What Are the Documentation Requirements for Justifying the Use of an SI over an OTF?

Concept

The Mandate for Justification in Execution

In the intricate landscape of MiFID II, the selection of an execution venue is a decision that requires a robust and evidence-based justification. The core of this justification lies not in a single, prescribed form, but in a comprehensive and dynamic process of demonstrating adherence to the principle of best execution. When an investment firm chooses to execute a client’s order through a Systematic Internaliser (SI) rather than on an Organised Trading Facility (OTF), it is making a deliberate choice for a bilateral execution environment over a multilateral one.

This decision necessitates a clear and documented rationale that proves the choice is in the client’s best interest. The documentation serves as a critical line of defense against regulatory scrutiny, demonstrating that the firm has taken all sufficient steps to achieve the best possible result for its clients.

The justification for using a Systematic Internaliser over an Organised Trading Facility is a documented process, not a single form, centered on the firm’s Best Execution Policy.

Distinguishing SIs and OTFs

At a fundamental level, SIs and OTFs represent two distinct models of execution. An SI is an investment firm that deals on its own account, executing client orders outside of a regulated market or multilateral trading facility. This is a bilateral arrangement where the SI is the counterparty to the client’s trade. In contrast, an OTF is a multilateral system where multiple third-party buying and selling interests in bonds, structured finance products, emission allowances, or derivatives are able to interact in a way that results in a contract.

The key difference lies in the nature of the interaction ▴ bilateral for SIs and multilateral for OTFs. This distinction is paramount when documenting the justification for choosing one over the other.

Key Characteristics of Systematic Internalisers

• Bilateral Execution ▴ The SI acts as the principal in the trade, creating a direct, bilateral relationship with the client.
• Own Account Dealing ▴ SIs use their own capital to execute client orders.
• Price Discovery ▴ SIs contribute to price discovery through their quoting obligations.

Key Characteristics of Organised Trading Facilities

• Multilateral Trading ▴ OTFs bring together multiple buyers and sellers.
• Discretionary Execution ▴ OTF operators have a degree of discretion in how they match orders, which is not permitted on regulated markets or MTFs.
• Non-Equity Focus ▴ OTFs are designed for non-equity instruments.

Strategy

The Central Role of the Best Execution Policy

The cornerstone of the justification for using an SI over an OTF is the firm’s Best Execution Policy. This document is not a static set of rules but a dynamic framework that outlines how the firm will achieve the best possible results for its clients on a consistent basis. The policy must be clear, comprehensive, and tailored to the firm’s specific business model and client base. It must detail the factors the firm considers when selecting an execution venue, and the relative importance of these factors.

A firm’s Best Execution Policy is the central document that outlines the rationale for its choice of execution venues, including the use of Systematic Internalisers.

Quantitative Justification through Data Analysis

Until recently, the primary source of data for justifying the use of a particular execution venue came from RTS 27 and RTS 28 reports. While the reporting requirements for these have been subject to change, the underlying principle of using data to justify execution choices remains.

RTS 27 Reports ▴ These reports were published by execution venues, including SIs and OTFs, and provided detailed information on execution quality. The data included metrics on price, costs, speed, and likelihood of execution. By analyzing these reports, firms could compare the execution quality offered by different venues and use this analysis to justify their selection of an SI.

RTS 28 Reports ▴ These reports were published by investment firms and disclosed their top five execution venues for each class of financial instrument. The reports also required a summary of the execution outcomes achieved. An RTS 28 report that lists an SI as a top venue would need to be supported by the firm’s internal analysis of execution quality data, demonstrating that the SI consistently provided best execution.

Qualitative Justification

Beyond the quantitative data, there are qualitative factors that can justify the use of an SI. These should also be documented in the Best Execution Policy.

• Order Size and Nature ▴ For large orders, executing on an SI may be preferable to avoid the market impact that could occur on a multilateral venue.
• Liquidity ▴ An SI may be able to provide liquidity in instruments that are not actively traded on OTFs.
• Client Instructions ▴ If a client provides a specific instruction to execute on a particular SI, the firm is obliged to follow that instruction.

Execution

Documenting the Decision Making Process

The practical execution of justifying the use of an SI over an OTF involves a clear and auditable trail of documentation. This documentation should demonstrate a systematic and evidence-based approach to venue selection.

A clear and auditable trail of documentation is essential for demonstrating a systematic and evidence-based approach to execution venue selection.

Key Documentation Requirements

The following is a list of the key documents and records that a firm should maintain to justify its use of SIs:

1. Best Execution Policy ▴ This is the most critical document. It should be reviewed and updated regularly, and should clearly articulate the firm’s approach to venue selection.
2. Execution Venue Analysis ▴ Firms should document their analysis of the execution quality of the various venues they use, including SIs and OTFs. This analysis should be based on both quantitative data and qualitative factors.
3. Monitoring and Review Records ▴ Firms must be able to demonstrate that they regularly monitor the effectiveness of their execution arrangements. This includes records of any reviews conducted and any changes made to the Best Execution Policy as a result.
4. Client Order Records ▴ For each client order, the firm should be able to demonstrate how it has complied with its Best Execution Policy. This includes records of the venue used and the price and costs of the transaction.
5. RTS 28 Reports (where applicable) ▴ While the future of these reports is under review, firms should maintain copies of any RTS 28 reports they have published, as these provide a public record of their top execution venues.

A Practical Example

Consider a firm that wishes to execute a large block trade in a corporate bond for a client. The firm’s Best Execution Policy states that for large orders in illiquid instruments, it will prioritize minimizing market impact and maximizing the likelihood of execution. The firm obtains quotes from several SIs and also assesses the liquidity available on relevant OTFs. It determines that executing the trade with a particular SI will result in a better price for the client and a lower risk of market impact than attempting to execute the trade on an OTF.

The firm documents this analysis and proceeds with the trade. This documented process provides a clear justification for the use of the SI in this specific instance.

Reflection

The documentation requirements for justifying the use of a Systematic Internaliser over an Organised Trading Facility are a reflection of the broader principles of transparency and accountability that underpin MiFID II. While the specific reporting requirements may evolve, the fundamental obligation to act in the best interests of clients and to be able to demonstrate this through a clear and evidence-based process will remain. The choice of execution venue is not merely an operational decision; it is a strategic one that has a direct impact on client outcomes. As such, it demands a level of diligence and documentation that is commensurate with its importance.