How Does the Use of Systematic Internalisers Affect Best Execution Obligations under Mifid Ii?

Concept

The SI Conundrum a New Locus of Liquidity

The Markets in Financial Instruments Directive II (MiFID II) introduced the Systematic Internaliser (SI) regime, fundamentally altering the European market structure. An SI is an investment firm that, on an organised, frequent, systematic, and substantial basis, deals on its own account when executing client orders outside a regulated market (RM), multilateral trading facility (MTF), or organised trading facility (OTF). In essence, SIs formalised a segment of over-the-counter (OTC) trading, bringing it within a defined regulatory perimeter. This development was a direct response to the increasing fragmentation of liquidity and the desire to enhance pre-trade transparency in markets that were becoming progressively opaque.

The operational mechanics of an SI are rooted in bilateral engagement. When an investment firm routes an order to an SI, it is trading directly with the SI’s own capital. The SI provides a quote, and the trade is executed on a principal basis. This model contrasts sharply with the multilateral, all-to-all environment of a public exchange, where anonymous participants interact through a central limit order book (CLOB).

The SI framework was designed to capture significant OTC activity, particularly from large banks and electronic liquidity providers, subjecting them to specific transparency and reporting obligations. The intention was to ensure that such internalisation of order flow does not undermine the efficiency of price formation on public venues.

Systematic Internalisers represent a regulated, bilateral trading environment where investment firms execute client orders against the SI’s proprietary capital, bringing a significant portion of OTC flow into a formalised transparency framework.

Best Execution a Mandate of Process and Outcome

The principle of best execution, as enshrined in MiFID II, is an uncompromising obligation for investment firms to take all sufficient steps to obtain the best possible result for their clients. This mandate is comprehensive, considering not just price, but also costs, speed, likelihood of execution and settlement, size, nature, or any other consideration relevant to the execution of the order. The directive requires firms to establish and implement an order execution policy that details the different venues and factors considered for each class of financial instrument. This policy is a dynamic document, subject to regular review and demonstration to clients and regulators that the firm is systematically working to achieve the optimal outcome.

The introduction of SIs adds a layer of complexity and opportunity to this obligation. A firm’s execution policy must now explicitly consider SIs as a potential execution venue alongside traditional exchanges and MTFs. The decision to route an order to an SI must be justifiable within the best execution framework.

This means firms must be able to demonstrate, with supporting data, that the choice of an SI was conducive to achieving the best possible result for a specific client order. The burden of proof lies with the investment firm, necessitating a robust process for venue selection, performance monitoring, and post-trade analysis.

Strategy

Navigating the Fragmented Liquidity Landscape

The emergence of Systematic Internalisers as a prominent execution venue under MiFID II necessitates a sophisticated and data-driven strategy for sourcing liquidity. Investment firms can no longer rely solely on public exchanges for order execution. A comprehensive strategy involves integrating SIs into the firm’s Smart Order Router (SOR) logic, allowing for dynamic and intelligent routing decisions based on real-time market conditions and the specific characteristics of each order. The strategic imperative is to view the market as a mosaic of interconnected liquidity pools, each with distinct advantages and disadvantages.

The primary strategic consideration when routing to an SI is the potential for price improvement. Because SIs are not bound by the same tick size regime as lit venues in all circumstances, they can offer execution at prices incrementally better than the European Best Bid and Offer (EBBO). For large, institutional orders, even a fractional price improvement can translate into significant cost savings.

However, this potential benefit must be weighed against the bilateral nature of the transaction. Unlike the anonymity of a central limit order book, trading with an SI involves a direct interaction, which carries its own set of strategic considerations regarding information leakage and market impact.

An effective execution strategy in the MiFID II era requires the integration of Systematic Internalisers into a dynamic, multi-venue routing framework, balancing the pursuit of price improvement with a rigorous assessment of market impact.

Comparative Analysis of Execution Venues

To fulfill best execution obligations, firms must conduct a rigorous and ongoing comparison of the execution quality offered by different venues. This analysis forms the bedrock of a defensible execution policy. The table below outlines a comparative framework for evaluating SIs against other common execution venues.

The Data Imperative RTS 27 and RTS 28

MiFID II introduced Regulatory Technical Standards (RTS) 27 and 28 to provide the data necessary for firms to monitor execution quality and substantiate their best execution policies. These reports are foundational to any strategy involving SIs.

• RTS 27 Reports ▴ These are public, quarterly reports published by execution venues, including SIs. They provide detailed data on execution quality, covering aspects like price, costs, and likelihood of execution for different financial instruments. Strategically, firms must develop the capability to ingest, process, and analyze RTS 27 data from all relevant SIs to benchmark their performance against other venues.
• RTS 28 Reports ▴ These are annual reports published by investment firms, disclosing their top five execution venues for each class of financial instruments. These reports must also include a summary of the analysis and conclusions drawn from monitoring execution quality. For a firm utilizing SIs, the RTS 28 report is a public declaration of its execution strategy and a key document for regulatory scrutiny. The preparation of this report requires a systematic and evidence-based approach to venue selection.

A forward-looking strategy treats these reporting obligations as an opportunity. The data from RTS 27 can feed a dynamic feedback loop, continuously refining the logic of the firm’s SOR. By analyzing which SIs consistently provide superior execution for specific types of orders, a firm can enhance its routing decisions, thereby improving client outcomes and strengthening its compliance posture. The strategic goal is to transform a regulatory requirement into a competitive advantage through superior data analysis.

Execution

A Framework for SI Integration and Monitoring

The practical execution of a trading strategy that incorporates Systematic Internalisers requires a disciplined, multi-stage process. This process moves from pre-trade analysis and venue selection to real-time order routing and post-trade evaluation. The objective is to create a robust and auditable framework that ensures every decision is consistent with the firm’s best execution policy.

The proliferation of SIs has been a defining feature of the post-MiFID II landscape, with some market experts anticipating that SI volumes in Europe could approach the levels of internalization seen in the US market. This makes a clear execution framework a necessity.

The execution workflow begins with the classification of client orders. Factors such as order size, liquidity profile of the instrument, and the client’s specific instructions will determine the universe of suitable execution venues. For orders below a certain size, routing to a lit market might be the default.

For larger orders, or those in less liquid instruments, the potential for price improvement and reduced market impact at an SI becomes a compelling consideration. The firm’s SOR must be calibrated with this logic, capable of making instantaneous routing decisions based on a pre-defined rule set that is itself informed by historical performance data.

Procedural Steps for Best Execution with SIs

Implementing a compliant and effective execution process involving SIs can be broken down into a series of distinct operational steps. This procedure ensures that the use of SIs is deliberate, monitored, and justifiable.

1. Onboarding and Due Diligence ▴
   • Conduct thorough due diligence on potential SI counterparties. This includes assessing their financial stability, technological capabilities, and the breadth of instruments they cover.
   • Establish legal agreements and connectivity. This involves setting up FIX protocol connections and ensuring that data flows for order execution and reporting are secure and reliable.
2. Calibration of Smart Order Router (SOR) ▴
   • Integrate SIs into the SOR’s venue list. The SOR should be configured to request quotes from multiple SIs simultaneously for relevant orders.
   • Define the routing logic. This logic should be based on the execution factors outlined in MiFID II, prioritizing those most relevant to the specific order type. For example, for a small, liquid order, price and speed might be paramount. For a large block order, likelihood of execution and minimizing market impact take precedence.
3. Pre-Trade Analysis ▴
   • For each order, the system should perform a pre-trade analysis to determine the optimal execution strategy. This involves assessing the available liquidity on lit markets versus the potential for execution at an SI.
   • The analysis should consider the potential for information leakage. Routing a large order to a single SI might signal the firm’s intentions to that counterparty. The strategy might involve breaking up the order and routing it to multiple venues.
4. Execution and Monitoring ▴
   • Once an order is routed to an SI, the firm must monitor the execution quality in real-time. This includes comparing the execution price against the prevailing EBBO to quantify any price improvement.
   • The system should capture all relevant data points for each execution, including timestamps, execution price, venue, and any associated fees.
5. Post-Trade Transaction Cost Analysis (TCA) ▴
   • Conduct regular TCA on all executions to evaluate the performance of SIs against other venues. This analysis should be granular, comparing performance across different instruments, order sizes, and market conditions.
   • The TCA results must be used to refine the SOR logic and the firm’s overall execution policy. If an SI consistently underperforms, it should be down-weighted or removed from the routing table.

Quantitative Analysis of Execution Quality

The cornerstone of demonstrating best execution is quantitative analysis. Firms must be able to produce detailed reports that compare execution outcomes across different venues. The following table provides a hypothetical example of a Transaction Cost Analysis (TCA) report for a large order to purchase 100,000 shares of a fictional company, “EuroStoxx Corp.” This analysis compares the execution quality of an SI against a lit market (RM).

A rigorous, data-driven Transaction Cost Analysis is the definitive mechanism for validating the inclusion of Systematic Internalisers within a best execution framework, translating regulatory obligations into quantifiable performance metrics.

This quantitative evidence is crucial for satisfying the best execution mandate. While the explicit costs at the RM were lower, the significant reduction in implicit costs (slippage) at the SI resulted in a superior overall outcome for the client. This type of analysis, performed consistently across all trades, provides the evidentiary basis for the firm’s execution policy and its RTS 28 reporting. It demonstrates a systematic approach to achieving the best possible result, moving the concept of best execution from a qualitative principle to a quantifiable and auditable process.

Reflection

Beyond Compliance a New Execution Philosophy

The integration of Systematic Internalisers into the European market fabric is a catalyst for a more profound evolution in execution philosophy. Adherence to the best execution obligations under MiFID II is the baseline. The true strategic opportunity lies in harnessing the fragmented liquidity landscape to build a more resilient and intelligent execution capability.

This requires a shift in perspective, viewing the market not as a single, monolithic entity, but as a dynamic system of interconnected venues, each with a specific role and utility. The challenge is to develop the institutional intelligence to navigate this system effectively.

This intelligence is built on a foundation of data, technology, and a relentless focus on quantitative analysis. The reports and procedures mandated by MiFID II provide the raw materials. The real work is in transforming this data into actionable insights that refine routing logic, inform counterparty selection, and ultimately, deliver superior outcomes for clients.

The process is iterative and continuous, a constant cycle of execution, analysis, and adaptation. It demands a commitment to technological investment and the cultivation of analytical expertise.

Ultimately, mastering the use of Systematic Internalisers within a best execution framework is about control. It is about having the clarity to understand the trade-offs between different liquidity sources, the capability to direct order flow with precision, and the evidence to demonstrate that every decision was made in the client’s best interest. The regulations have provided the map; the firm must build the navigation system. The journey leads to a more sophisticated, data-driven, and ultimately more effective approach to engaging with modern financial markets.