, key indicators of execution cost and risk increased.

The following table summarizes the measured effects on market quality at Nasdaq Stockholm after the SI tick size regime was enforced.

Predictive Scenario Analysis a Tale of Two Trades

Consider an asset manager needing to buy 100,000 shares of a moderately liquid stock. The lit market quote is €25.05 / €25.06, with a €0.01 tick size. The depth at the best offer is 10,000 shares.

Scenario 1 The Pre-Regime Execution The asset manager’s EMS/SOR assesses the landscape. It sees the €25.06 offer on the lit book. Simultaneously, it queries its network of SIs. One SI responds with a firm quote to sell the full 100,000 shares at €25.058.

This price is inside the lit market’s tick. The SOR’s logic is clear ▴ it routes the entire order to the SI. The benefits are twofold ▴ a guaranteed execution for the full size, and a cost saving of €0.002 per share (€200 total) compared to the lit offer. The trade occurs with zero market impact, as no information is revealed on the public order book.

Scenario 2 The Post-Regime Execution The same order is entered. The lit market is still €25.05 / €25.06. The SOR queries the SIs. Because of the tick size regime, the best offer the SI can make is now €25.06, the same as the lit market.

The price advantage has vanished. The SOR’s decision matrix is now far more complex. It could send the order to the SI to guarantee the fill and minimize information leakage. Alternatively, it could start working the order on the lit market, perhaps placing a passive order at €25.05 or hitting the €25.06 offer for a small portion to test the market’s reaction.

The execution strategy becomes a trade-off between the certainty and discretion of the SI and the potential price discovery of the lit market. The SI’s competitiveness now hinges entirely on the client’s desire to avoid the risks of interacting with the public order book.

System Integration and Technological Architecture

The competition between SIs and lit markets is arbitrated by technology. The integration of SIs into the institutional trading workflow is managed through sophisticated OMS and EMS platforms. Communication relies on standardized protocols, primarily the Financial Information eXchange (FIX) protocol. Client orders are sent to SIs, and execution reports are returned, using FIX messages.

The key difference is the nature of the data stream. Lit markets provide a continuous public feed of pre-trade data (the order book). SIs provide private, bilateral pre-trade data (quotes) only in response to a specific inquiry. Both contribute to post-trade public data feeds for transparency purposes. For an SI to compete effectively in the post-regime world, its technology must be fast, reliable, and seamlessly integrated into the client’s execution systems, ensuring that its quotes for certainty and discretion are as accessible as the lit market’s quotes for price.

Reflection

The application of the tick size regime to Systematic Internalisers was an act of architectural intervention, intended to rebalance the flow of liquidity between private and public channels. The resulting data, however, suggests that market quality is an emergent property of the entire system, not a simple variable that can be optimized by adjusting a single protocol. The evidence of wider spreads and increased price impact on lit venues post-reform compels a deeper consideration. It forces us to ask what “competitiveness” truly means within our own execution framework.

Is it the pursuit of the smallest possible price increment, or is it the strategic management of information and risk across a diverse set of venues, each with a distinct purpose? The neutralization of the SI’s pricing advantage does not render it obsolete; it clarifies its function as a tool for discretion and certainty. The ultimate question for any market participant is how to intelligently integrate these specialized tools into a cohesive execution strategy that recognizes the intricate, and often counterintuitive, behavior of the total market system.