How Has the Rise of Systematic Internalisers Impacted Liquidity on Lit Markets?

Concept

The rise of Systematic Internalisers (SIs) is not an isolated phenomenon; it is a direct and logical consequence of a fundamental tension within modern market architecture. This tension exists between the search for execution quality and the public good of transparent price discovery. To understand the impact of SIs on lit markets, one must first view the market not as a monolithic entity, but as a complex, interconnected system of competing liquidity venues, each with its own set of rules and incentives.

The core of the issue lies in how SIs operate ▴ they are private liquidity pools that execute client orders on their own books, but they derive their pricing information from the very public markets they compete with. This creates a parasitic relationship that fundamentally alters the dynamics of liquidity across the entire system.

An SI functions as an investment firm that deals on its own account when executing client orders outside a regulated market or a multilateral trading facility (MTF). Under the Markets in Financial Instruments Directive (MiFID II) framework in Europe, this activity is formalized. An SI has the right, but not the obligation, to execute its customers’ orders. They profit from the bid-ask spread and by internalizing uninformed order flow, which is statistically less likely to move the price against them.

The critical point is that the prices they offer are benchmarked against the lit markets. They can offer a marginal price improvement ▴ a fraction of a tick better than the public quote ▴ which makes them attractive to best execution algorithms while not contributing to the formation of that public quote. This process effectively removes a segment of order flow from the public domain, a process known as market fragmentation.

Systematic Internalisers function as private liquidity venues that execute client orders internally, referencing prices from public exchanges without contributing to the price discovery process.

This fragmentation has profound consequences. Lit markets, or transparent exchanges, depend on a diverse mix of order flow to function efficiently. This includes both informed flow (from traders who have superior information) and uninformed flow (often from retail investors or passive funds). Market makers on lit exchanges provide liquidity by posting bids and offers, and their profitability depends on interacting with a high volume of uninformed flow to compensate for the losses they inevitably incur when trading with informed participants.

When SIs systematically siphon off the most desirable, uninformed orders, they leave the lit market makers to face a higher concentration of informed, or ‘toxic,’ flow. This increases the risk for lit market makers, forcing them to widen their bid-ask spreads and reduce the depth of their quotes to protect themselves. The result is a degradation of liquidity on the very markets that everyone, including the SIs, relies upon for accurate price discovery.

The contribution of SIs to overall price discovery is therefore minimal. They are price takers, not price makers. While they offer liquidity, it is a form of dependent liquidity. This is a critical distinction.

Lit markets are primary centers of price discovery because they aggregate a wide range of buying and selling interest in a transparent manner, creating a reliable public price signal. SIs, along with other off-exchange venues like dark pools, are secondary sources of liquidity that leverage this price signal without meaningfully contributing to it. The systemic impact is a potential hollowing out of the central lit markets, leading to a less resilient and potentially more volatile market structure. The very transparency that makes lit markets valuable also makes them vulnerable to being undermined by private execution venues that can operate with greater discretion and lower direct costs.

Strategy

The proliferation of Systematic Internalisers represents a strategic adaptation to the regulatory and technological landscape of modern finance. For market participants, interacting with SIs is not a random occurrence but a deliberate choice driven by a complex interplay of cost, risk, and regulatory obligations. Understanding the strategic calculus of each major player ▴ the buy-side, the sell-side, and the lit market makers ▴ is essential to grasping the systemic impact of this market structure.

The Buy-Side Strategic Imperative Best Execution

For an institutional investor, such as a pension fund or asset manager, the primary directive is to achieve ‘best execution’ for its clients. The MiFID II framework expanded this concept beyond simply achieving the best price. It now encompasses a broader set of factors, including cost, speed, likelihood of execution, and settlement. This multi-faceted definition provides the strategic opening for SIs.

A buy-side firm’s Smart Order Router (SOR) is programmed to find the optimal execution venue based on these criteria. When a large order needs to be executed, routing it directly to a lit market can cause significant market impact. The order’s visibility can alert other market participants, who may trade ahead of it, driving the price up (for a buy order) or down (for a sell order). This price movement, known as slippage, can be a major cost to the investor.

SIs offer a solution to this problem. By executing the trade internally, an SI can offer a guaranteed price, often with a slight improvement over the lit market quote, and with zero market impact. This is particularly valuable for large, non-urgent trades where certainty of execution price is paramount.

Buy-side firms strategically use Systematic Internalisers to minimize market impact and satisfy multi-faceted best execution requirements that extend beyond price alone.

The strategic decision for a buy-side trader, therefore, involves a trade-off. While they may recognize that routing flow to SIs could contribute to a long-term decline in lit market liquidity, their immediate fiduciary duty is to secure the best outcome for the specific trade at hand. The SI provides a quantifiable benefit in the form of price improvement and reduced slippage, making it a compelling choice, especially when compared to the uncertainty and potential costs of working a large order on a public exchange.

The Sell-Side Calculus Capturing Order Flow

For the sell-side firms that operate as SIs, the strategy is one of vertical integration and revenue optimization. By creating an internal marketplace, a large bank or dealer can capture its own clients’ order flow instead of sending it to an external venue. This has several advantages:

• Revenue Generation ▴ The firm earns the bid-ask spread on every trade it internalizes. This is a direct revenue stream that would otherwise be paid to an exchange or another market maker.
• Risk Management ▴ By seeing a large volume of client orders, the firm gains valuable information about market sentiment and positioning. This allows it to manage its own inventory and risk more effectively.
• Client Retention ▴ Offering high-quality execution via an SI is a powerful tool for retaining valuable clients. The ability to provide price improvement and minimize market impact is a significant competitive differentiator.

The “free-rider” problem is central to the SI strategy. The SI does not need to invest in the expensive infrastructure of a public exchange or take on the risks of a dedicated market maker who must quote continuously. Instead, it can opportunistically use the public quotes as a reference, step in front of them with a marginal price improvement, and execute the least risky orders (i.e. uninformed flow). This is a highly efficient and profitable business model that leverages the public good of price discovery without contributing to its upkeep.

The Plight of the Lit Market Maker

For market makers operating on lit exchanges, the rise of SIs represents a direct threat to their business model. Their role is to provide continuous liquidity by posting bids and offers, and they profit from the spread by trading with a balanced mix of informed and uninformed participants. SIs disrupt this balance by systematically filtering out the uninformed flow.

When a retail broker, for example, sends its entire order book to an SI, the lit market maker is deprived of this valuable, low-risk flow. The orders that do reach the lit market are more likely to be from informed traders or from large institutions that could not find liquidity elsewhere. This phenomenon is known as adverse selection. The market maker is left facing a higher proportion of “toxic” flow, meaning trades that are more likely to result in losses.

To compensate for this increased risk, the market maker has no choice but to widen its spreads and reduce the size of its quotes. This directly translates to lower liquidity and higher trading costs for everyone who uses the lit market.

How Does This Impact Market Structure?

The strategic interactions of these players create a feedback loop that can alter the entire market structure. As more flow is diverted to SIs, liquidity on lit markets may decline. This makes lit markets less attractive, potentially driving even more flow to SIs and other off-exchange venues. This fragmentation can lead to a two-tiered market ▴ a private tier for standard, uninformed flow, and a public, more volatile tier for everything else.

Regulators are acutely aware of this dynamic. Measures such as the tick-size regime, which aims to prevent SIs from offering price improvements that are too small, are attempts to level the playing field. However, the fundamental strategic incentives for using and operating SIs remain powerful, making this an ongoing area of tension and evolution in market design.

The following table illustrates the conflicting strategic objectives of the key market participants:

Execution

The theoretical and strategic implications of Systematic Internalisers are realized through a precise, technology-driven execution process. For institutional traders and portfolio managers, understanding the mechanics of how an order is routed, priced, and executed is not merely an academic exercise; it is fundamental to achieving control over trading outcomes. The decision to interact with an SI is embedded in a complex architecture of order management systems, smart order routers, and quantitative models designed to navigate a fragmented liquidity landscape.

The Operational Playbook the Life of a Trade

When a portfolio manager decides to execute a trade, the order does not simply appear on an exchange. It embarks on a journey through a sophisticated technological pipeline, where critical decisions are made in microseconds. The following steps outline a typical execution workflow involving the potential for SI interaction:

1. Order Generation ▴ The process begins in the Portfolio Manager’s Order Management System (OMS), where the investment decision is translated into a specific order (e.g. “Buy 100,000 shares of XYZ Corp”).
2. Execution Strategy Selection ▴ The order is passed to the trader’s Execution Management System (EMS). Here, the trader applies a high-level strategy. For a large order, this might involve an algorithmic strategy like a Volume-Weighted Average Price (VWAP) or a simple “point-and-shoot” approach for smaller, less sensitive orders.
3. Smart Order Routing (SOR) ▴ This is the critical juncture. The EMS hands the order (or a small part of it, in the case of an algorithmic strategy) to the Smart Order Router. The SOR’s sole function is to find the best possible execution venue at that precise moment. Its logic is programmed to consider all available sources of liquidity, including:
   • Lit exchanges (e.g. NYSE, LSE)
   • Multilateral Trading Facilities (MTFs)
   • Dark Pools
   • Systematic Internalisers
4. The SI Ping ▴ Before routing to a public market, the SOR will often “ping” the SIs with which the firm has a relationship. It sends a request for a quote. The SI’s system instantly assesses the order and decides whether to offer a quote. If it does, the quote will typically be at or slightly better than the current National Best Bid and Offer (NBBO) on the lit markets.
5. The Execution Decision ▴ The SOR compares the SI’s quote with the prices available on all other venues. Factoring in exchange fees, speed, and the likelihood of a fill, it makes its routing decision. If the SI offers the best all-in price, the trade is executed internally on the SI’s book. The confirmation is sent back to the EMS, and the trade is complete, having never touched a public exchange. If the SI declines to quote or its price is not competitive, the SOR will route the order to the next best venue, which is often a lit market.

Quantitative Modeling and Data Analysis

The decision-making process within the SOR is driven by quantitative data. Traders and brokers constantly analyze execution quality to refine their routing logic. The following table provides a hypothetical comparison of execution outcomes for a 50,000-share buy order in a moderately liquid stock, comparing a direct execution on a lit market versus an execution via an SI.

This data illustrates the powerful incentive for the buy-side. The SI offers a demonstrably better outcome for this specific trade. However, the systemic effect is hidden.

What happens when a significant portion of the market’s order flow follows this path? The next table models the potential impact on the lit market itself as SI market share increases.

What Is the Systemic Impact on Lit Market Quality?

This model demonstrates the corrosive effect of rising SI volume on the primary public markets. As the most benign, uninformed flow is internalized, the risk for lit market makers increases, forcing them to protect themselves by widening spreads and reducing the liquidity they are willing to show. This degradation in lit market quality can, in turn, make SIs appear even more attractive, creating a self-reinforcing cycle.

System Integration and Technological Architecture

The seamless interaction between a trading desk and an SI is a feat of significant technological integration. The entire process is mediated by a standardized messaging protocol, the Financial Information eXchange (FIX) protocol. When an SOR “pings” an SI, it is sending a FIX message ▴ typically a ‘New Order – Single’ (35=D) message with a ‘Time in Force’ (59) set to ‘Immediate or Cancel’ (IOC).

The SI’s system receives this message, runs its internal pricing and risk checks, and if it chooses to trade, sends an ‘Execution Report’ (35=8) back to the SOR confirming the fill. If it declines, it may send a ‘Reject’ message.

This high-speed communication is built on a foundation of sophisticated technology:

• Low-Latency Networks ▴ Co-location of servers in data centers and dedicated fiber optic lines are used to minimize the physical time it takes for messages to travel between the broker and the SI.
• High-Throughput Engines ▴ Both the SOR and the SI’s matching engine must be capable of processing thousands of messages per second to handle the volume of modern electronic trading.
• Risk Management Systems ▴ The SI’s ability to internalize flow is contingent on a real-time risk management system that constantly monitors the firm’s overall exposure and profitability.

The rise of SIs has forced a co-evolution in the technology of both the buy-side and the sell-side. Buy-side firms must invest in sophisticated SORs to navigate the fragmented landscape, while sell-side firms must build robust, high-performance systems to compete for and monetize order flow. The result is a technological arms race where the ultimate goal is to achieve a fractional advantage in price, speed, or certainty of execution.

Reflection

The architecture of our markets is not a static blueprint; it is a living system in a constant state of flux, shaped by the currents of regulation, technology, and strategic self-interest. The ascent of the Systematic Internaliser is a testament to this dynamism. It presents a fundamental question not just about market structure, but about the very nature of liquidity itself.

Is liquidity a public utility, a shared resource to be nurtured for the collective good of price discovery? Or is it a private commodity, to be captured, internalized, and optimized for individual gain?

Viewing this through a systems lens, we see a structure under stress. The lit markets, the traditional heart of the system, are being bypassed. The very participants who rely on the health of this heart for the lifeblood of pricing information are the ones performing the bypass.

This is not a judgment, but an observation of the system’s internal logic. The incentives for short-term execution quality are powerful and, under current frameworks, often align with routing flow away from the central arteries of the market.

The knowledge gained here is a component in a larger operational framework. How does your own firm’s execution protocol account for this fragmented reality? Is your definition of best execution static, or does it adapt to changing market conditions?

The challenge is not to simply choose between lit and dark, but to build an intelligent, responsive system that can navigate the complexities of both. The ultimate strategic edge lies not in finding a single ‘best’ venue, but in mastering the entire, interconnected system of liquidity.