What Are the Key Differences in Due Diligence for Equity versus Non-Equity SIs?

Concept

The operational imperative of due diligence when engaging with a Systematic Internaliser (SI) is a function of the instrument being traded. An SI, at its core, is an investment firm that, on an organised, frequent, systematic, and substantial basis, deals on its own account when executing client orders outside a regulated market, a multilateral trading facility (MTF), or an organised trading facility (OTF). The critical distinctions in due diligence between equity and non-equity SIs are rooted in the fundamental structural differences of their respective markets, the nature of the instruments themselves, and the corresponding regulatory frameworks designed to govern them. For equities, the market is largely characterised by centralised liquidity, standardised products, and a high degree of transparency, which shapes the due diligence process around best execution and price formation.

In contrast, the non-equity space, encompassing instruments like bonds, derivatives, and structured finance products, is inherently more fragmented, bespoke, and opaque. This necessitates a due diligence framework that places a greater emphasis on counterparty risk, valuation complexity, and the specifics of bilateral relationships.

What Defines the Scope of Due Diligence for Systematic Internalisers?

The scope of due diligence for SIs is defined by the regulatory obligations imposed by frameworks such as MiFID II. These regulations establish the foundation for transparency, best execution, and reporting, which in turn dictate the investigative priorities for any firm connecting to an SI. For equity SIs, the focus is sharpened by the existence of a consolidated tape and a more homogenous market structure. This allows for a more quantitative approach to due diligence, centered on execution quality metrics like price improvement, speed of execution, and certainty of fill.

The availability of public data facilitates a more direct comparison of an SI’s performance against the broader market. For non-equity SIs, the due diligence process is less about direct comparison and more about qualitative assessment. The bespoke nature of many non-equity products means that valuation is a key area of scrutiny. Due diligence must therefore extend to the SI’s pricing methodologies, the sources of its market data, and the expertise of its trading desk. The absence of a consolidated tape for most non-equity instruments also means that firms must rely more heavily on the SI’s own disclosures and their bilateral relationship to ensure best execution.

Due diligence for equity SIs is a quantitative exercise in verifying execution quality against a transparent market, while for non-equity SIs, it is a qualitative assessment of counterparty risk and valuation expertise in an opaque environment.

The Regulatory Landscape and Its Impact on Due Diligence

The regulatory landscape, primarily shaped by MiFID II in Europe, creates a clear demarcation between the due diligence requirements for equity and non-equity SIs. The pre-trade transparency obligations for equity SIs are significantly more stringent than for their non-equity counterparts. Equity SIs are required to make public firm quotes for trades up to a standard market size, providing a clear benchmark for price comparison. This transparency simplifies the due diligence process, as it allows for a direct and ongoing assessment of an SI’s pricing competitiveness.

For non-equity SIs, the pre-trade transparency requirements are more nuanced. They are generally only required to provide quotes to clients on request, and the obligation to make those quotes public is limited. This distinction has a profound impact on due diligence. Instead of relying on public data, firms must establish robust internal processes to request, record, and analyse quotes from non-equity SIs to satisfy their best execution obligations. This necessitates a more active and ongoing due diligence process, with a greater emphasis on the documentation of the quoting process and the rationale for execution decisions.

Strategy

A strategic approach to due diligence for Systematic Internalisers (SIs) requires a nuanced understanding of the distinct risk profiles and operational mechanics of equity and non-equity markets. The overarching goal is to construct a due diligence framework that is not only compliant with regulatory mandates but also serves as a source of competitive advantage by ensuring optimal execution and mitigating counterparty risk. The strategic divergence in due diligence for equity versus non-equity SIs is a direct consequence of the structural dissimilarities between these two market segments.

For equities, the strategy is one of continuous, data-driven performance monitoring. For non-equity instruments, the strategy is one of deep, qualitative counterparty assessment and the cultivation of robust bilateral relationships.

A Framework for Equity SI Due Diligence

The strategic framework for equity SI due diligence is built on a foundation of quantitative analysis. The high degree of transparency and standardisation in equity markets allows for a systematic and data-centric approach to evaluating SI performance. The primary objective is to verify that the SI is consistently delivering best execution, which can be measured through a variety of key performance indicators (KPIs). A comprehensive due diligence strategy for equity SIs should encompass the following components:

• Execution Quality Analysis ▴ This involves a rigorous analysis of the SI’s execution data, including metrics such as price improvement versus the European Best Bid and Offer (EBBO), execution speed, fill rates, and the frequency of quote withdrawals. This analysis should be conducted on an ongoing basis to detect any degradation in performance.
• Technology and Connectivity Assessment ▴ A thorough evaluation of the SI’s technological infrastructure is essential. This includes an assessment of the stability and latency of its connectivity options, the sophistication of its order routing logic, and the robustness of its risk management systems.
• Compliance and Regulatory Adherence ▴ Verification of the SI’s compliance with all relevant regulatory obligations, including pre-trade transparency, post-trade reporting, and the segregation of client assets, is a critical component of the due diligence process.

A Framework for Non-Equity SI Due Diligence

The strategic framework for non-equity SI due diligence is necessarily more qualitative and relationship-driven. The opacity and fragmentation of non-equity markets, coupled with the bespoke nature of many of the instruments, demand a more intensive and ongoing assessment of counterparty risk and valuation expertise. The following components are central to a robust due diligence strategy for non-equity SIs:

• Counterparty Risk Assessment ▴ This is the cornerstone of non-equity SI due diligence. It involves a deep dive into the SI’s financial stability, creditworthiness, and operational resilience. This assessment should be updated regularly to reflect any changes in the SI’s risk profile.
• Valuation and Pricing Methodology Review ▴ A thorough understanding of the SI’s valuation methodologies is critical. This includes an evaluation of the sources of its market data, the models it uses to price complex instruments, and the expertise of its trading and risk management teams.
• Relationship and Communication Protocol Evaluation ▴ The quality of the bilateral relationship with a non-equity SI is a key determinant of execution quality. The due diligence process should assess the clarity and efficiency of the SI’s communication protocols, the responsiveness of its trading desk, and its willingness to provide transparency into its pricing and execution logic.

The strategic imperative for equity SI due diligence is the systematic optimization of execution quality through data analysis, while for non-equity SIs, it is the mitigation of counterparty risk through deep qualitative assessment.

Execution

The execution of a due diligence program for Systematic Internalisers (SIs) is a critical operational function that requires a meticulous and systematic approach. The process must be tailored to the specific characteristics of the asset class, with a clear understanding of the distinct risks and opportunities presented by equity and non-equity SIs. The ultimate goal is to create a robust and repeatable process that not only satisfies regulatory requirements but also enhances the firm’s execution quality and protects it from unforeseen counterparty risks. This section provides a detailed operational playbook for executing due diligence on both equity and non-equity SIs.

The Operational Playbook for Equity SI Due Diligence

The execution of due diligence for an equity SI is a data-intensive process that can be broken down into a series of distinct steps. The following playbook provides a structured approach to this process:

1. Initial Scoping and Information Gathering ▴ The first step is to define the scope of the due diligence and gather all relevant documentation from the SI. This includes their regulatory status, their best execution policy, their connectivity specifications, and any other relevant legal or operational documents.
2. Quantitative Performance Analysis ▴ This is the core of the equity SI due diligence process. It involves a deep dive into the SI’s execution data to assess its performance against a range of key metrics. This analysis should be conducted using a Transaction Cost Analysis (TCA) framework and should compare the SI’s performance to relevant benchmarks, such as the volume-weighted average price (VWAP) and the implementation shortfall.
3. Technology and Infrastructure Assessment ▴ This step involves a thorough review of the SI’s technology stack, including its order management system (OMS), its smart order router (SOR), and its risk management systems. The assessment should focus on the stability, latency, and scalability of the SI’s infrastructure.
4. On-site Visit and Management Interviews ▴ Where possible, an on-site visit to the SI’s premises can provide valuable insights into its operations and culture. Interviews with key personnel, including the head of trading, the chief technology officer, and the chief compliance officer, can help to corroborate the findings of the quantitative and technological assessments.
5. Final Report and Recommendation ▴ The final step is to compile a comprehensive due diligence report that summarises the findings of the investigation and provides a clear recommendation on whether to approve the SI as a counterparty. The report should include a detailed analysis of the SI’s strengths and weaknesses, as well as a clear articulation of any identified risks and mitigating factors.

The Operational Playbook for Non-Equity SI Due Diligence

The execution of due diligence for a non-equity SI is a more qualitative and investigative process. The following playbook provides a structured approach:

1. Counterparty Risk Deep Dive ▴ The initial and most critical step is a thorough assessment of the SI’s financial health. This involves a review of its audited financial statements, its credit ratings from major agencies, and its capital adequacy ratios. The goal is to build a comprehensive picture of the SI’s ability to withstand market shocks and meet its financial obligations.
2. Valuation Methodology and Transparency Review ▴ This step requires a detailed examination of how the SI prices the non-equity instruments it trades. The due diligence team should request and review the SI’s valuation policies, its model validation procedures, and the sources of its market data. The objective is to gain confidence in the fairness and accuracy of the SI’s pricing.
3. Operational and Legal Framework Analysis ▴ This involves a review of the SI’s operational infrastructure, including its trade processing, settlement, and collateral management capabilities. The legal team should also review the master trading agreement and any other relevant legal documentation to ensure that the firm’s interests are protected.
4. Relationship and Performance Assessment ▴ This is an ongoing process of evaluating the quality of the relationship with the SI. It includes an assessment of the responsiveness of its sales and trading teams, the clarity of its communication, and its willingness to provide transparency on an ongoing basis. Regular performance reviews should be conducted to track key metrics such as quote response times, fill rates, and post-trade processing efficiency.
5. Ongoing Monitoring and Review ▴ Due diligence for a non-equity SI is not a one-time event. It is an ongoing process of monitoring and review. The due diligence team should establish a regular cadence for reassessing the SI’s creditworthiness, its valuation practices, and its operational performance.

Executing due diligence on an equity SI is a process of verifying performance through data, while for a non-equity SI, it is a process of building confidence through investigation.

Reflection

The rigorous application of a differentiated due diligence framework for equity and non-equity Systematic Internalisers is a hallmark of a sophisticated and risk-aware trading operation. The insights gained from this process extend far beyond simple counterparty approval. They inform the very architecture of a firm’s trading strategy, shaping its approach to liquidity sourcing, its allocation of order flow, and its management of execution risk. The discipline of due diligence, therefore, becomes a foundational element in the pursuit of a sustainable competitive edge.

As market structures continue to evolve and the lines between asset classes blur, the ability to dissect and understand the nuanced risks of each execution pathway will become an increasingly vital determinant of success. The question then becomes, how can the intelligence gathered through due diligence be integrated into a dynamic and adaptive execution framework that anticipates and responds to the ever-changing landscape of modern markets?