How Has MiFID II Impacted the Market Share of Systematic Internalisers versus Dark Pools?

Concept

The core inquiry into MiFID II’s effect on the market structure of Systematic Internalisers (SIs) and dark pools moves directly to the heart of a fundamental tension in modern financial regulation. It is an examination of intended consequences versus emergent system behavior. The directive’s architectural goal was to channel liquidity from opaque, off-exchange venues back into the transparent, pre-trade price discovery mechanisms of lit markets. The primary tool for this purpose was the implementation of the Double Volume Cap (DVC) mechanism, a quantitative constraint designed to limit the amount of trading that could occur in dark pools operating under the reference price waiver.

This regulatory action created a significant operational challenge for market participants accustomed to using dark pools to execute large orders while minimizing information leakage and market impact. The system, faced with a new constraint, did not react as the architects had planned. Instead of a wholesale migration of flow to lit exchanges, the liquidity found a new, more efficient path. The existing, yet previously less prominent, Systematic Internaliser regime became the primary beneficiary of this displaced volume.

An SI is an investment firm that deals on its own account by executing client orders outside a regulated market or an MTF. The SI regime offered a compliant alternative for bilateral execution, allowing broker-dealers to internalize client order flow and provide liquidity from their own principal books.

The regulatory constriction of one liquidity channel directly precipitated the expansion and elevation of another, reconfiguring the landscape of European off-exchange trading.

The result was a structural recalibration of European equity markets. Dark pool volumes, particularly for stocks subject to the DVC, experienced a material decline. Concurrently, the number of firms registering as SIs expanded dramatically, from a small handful pre-MiFID II to over a hundred in the immediate aftermath. This shift was not merely a one-for-one replacement.

It represented a fundamental change in how non-displayed liquidity was accessed and provisioned, moving from a multilateral, anonymous model (dark pools) to a bilateral, disclosed counterparty model (SIs). Understanding this impact requires a precise grasp of the mechanics of each venue and the strategic incentives that MiFID II created for every actor in the execution chain.

The Preexisting Market Architecture

To fully appreciate the scale of the transformation, one must first model the pre-MiFID II ecosystem. It was a landscape with a clearer, albeit still complex, demarcation between different liquidity sources.

• Lit Markets These venues, including regulated markets and Multilateral Trading Facilities (MTFs), formed the bedrock of price discovery. Their central limit order books (CLOBs) provided continuous, pre-trade transparency, displaying bids and offers to all participants. They were the primary mechanism for price formation.
• Dark Pools (MTFs) These were typically operated as MTFs without pre-trade transparency, relying on waivers to execute trades. The most common was the reference price waiver, which allowed them to match orders at the midpoint of the best bid and offer (BBO) from a lit market. Their value proposition was the mitigation of market impact for institutional-sized orders.
• Systematic Internalisers Before MiFID II, the SI regime was far less utilized. It permitted bilateral principal trading but had less formal quoting obligations and was generally a smaller component of the overall market structure. It was a recognized channel but not a dominant one.

How Did the Double Volume Cap Restructure the Market?

The Double Volume Cap mechanism was the specific catalyst for the market share shift. It operates on two levels, creating a powerful incentive for market participants to seek alternative execution methods.

The DVC imposes a strict limit on the volume of trading in a specific stock that can occur in the dark on any single trading venue and across all venues in the European Union. The caps are set at:

1. 4% of total volume on any single dark trading venue.
2. 8% of total volume across all dark trading venues combined.

Once these thresholds are breached for a particular instrument, a six-month ban on dark pool trading for that stock under the reference price waiver is triggered. This mechanism directly threatened the viability of the dark pool model for a significant portion of the most actively traded stocks. Faced with the inability to access their preferred execution channel, market participants were forced to adapt their strategies, leading them directly to the SI regime, which was exempt from the DVCs. This regulatory arbitrage was the foundational driver of the market share migration from dark pools to Systematic Internalisers.

Strategy

The implementation of MiFID II, particularly the Double Volume Caps, was a seismic event that compelled a strategic re-evaluation from every market participant. The shift in market share from dark pools to Systematic Internalisers was not a passive drift; it was the result of deliberate, strategic decisions made by broker-dealers and asset managers in response to a new set of operational constraints and opportunities. The core of this strategic realignment lies in the differing characteristics of the venues and how they fulfilled the objectives of institutional traders in a post-DVC world.

The Broker-Dealer Pivot to Systematic Internalisation

For sell-side firms, the rise of the SI regime was a strategic imperative. Before MiFID II, many brokers operated Broker Crossing Networks (BCNs), which functioned much like dark pools, allowing them to cross client orders internally. MiFID II effectively outlawed the traditional BCN model, forcing brokers to choose a new path for handling their internal liquidity. The options were to register their crossing activity as a formal MTF, subject to the DVCs, or to embrace the SI regime.

The SI model presented a superior strategic alternative for several reasons:

• Exemption from Double Volume Caps The most immediate advantage was that trading on an SI was not subject to the DVCs. This allowed brokers to continue offering non-displayed liquidity to clients even in stocks where dark pool trading was suspended. It became the only reliable channel for sub-LIS (Large-in-Scale) dark execution.
• Control and Monetization of Order Flow The SI model allows a firm to trade as principal against its client flow. This provides greater control over the execution process and creates opportunities for revenue generation through the bid-ask spread. It transforms the broker from an agent into a principal liquidity provider.
• Flexibility in Pricing Unlike registered markets, SIs historically had more flexibility in their quoting, including the ability to offer price improvement at sub-tick increments. This created a powerful incentive for clients to route orders to the SI, as they could achieve a better price than what was available on the lit market.
• Client Relationship Management By providing a reliable source of liquidity and superior execution quality, brokers could strengthen their client relationships. Becoming an indispensable liquidity partner in a fragmented market was a key competitive advantage.

The strategic decision for a broker-dealer to become a Systematic Internaliser was a direct response to regulatory pressure, transforming a compliance requirement into a significant business opportunity.

The Buy-Side Quest for Non-Displayed Liquidity

From the perspective of an asset manager or institutional trader, the primary goal remains consistent ▴ execute orders, particularly large ones, with minimal market impact and at the best possible price. MiFID II disrupted the primary tool used for this purpose. The strategic response from the buy-side was to follow the liquidity.

As brokers established and promoted their SI platforms, buy-side traders adapted their execution strategies accordingly:

• SOR Adaptation Smart Order Routers (SORs) had to be recalibrated. Pre-MiFID II, an SOR might split a large order among various dark pools. Post-MiFID II, the SOR logic was updated to first check the DVC status of a stock. If the stock was capped, the SOR would then prioritize routing to a network of SIs for execution.
• Accessing Sub-LIS Liquidity The Large-in-Scale waiver always allowed very large orders to trade in the dark without restriction. The DVCs primarily affected orders that were institutional in size but fell below the LIS threshold. SIs became the primary destination for this crucial segment of order flow.
• Best Execution MiFID II reinforced best execution obligations. By routing to an SI that offered price improvement over the lit market BBO, buy-side firms could more easily demonstrate that they were achieving the best possible outcome for their end clients.

The table below provides a strategic comparison of the primary execution venues following the implementation of MiFID II, illustrating the distinct roles they came to occupy.

Execution

The systemic shift from dark pools to Systematic Internalisers was not merely a change in labels; it was a profound re-architecting of the European equity market’s plumbing. Executing within this new landscape required significant operational, technological, and quantitative adjustments from all participants. Understanding the precise mechanics of the SI regime and its quantitative impact is essential for navigating the post-MiFID II environment.

The Operational Playbook for Systematic Internalisers

Becoming a Systematic Internaliser involves more than a simple registration. It requires a firm to meet specific quantitative thresholds and adhere to a distinct set of operational rules that differ significantly from those governing multilateral venues.

An investment firm is classified as an SI for a specific instrument if it deals on own account when executing client orders outside a regulated market, an MTF, or an OTF on an “organised, frequent, systematic and substantial basis.” The “frequent and systematic” test is instrument-specific and based on the number of OTC trades, while the “substantial basis” test is based on the size of OTC trading relative to the firm’s total trading or total EU trading in that instrument. This granular, instrument-by-instrument designation adds a layer of complexity to the operational setup.

Key operational protocols include:

1. Quoting Obligations Unlike a passive dark pool, an SI has an active obligation to provide quotes to its clients upon request. These quotes must be firm up to a certain size and must reflect prevailing market conditions.
2. Principal Risk Every trade executed on an SI is a bilateral engagement with the firm acting as principal. This means the SI takes on market risk, even if only for a moment. This is fundamentally different from an MTF, which acts as a neutral matching engine for third-party interests.
3. Trade Reporting The SI is responsible for making the trade public through a post-trade report to an Approved Publication Arrangement (APA). This reporting obligation shifts the burden away from the buy-side client, a significant operational convenience.

Quantitative Modeling of the Market Share Shift

The impact of MiFID II on market structure is most clearly seen through a quantitative lens. The migration of volume was not uniform across all stocks; it was most pronounced in instruments that were directly affected by the Double Volume Caps. Analysis of market data from the period reveals a clear and causal relationship.

The following table presents a model of the market share evolution, using realistic percentage ranges derived from market reports to illustrate the scale of the change.

Initial estimates post-MiFID II suggested SIs captured a market share of around 30-40%, though these figures likely included a broader definition of bilateral trading. More recent, specific analysis places the dedicated SI regime’s share at a substantial 13%. The data clearly shows that the drop in dark pool volume was not absorbed by the lit markets, as regulators had hoped, but was instead captured almost entirely by the SI regime.

What Is the Future Regulatory Trajectory?

The success and rapid growth of the SI regime drew the attention of European regulators. Concerns arose that SIs were creating a new, less transparent tier of the market that undermined the central tenet of MiFID II ▴ moving trading onto lit venues. In response, regulators have proposed and implemented further adjustments to the rules.

Key proposals have included:

• Minimum Quote Sizes To ensure SIs are providing meaningful liquidity, proposals were made to increase the minimum quote size an SI must offer, for instance, to two times the standard market size (SMS) for a given instrument.
• Tick Size Adherence Efforts were made to remove the pricing advantages of SIs by requiring them to adhere to the same tick size regime as lit venues for certain types of trades.

These regulatory counter-moves demonstrate the dynamic nature of market structure. The system is in a continuous state of flux, with regulation driving market innovation, which in turn prompts further regulatory refinement. The strategic challenge for market participants is to build an execution framework that is robust and adaptable enough to thrive in this evolving environment.

Reflection

The systemic reconfiguration prompted by MiFID II offers a powerful lesson in market dynamics. It underscores that liquidity, like water, will always seek the path of least resistance. A regulatory framework that closes one channel without fully addressing the underlying commercial needs of market participants will invariably lead to the emergence of another. The strategic question for any institution is not how to operate within a static market structure, but how to build an operational framework that anticipates and adapts to these inevitable shifts.

How Resilient Is Your Execution Framework?

Consider your own firm’s access to liquidity. How is your Smart Order Router logic architected to assess venue quality beyond simple metrics of price and size? Does it quantitatively account for the regulatory status of a venue, such as the DVC list, and dynamically reroute flow? The migration from dark pools to SIs was a stress test of this very capability.

A truly superior execution system is one that models the entire ecosystem, understanding not just where liquidity is today, but where it is likely to flow tomorrow under new pressures. The knowledge gained from this analysis should serve as a foundational component in the continuous process of refining that system.