What Are the Best Execution Requirements for Systematic Internalisers under MiFID II?

Concept

The operational mandate for a Systematic Internaliser under the Markets in Financial Instruments Directive II (MiFID II) is a study in controlled friction. Your function is to exist as a contained, private liquidity mechanism operating parallel to the public architecture of regulated markets and multilateral trading facilities. You are, by design, an entity that absorbs client order flow onto its own balance sheet, internalising risk and providing a quote-driven execution pathway. The core challenge resides in reconciling this principal-acting capacity with the unyielding demand for demonstrable best execution.

The regulatory framework requires you to prove, with verifiable data, that your internal execution provides a result for your client that is at least as good as, if not superior to, what they could achieve on a public venue. This creates a fundamental tension ▴ your commercial incentive as a principal dealing on your own account must be systemically aligned with your fiduciary duty to the client. The entire architecture of your best execution policy is the engineering solution to this tension. It is the system of rules, monitoring, and governance that ensures your proprietary trading activity serves, rather than compromises, the client’s interests.

Understanding this dual mandate is the foundational prerequisite to constructing a compliant and commercially viable SI operation. The system is not designed to prevent you from profiting; it is designed to ensure that your profit is the result of providing genuine, measurable value to the client in the form of superior execution quality.

At its core, the MiFID II framework re-architected the European market landscape to enhance transparency and investor protection. Within this new topography, the Systematic Internaliser role was formalized as a specific type of execution venue. An investment firm becomes an SI for a particular financial instrument when it deals on own account by executing client orders outside a regulated market, an MTF, or an OTF on an organised, frequent, systematic, and substantial basis. The transition from a qualitative definition under MiFID I to a more quantitative and formalised one under MiFID II forced a systemic shift.

Firms that previously internalised flow on an ad-hoc basis were required to build robust, auditable systems to manage their new status as designated liquidity providers. This involves a profound architectural commitment. You are building a private market, with all the attendant responsibilities for price formation, pre-trade transparency (in the form of firm quotes), and post-trade reporting. The best execution obligation is the central pillar of this architecture.

It is the governor on your pricing engine, the logic behind your order handling protocols, and the primary output of your compliance monitoring systems. The regulator’s perspective is clear ▴ if you are to be granted the privilege of internalising client flow, you must accept the absolute responsibility of proving its value to the end client.

The best execution framework for a Systematic Internaliser is an engineered solution designed to align the firm’s principal trading incentives with its fiduciary duty to deliver optimal client outcomes.

What Defines the SI Operating System?

The operating system of a Systematic Internaliser is built upon a foundation of specific obligations that differentiate it from other execution venues. The most critical component is the mandatory quoting obligation for liquid instruments. An SI must provide firm, two-way quotes for equity and equity-like instruments up to a Standard Market Size (SMS). This quote is not merely indicative; it is a binding commitment to trade at that price for a specified size.

This requirement transforms the SI from a passive recipient of orders into an active, public price-setter. The quotes must be made public in a manner that is easily accessible to other market participants, typically through an Approved Publication Arrangement (APA). This pre-trade transparency is a core tenet of MiFID II, designed to ensure that even when execution occurs off-venue, it contributes to the overall price discovery process of the market. For less liquid instruments, the obligation is to provide quotes to clients upon request. This entire quoting mechanism must be powered by a sophisticated pricing engine capable of ingesting market data from reference venues, calculating a compliant quote that reflects “prevailing market conditions,” and managing the risk of the positions it takes on.

The concept of “prevailing market conditions” is central to the SI’s operational logic. ESMA has clarified that SI quotes must be close in price to the quotes for the same instrument on the most relevant market in terms of liquidity. This effectively tethers the SI’s pricing to the public markets, preventing the creation of a disconnected, opaque pool of liquidity. The SI must systematically monitor the best bid and offer on the primary exchange and ensure its own quotes are competitive within that context.

This creates a dynamic and technologically demanding environment. The SI’s systems must be capable of updating quotes in real-time to reflect changes in the broader market, managing latency to avoid stale prices, and ensuring that every execution is logged with sufficient data to demonstrate compliance with this principle. The best execution framework, therefore, begins with the integrity of the quote itself. Before an order is even received, the SI has a duty to ensure its pricing is fair and reflective of the wider market, setting the stage for the subsequent evaluation of execution quality.

Strategy

The strategic framework for a Systematic Internaliser is centered on the creation and diligent application of a comprehensive Order Execution Policy. This document is the strategic blueprint that dictates how the firm will satisfy its overarching best execution duty. Under MiFID II, firms are required to take “all sufficient steps” to obtain the best possible result for their clients, a higher standard than the “all reasonable steps” under the previous regime. This policy must be more than a static compliance document; it is an active, data-driven strategy that governs every aspect of the SI’s interaction with client orders.

It must clearly articulate, for each class of financial instrument, the execution factors the firm will prioritize and the execution venues it will use. For an SI, the primary “venue” is itself, which places an even greater burden of proof on the firm. The policy must meticulously detail how executing on a principal basis against the firm’s own book is designed to achieve the best outcome for the client.

The strategy begins with the identification and weighting of the best execution factors. While price and costs are paramount, MiFID II explicitly requires firms to consider a broader range of criteria. These include the speed of execution, the likelihood of execution and settlement, the size and nature of the order, and any other consideration relevant to the execution. An SI’s strategy must define how it balances these factors.

For a large, illiquid order, the likelihood of execution and minimizing market impact might be more important than achieving a marginal price improvement. Conversely, for a small, liquid order, price and speed are likely the dominant factors. The Order Execution Policy must codify this logic. It should explain the circumstances under which the SI will execute an order internally versus routing it to another venue.

This decision cannot be arbitrary; it must be based on a systematic and demonstrable assessment of which path will lead to the superior result for the client. The strategy, therefore, is one of constrained optimization ▴ optimizing for the best client outcome within the operational and risk parameters of the SI model.

Constructing the Order Execution Policy

A robust Order Execution Policy for a Systematic Internaliser is a granular, evidence-based document. It moves beyond generic statements to provide clients with a clear and detailed understanding of the firm’s execution methodology. Recent guidance from ESMA has emphasized the need for policies to be specific and to avoid boilerplate language. The policy must be tailored to the SI’s specific business model and the instruments it trades.

• Venue Selection ▴ The policy must explicitly name the execution venues the firm relies on. For an SI, this list must begin with the firm itself. It must then justify why it is included, explaining how principal execution provides a high-quality outcome. The policy should also list any backup or alternative venues (e.g. regulated markets, MTFs) that may be used if internal execution is not in the client’s best interest.
• Factor Prioritization ▴ For each class of instrument, the policy must detail the relative importance of the execution factors. For example, for liquid equities, the policy might state that price, costs, and speed are the primary determinants of venue selection. For OTC derivatives, it might emphasize the importance of price and likelihood of settlement.
• Client Categorization ▴ The best execution duty differs for retail and professional clients. The policy must explain how the firm’s approach is calibrated for each client type. While the overarching obligation applies to both, the firm may place different emphasis on the execution factors based on the client’s sophistication and objectives.
• Conflicts of Interest ▴ The policy must explicitly address the inherent conflict of interest in principal dealing. It needs to describe the measures in place to prevent the firm’s commercial interests from negatively impacting client outcomes. This includes controls around information leakage and ensuring that the price offered to the client is fair and transparent.

How Does Price Improvement Function Strategically?

Price improvement is a key strategic tool for a Systematic Internaliser to demonstrate the value of its execution model. It is the mechanism by which an SI can provide a better price to the client than is currently available on the reference public venue. MiFID II allows SIs to execute at prices better than their published quotes in “justified cases.” ESMA has clarified that for such improvements to be justified, they must be meaningful and genuinely benefit the client, not just serve to attract order flow with marginal, insignificant price changes. This has led to the common practice of providing price improvement at the midpoint of the best bid and offer (BBO) of the reference market, or at a full tick increment better than the BBO.

The strategic application of price improvement is a core component of the SI’s value proposition. By systematically offering to execute client orders at the midpoint, the SI can provide a tangible, quantifiable benefit. The client saves half of the bid-ask spread they would have paid on the public market. This is a powerful argument for the quality of the SI’s execution.

The firm’s strategy must define the conditions under which price improvement will be offered. This is often automated within the firm’s Smart Order Router (SOR) and trading engine. When a marketable client order is received, the system checks the BBO on the reference venue and, if conditions are met, executes the order internally at the midpoint, capturing the data as evidence of best execution.

The following table illustrates a strategic comparison of execution pathways an SI might consider for a client order to buy 1,000 shares of a liquid stock.

Execution

The execution framework for a Systematic Internaliser is where strategic policy is translated into auditable, operational reality. It is a system of technology, data management, and governance designed to produce and, crucially, to prove best execution on a continuous basis. The entire apparatus must function with precision, as every client execution generates a data footprint that is subject to regulatory scrutiny. The core components of this framework are the quoting and pricing engine, the data and reporting infrastructure, and the overarching compliance and governance structure.

These elements work in concert to ensure that the SI not only meets its obligations but can also defend its execution quality with empirical evidence. The focus is on building a machine that is both commercially effective and regulatorily sound, where the pursuit of optimal execution is embedded into the firm’s technological DNA.

An SI’s execution framework must be an auditable system of technology and governance that translates the abstract duty of best execution into verifiable, data-driven proof for every transaction.

The Quoting and Pricing Engine Mechanics

The heart of an SI’s execution capability is its quoting and pricing engine. This system is responsible for fulfilling the pre-trade transparency obligations under MiFIR Article 14. It must continuously generate firm, two-way quotes for liquid instruments that reflect “prevailing market conditions.” Operationally, this means the engine must have a low-latency connection to the primary market data feed for each instrument it quotes. It ingests the Level 1 data (Best Bid and Offer) from the reference venue and uses this as the basis for its own price.

The engine’s logic must be programmed to adhere to the tick size regime applicable to the reference venue. ESMA has clarified that while SIs are not trading venues, their quotes should align with the price increments on those venues to ensure a level playing field. This prevents the SI from gaining an advantage by offering infinitesimally better prices that fragment liquidity without providing real benefit to investors. The engine must therefore calculate its bid and offer based on the reference BBO and snap them to the correct tick.

For example, if the reference BBO is 10.01 / 10.03 and the tick size is 0.01, the SI cannot quote 10.011. It must quote at a valid price point like 10.01, 10.02, or 10.03.

The following table provides a hypothetical example of an SI’s pricing engine logic for a client’s marketable buy order, demonstrating compliance and price improvement:

Data Monitoring and Reporting Protocols

While the specific obligations to publish quarterly RTS 27 reports (by venues) and annual RTS 28 reports (by firms) have been subject to review and suspension, the underlying requirement for firms to monitor the quality of their execution remains firmly in place. ESMA has been clear that the potential removal of these specific reporting formats does not absolve firms of their core best execution duty. In fact, it places a greater emphasis on the quality and accessibility of a firm’s internal monitoring and data analysis capabilities. An SI must operate a sophisticated transaction cost analysis (TCA) function to continuously assess its performance.

The operational execution of this involves capturing a rich dataset for every single client order. This data must be sufficient to reconstruct the execution decision and compare the outcome against relevant benchmarks. The monitoring process should be systematic and integrated into the firm’s regular compliance reviews.

1. Data Capture ▴ For every order, the SI must log the precise time of receipt, the client details, the instrument, size, and order type. Crucially, it must also capture a snapshot of the market at that exact moment, including the BBO on the primary reference venue and any other relevant venues listed in the execution policy.
2. Execution Analysis ▴ The captured data is then used to calculate a range of performance metrics. These include:
   • Price Improvement ▴ The frequency and monetary value of execution at prices better than the reference market BBO.
   • Effective Spread ▴ A measure of the cost paid by the client relative to the midpoint at the time of execution.
   • Execution Speed ▴ The latency between order receipt and execution confirmation.
   • Likelihood of Execution ▴ The percentage of orders that are successfully executed.
3. Review and Governance ▴ The output of this analysis must be regularly reviewed by a designated committee or function within the firm. This review process must assess whether the firm’s execution arrangements are consistently delivering the best possible results. If the data reveals deficiencies, the firm must take corrective action, which could include adjusting its pricing engine logic, changing its routing strategy, or updating its Order Execution Policy. This entire process must be documented to create an audit trail for regulators.

What Is the Required Compliance and Governance Framework?

A compliant Systematic Internaliser operation requires a formal governance structure to oversee the best execution process. This is not simply an IT or trading function; it is a firm-wide responsibility that requires senior management oversight. The framework ensures that there are clear lines of accountability and that the best execution policy is actively managed and enforced.

The governance structure typically includes a Best Execution Committee, composed of senior representatives from trading, compliance, risk, and technology. This committee is responsible for the annual review and approval of the Order Execution Policy. The annual review is a critical process that must assess whether the venues and strategies outlined in the policy remain appropriate. It involves analyzing the TCA data from the preceding year, considering any changes in market structure or the availability of new execution venues, and ensuring the policy remains compliant with the latest regulatory guidance.

The findings of this review, and any subsequent changes to the policy, must be formally documented and approved. This creates a robust, defensible process that demonstrates to regulators that the firm is not just following rules, but is actively and intelligently pursuing the best possible outcomes for its clients.

Reflection

The architecture you have built to comply with the best execution requirements for a Systematic Internaliser is a direct reflection of your firm’s commitment to its clients. The regulations provide the blueprint, but the quality of the final construction is determined by your choices in technology, data analysis, and governance. Consider your current operational framework. Does it merely satisfy the letter of the law, or does it embody its spirit?

Is your TCA function a forensic tool used to drive continuous improvement, or is it a retrospective reporting exercise? The data your systems generate is more than a compliance artifact; it is the primary intelligence feed on the quality of your market interaction. A superior operational framework views best execution not as a constraint, but as a core competency. It is the engine that drives capital efficiency, manages risk, and ultimately, builds the institutional-grade trust that is the true foundation of a successful Systematic Internaliser.