What Are the Key Differences in Best Execution Obligations for Liquid versus Illiquid Instruments under the SI Regime?

Concept

The distinction between liquid and illiquid instruments within the Systematic Internaliser (SI) regime is not an abstract classification; it is the central pivot upon which the entire framework of best execution and pre-trade transparency balances. For an SI, which deals on its own account by executing client orders outside of a traditional trading venue, the liquidity of an instrument dictates a fundamentally different set of obligations. This operational divergence arises because the price formation process for a liquid instrument, characterized by frequent and readily available pricing data, is systemically different from that of an illiquid one, where price discovery is sporadic and opaque. The Markets in Financial Instruments Directive II (MiFID II) establishes this binary system to ensure that the internalization of order flow does not harm public price discovery while acknowledging the practical realities of trading instruments with sparse data.

The Regulatory Definition of Liquidity

Underpinning the SI regime is a quantitative, data-driven definition of liquidity. It is not left to subjective market interpretation. For non-equity instruments like bonds, the European Securities and Markets Authority (ESMA) has established specific thresholds. An instrument is generally deemed liquid if it trades above a certain frequency and volume over a defined observation period.

For instance, a bond might be classified as liquid if the number of trades over the preceding six months surpasses a set percentage of total EU transactions for that instrument class. This granular, instrument-by-instrument assessment creates a dynamic environment where an asset’s classification can change, compelling SIs to maintain robust systems for continuous monitoring. The core principle is that if an instrument has a sufficiently deep and active market, the SI’s pricing and execution duties must reflect that public liquidity.

The fundamental obligation of best execution requires firms to take all sufficient steps to obtain the best possible result for their clients, considering factors like price, cost, and speed.

Systematic Internalisers a Hybrid Function

The SI occupies a unique position in the market ecosystem, functioning as a hybrid between a traditional bilateral counterparty and a formal trading venue. Unlike a multilateral trading facility (MTF) or an organized trading facility (OTF), an SI executes client orders against its own proprietary capital. This model provides clients with a source of dedicated liquidity. However, to prevent this activity from creating a two-tiered market that disadvantages public venues, MiFID II imposes venue-like transparency requirements on SIs.

The extent of these obligations is directly calibrated to the liquidity of the instrument being traded. For liquid instruments, the SI must operate in a manner that contributes to public price information, whereas for illiquid instruments, the framework provides greater flexibility to reflect the challenges of price formation.

The Core Execution Mandate

The best execution mandate under MiFID II is an overarching requirement that applies regardless of an instrument’s liquidity classification. It compels firms to establish and implement an order execution policy that consistently delivers the best possible result for clients. This policy must detail the execution venues and factors considered for each class of financial instrument. The critical difference emerges in how an SI demonstrates compliance with this mandate.

For liquid instruments, proof of best execution is heavily reliant on benchmarking against public market data. For illiquid instruments, the demonstration becomes more qualitative, focusing on the fairness of the price in the context of the prevailing market conditions, even when those conditions are difficult to observe.

Strategy

An investment firm’s decision to operate as a Systematic Internaliser necessitates a sophisticated strategy that adapts dynamically to the liquidity profile of the instruments it trades. The regulatory framework under MiFID II is not a monolithic set of rules; it is a carefully calibrated system where obligations for liquid and illiquid assets diverge significantly. This divergence forces SIs to develop a dual-track operational strategy covering pre-trade transparency, client quoting, and post-trade reporting. The strategic objective is to fulfill the best execution mandate for all clients while managing the distinct operational burdens and market impact risks associated with each liquidity category.

Pre-Trade Transparency a Tale of Two Mandates

The most pronounced strategic difference lies in pre-trade transparency, specifically the obligation to publish firm quotes. This duty is a cornerstone of the SI regime’s goal to support public price discovery.

• Liquid Instruments For instruments classified as liquid, an SI must provide public, firm quotes for transactions up to a standard market size. These quotes must be readily available to other market participants during continuous trading hours. This requirement effectively turns the SI into a public price point, contributing to the overall market’s transparency. The strategic challenge here is managing the risk of being picked off by high-frequency traders or other informed market participants while fulfilling the legal obligation to provide firm, executable prices.
• Illiquid Instruments For illiquid instruments, this public quoting obligation is lifted. An SI is not required to display firm quotes to the entire market. Instead, transparency obligations are triggered only upon a client’s request for a quote (RFQ). This allows the SI to manage its risk more effectively in markets where continuous price formation is absent. The strategy shifts from public price provision to demonstrating fairness and best execution within the context of a bilateral negotiation.

Firms must provide clients with clear information on their order execution policy, detailing the venues and factors affecting choice for each instrument class.

The Quoting Process and Price Formation

The client interaction model also bifurcates based on liquidity. For liquid instruments, the SI’s quoted price is expected to be at or better than the prices available on public venues. The SI must be able to demonstrate that the price offered to the client is competitive against the European Best Bid and Offer (EBBO). This necessitates a real-time connection to market data feeds and sophisticated internal pricing engines.

For illiquid instruments, the concept of a single “best” price is more ambiguous. The SI’s strategy must focus on constructing a “fair” price. This process involves gathering relevant data points, which may include:

• Recent trades in the same or similar instruments.
• Quotes from other liquidity providers.
• Internal valuation models.
• Information on the client’s specific needs and the size of the order.

The ability to document this price formation process is a critical component of the compliance strategy for illiquid assets.

Comparative Obligations for SIs

The following table outlines the key strategic differences in the obligations for SIs when handling liquid versus illiquid instruments.

Post-Trade Reporting and Risk Management

The strategic considerations extend into the post-trade environment. While all trades must be reported, the timelines for this reporting differ. For liquid instruments, the goal is rapid dissemination of trade data to inform the market. For illiquid instruments, regulators acknowledge that immediate publication of a large trade could expose the SI to significant risk, as other market participants could trade against the SI’s remaining position.

Consequently, the rules allow for longer publication deferrals for illiquid trades. An SI’s strategy must incorporate a clear policy on when and how to use these deferrals, balancing the need for risk management with the ultimate goal of market transparency.

Execution

The execution framework for a Systematic Internaliser is a high-stakes engineering challenge, demanding a technical and procedural architecture capable of flawlessly navigating the dual obligations for liquid and illiquid instruments. At this level, strategic policy translates into concrete operational workflows, data management protocols, and compliance verification systems. The quality of execution is not an abstract goal but a measurable output of this finely tuned machinery. A failure to correctly classify an instrument or apply the corresponding execution logic can result in regulatory sanction and significant reputational damage.

Operationalizing Instrument Classification

The first critical step in the execution process is the continuous and accurate classification of every financial instrument. This is not a one-time setup but a dynamic process.

1. Data Ingestion The SI must have systems to ingest and process large volumes of market data from ESMA and other sources that determine an instrument’s liquidity status. This data includes trading volumes and frequency across all EU venues.
2. Classification Engine An internal rules engine must apply the regulatory criteria to this data to assign a “liquid” or “illiquid” status to each instrument in the SI’s trading universe. This engine must be updated regularly to reflect changes in market activity.
3. System-Wide Propagation Once an instrument’s status is determined, that information must be propagated across all relevant internal systems, including the order management system (OMS), execution management system (EMS), and quoting engines. This ensures that the correct handling logic is applied from the moment a client inquiry is received.

Execution Workflows a Divergent Path

Upon receiving a client order, the execution path diverges immediately based on the instrument’s liquidity classification. This requires two distinct, pre-programmed workflows within the firm’s trading systems.

The Liquid Instrument Workflow

For a liquid instrument, the process is built for speed, transparency, and benchmarking against the public market.

• Quote Generation The SI’s pricing engine must generate a quote that is at or better than the best available public price. This requires real-time data feeds from all relevant trading venues. The quote sent to the client must be firm and executable up to the standard market size.
• Public Dissemination Simultaneously, this quote must be made public through the appropriate channels, contributing to the consolidated tape.
• Execution and Reporting Upon client acceptance, the trade is executed against the SI’s principal book. The post-trade report is then generated and published in near real-time, typically within minutes of the transaction.

The Illiquid Instrument Workflow

For an illiquid instrument, the process is more deliberative, prioritizing the construction of a fair price over speed.

• Price Discovery The trader or an automated system begins a price discovery process. This may involve querying other dealers, consulting recent transaction data (if available), and running internal valuation models. All data points used in this process must be logged for compliance purposes.
• Bilateral Negotiation The quote is provided directly to the client. This may lead to a negotiation process, which must also be documented.
• Execution and Deferred Reporting Once a price is agreed upon, the trade is executed. The firm’s systems must then apply the appropriate deferral logic for post-trade publication, delaying the public report to mitigate risk.

The obligation to execute orders on terms most favorable to the client applies to all financial instruments, including those traded over-the-counter.

Illustrative Execution Data

The following table provides a simplified example of the data generated during the execution process for both types of instruments.

Compliance and Monitoring

A robust execution framework must be complemented by a rigorous compliance and monitoring layer. Transaction Cost Analysis (TCA) is essential for both liquid and illiquid instruments, although the metrics used will differ. For liquid products, TCA focuses on metrics like price improvement versus the public benchmark. For illiquid products, TCA must assess the fairness of the price against the documented price discovery efforts.

Firms are required to regularly review their execution policies and demonstrate to regulators that their arrangements are effective in delivering best execution on a consistent basis. This requires storing vast amounts of data about every order and being able to reconstruct the entire lifecycle of a trade upon request.

Reflection

Calibrating the Execution Machinery

The intricate web of rules governing liquid and illiquid instruments under the Systematic Internaliser regime is more than a compliance exercise; it is a mandate to build a sophisticated, intelligent, and responsive trading apparatus. The regulations force a firm to look inward, to dissect its own operational DNA, and to ask fundamental questions about its execution capabilities. Does our technology possess the acuity to distinguish liquidity on an instrument-by-instrument basis in real time? Is our data architecture robust enough to not only ingest market-wide information but also to log every internal data point that contributes to a “fair” price in an opaque market?

Viewing these obligations through a purely regulatory lens is to miss the strategic imperative. The capacity to provide competitive, compliant execution in liquid instruments while simultaneously navigating the complexities of illiquid markets is a significant commercial advantage. It signals to clients a mastery of market structure and a commitment to their interests that transcends any single transaction. The framework, therefore, becomes a catalyst for operational excellence.

It compels the development of systems that are not just compliant, but also smarter, faster, and more precise. The ultimate reflection for any firm operating as an SI is whether its execution framework is merely a response to regulatory pressure, or if it has been engineered to be a core component of its strategic market offering.