Concept
The decision to connect with a new Systematic Internaliser (SI) is a deep commitment to a specific liquidity architecture. It represents a calculated choice to engage with a counterparty that operates under a distinct regulatory and functional mandate, executing client orders against its own principal book. Understanding this mechanism is the foundational requirement before any due diligence checklist is even contemplated. An SI is an investment firm that, on an organised, frequent, systematic, and substantial basis, deals on its own account by executing client orders outside a traditional trading venue.
This structure presents a unique source of liquidity, one that is proprietary and curated by the SI itself. The primary due diligence process, therefore, begins with a conceptual grasp of this reality. You are not merely connecting to another execution venue; you are establishing a direct, bilateral relationship with a principal risk taker.
This relationship’s architecture is governed by the Markets in Financial Instruments Directive II (MiFID II), which extended the SI regime beyond equities to a wider array of financial instruments, including bonds and derivatives. The directive’s purpose was to enhance transparency in markets by subjecting these major liquidity providers to pre-trade transparency obligations similar to those of regulated markets. For the onboarding firm, this means the SI is obligated to provide firm quotes, creating a more structured and transparent form of off-exchange trading. The initial phase of due diligence is an appraisal of this very structure.
It requires an analysis of how this specific form of bilateral, principal-based liquidity will integrate with the firm’s existing execution protocols and best execution mandate. The core question is not “Can we connect?” but “How does this specific principal’s liquidity profile and operational framework enhance our own system for achieving optimal client outcomes?”
The initial due diligence phase is a strategic assessment of how a Systematic Internaliser’s principal-based liquidity model integrates into and enhances a firm’s existing execution architecture.
The functional reality of an SI is that it is a curated liquidity pool. The prices quoted are not passive reflections of a central limit order book; they are active expressions of the SI’s own risk appetite and inventory. This has profound implications for the due diligence process. It must extend beyond a simple check of regulatory status.
It must become an investigation into the SI’s market-making philosophy, its sources of liquidity, and its behavior under various market conditions. A firm must ascertain how the SI manages its own risk, as this will directly influence the quality and reliability of the liquidity it provides. The process is an exercise in systems thinking, mapping the flow of information and risk between the firm’s execution management system (EMS) and the SI’s proprietary trading engine. This initial conceptual framing shapes every subsequent stage of due diligence, from technical connectivity to legal agreements, ensuring that the entire process is aligned with the strategic goal of sourcing superior liquidity, not just adding another counterparty.
Strategy
A robust strategy for onboarding a Systematic Internaliser moves beyond rote compliance to a sophisticated, multi-layered risk and performance assessment. The objective is to construct a comprehensive framework that evaluates a potential SI counterparty across several critical vectors ▴ financial stability, operational resilience, execution quality, and regulatory alignment. This framework serves as the strategic filter through which all potential SIs are vetted, ensuring that any new relationship is a net positive for the firm’s execution capabilities and overall risk posture. The development of this strategy is the second tier of the due diligence process, translating conceptual understanding into a concrete plan of action.
What Is the Core of a Counterparty Risk Framework?
At the heart of the onboarding strategy lies the counterparty risk framework. This is a structured methodology for quantifying and qualifying the risks associated with entering into a bilateral trading relationship. The framework must be dynamic, allowing for the ongoing monitoring of the SI long after the initial onboarding is complete. It is a system designed to protect the firm from financial, operational, or reputational damage resulting from a counterparty failure.
The framework is built upon several pillars of analysis. Each pillar represents a distinct domain of risk that must be thoroughly investigated. The output of this analysis should be a clear, data-driven assessment that informs the final decision to onboard.
- Financial Stability Analysis This involves a deep dive into the SI’s financial health. The analysis should scrutinize balance sheets, income statements, and cash flow statements. Key metrics include capital adequacy ratios, leverage ratios, and liquidity coverage ratios. The goal is to assess the SI’s ability to withstand market shocks and meet its financial obligations.
- Operational Resilience Assessment This pillar focuses on the SI’s technological and operational infrastructure. It includes a review of the firm’s trading systems, data security protocols, and business continuity plans. The assessment must verify that the SI can provide reliable, uninterrupted service and protect sensitive client data.
- Execution Quality and Market Impact Analysis This is a quantitative assessment of the SI’s performance as a liquidity provider. It involves analyzing historical trade data to measure execution quality against various benchmarks. Key metrics include price improvement, effective spread, fill rates, and adverse selection. The analysis seeks to understand how the SI’s pricing and liquidity provision will impact the firm’s trading costs and information leakage.
Developing a Comparative Analysis Model
To operationalize the risk framework, a comparative analysis model is an indispensable tool. This model allows the firm to score and rank potential SI counterparties based on a consistent set of criteria. The model should be tailored to the firm’s specific needs and risk appetite, with weightings assigned to different criteria based on their perceived importance. This systematic approach ensures that the selection process is objective and aligned with the firm’s strategic priorities.
The following table provides an illustrative example of a comparative analysis model for evaluating two hypothetical SI counterparties. The scores are based on a scale of 1 to 5, with 5 being the highest rating.
| Diligence Criterion | Systematic Internaliser A | Systematic Internaliser B | Weighting | Weighted Score A | Weighted Score B |
|---|---|---|---|---|---|
| Financial Stability (Credit Rating, Capital Ratios) | 4 | 3 | 30% | 1.2 | 0.9 |
| Operational Resilience (System Uptime, DR Plan) | 5 | 4 | 25% | 1.25 | 1.0 |
| Asset Class Coverage (Equities, Bonds, FX) | 3 | 5 | 20% | 0.6 | 1.0 |
| Execution Quality (Price Improvement, Fill Rate) | 4 | 4 | 15% | 0.6 | 0.6 |
| Technological Integration (FIX Protocol, API) | 5 | 3 | 10% | 0.5 | 0.3 |
| Total Score | – | – | 100% | 4.15 | 3.80 |
A successful onboarding strategy relies on a dynamic, multi-faceted risk framework that systematically evaluates counterparties across financial, operational, and performance-based criteria.
Integrating with Best Execution Obligations
A critical component of the strategy is ensuring that the onboarding of a new SI aligns with the firm’s overarching best execution obligations under MiFID II. This requires a documented process for how the SI will be incorporated into the firm’s order routing logic and execution policy. The firm must be able to demonstrate that the inclusion of the SI is reasonably expected to lead to better outcomes for clients.
This involves defining the specific scenarios in which flow will be directed to the SI. For example, the SI might be prioritized for certain order types, sizes, or asset classes where it has demonstrated a consistent ability to provide superior liquidity or pricing. The firm’s best execution committee should review and approve the strategy for incorporating the SI, and the decision should be documented with a clear rationale. The ongoing monitoring of the SI’s execution quality is also a crucial part of this process, with regular reviews to ensure that it continues to contribute positively to the firm’s best execution performance.
Execution
The execution phase of onboarding a Systematic Internaliser is where strategic theory is translated into operational reality. This is a meticulous, multi-stage process that requires the coordinated effort of legal, compliance, operations, and technology teams. It is a project with zero tolerance for error, as any failure can result in regulatory sanction, financial loss, or reputational damage. The execution is governed by a detailed operational playbook that breaks down the onboarding process into a series of discrete, manageable tasks, each with its own set of procedures and controls.
The Operational Playbook a Step by Step Guide
The operational playbook is the master document that guides the entire execution phase. It provides a granular, step-by-step checklist of all the activities that must be completed to bring a new SI online. The playbook is typically divided into several distinct phases, from initial due diligence to post-live monitoring.
Phase 1 Initial Due Diligence and Information Gathering
This phase involves the collection and review of all necessary documentation from the potential SI counterparty. The objective is to build a comprehensive profile of the firm and perform a preliminary assessment of its suitability.
- Documentation Request A formal request is sent to the SI for a comprehensive package of due diligence materials. This includes constitutional documents, financial statements, regulatory licenses, compliance manuals, and details of their operational and technological infrastructure.
- Know Your Counterparty (KYC) and Anti-Money Laundering (AML) Checks A thorough KYC and AML check is performed to verify the identity of the counterparty and assess its risk profile. This includes screening against sanctions lists and checking for adverse media. The requirement for a Legal Entity Identifier (LEI) is fundamental for all counterparties under MiFID II.
- Preliminary Risk Assessment A high-level review of the collected documents is conducted to identify any immediate red flags. This assessment covers financial stability, regulatory standing, and operational capabilities.
Phase 2 Deep Dive Departmental Reviews
In this phase, the detailed analysis of the SI is carried out by the relevant internal teams. Each team performs a specialized review based on its area of expertise.
- Legal and Compliance Review The legal team reviews all agreements, including the master trading agreement and the FIX connectivity agreement. The compliance team assesses the SI’s regulatory status, its adherence to MiFID II requirements, and its internal policies and procedures. This includes verifying their product governance and distribution strategies.
- Credit Risk Review The credit risk team performs a detailed financial analysis of the SI. This involves stress testing their balance sheet, analyzing their funding sources, and assigning an internal credit rating. The objective is to quantify the potential financial loss in the event of a counterparty default.
- Operational and Technology Review The operations and technology teams conduct a thorough review of the SI’s operational and technical capabilities. This includes an assessment of their trade processing workflow, settlement procedures, and disaster recovery plans. A key part of this review is the analysis of their FIX protocol specification and connectivity options.
Quantitative Modeling and Data Analysis
A cornerstone of the execution phase is the quantitative analysis of the SI’s potential performance. This involves using data-driven models to forecast execution quality and to establish a baseline for ongoing monitoring. This analysis must be rigorous and objective, providing a clear-eyed view of the expected costs and benefits of the relationship.
Counterparty Financial Health Scorecard
A quantitative scorecard is used to distill the complex financial data of the SI into a single, easily understandable risk rating. This model combines various financial metrics, each with a specific weighting, to produce a composite score. This score provides a standardized measure of financial health that can be used to compare different counterparties and to track the SI’s financial stability over time.
| Financial Metric | Data Point | Weighting | Score (1-10) | Weighted Score |
|---|---|---|---|---|
| Common Equity Tier 1 (CET1) Ratio | 14.5% | 25% | 8 | 2.0 |
| Leverage Ratio | 5.2% | 20% | 7 | 1.4 |
| Liquidity Coverage Ratio (LCR) | 130% | 20% | 9 | 1.8 |
| 5-Year Credit Default Swap (CDS) Spread | 75 bps | 15% | 6 | 0.9 |
| External Credit Rating (S&P, Moody’s) | A+ | 20% | 8 | 1.6 |
| Total Composite Score | – | 100% | – | 7.7 |
Phase 3 Integration and Testing
Once the deep-dive reviews are complete and the SI has been approved, the technical integration and testing phase begins. This is a critical phase that ensures the seamless and secure flow of orders and executions between the firm and the SI.
- Connectivity Establishment A secure network connection is established between the firm and the SI. This can be a dedicated line, a VPN connection, or a connection through a third-party network provider.
- FIX Session Certification The firm’s technology team works with the SI to certify the FIX protocol messaging. This involves a series of tests to ensure that all message types (e.g. New Order, Cancel, Execution Report) are sent and received correctly.
- User Acceptance Testing (UAT) The trading desk and operations teams conduct UAT to validate the end-to-end workflow. This includes placing test orders, verifying execution reports, and ensuring that trades flow correctly to the firm’s back-office systems.
The execution of an SI onboarding project is a regimented, multi-phase process that culminates in rigorous testing to ensure complete operational and technological integrity before any client order is routed.
Phase 4 Go-Live and Ongoing Monitoring
The final phase is the activation of the SI for live trading. This is done in a controlled and phased manner to minimize any potential disruption.
The go-live process typically involves a gradual ramp-up of trading volume, starting with small, non-critical orders. The performance of the SI is closely monitored in the initial days and weeks of trading. This includes tracking execution quality, system stability, and settlement rates.
A formal post-live review is conducted to assess the success of the onboarding project and to identify any lessons learned. The ongoing monitoring of the SI becomes part of the firm’s regular counterparty risk management process, with periodic reviews to ensure that the SI continues to meet the firm’s standards.
References
- Fenergo. “MiFID II ▴ 6 Key Changes for Client Lifecycle Management.” Fenergo, 15 June 2017.
- International Capital Market Association. “MiFID II/R ▴ Systematic Internalisers An ICMA ‘FAQ’ for bond markets.” ICMA, Nov. 2016.
- Societe Generale. “MIFID II LEAFLET.” Societe Generale Corporate & Investment Banking, 2017.
- European Securities and Markets Authority. “Guidelines on MiFID II product governance requirements.” ESMA, 5 Feb. 2018, ESMA35-43-620.
- A-Team Group. “Meeting Client and Counterparty Identity Requirements Under MiFID II.” A-Team Insight, 2017.
Reflection
The process of onboarding a Systematic Internaliser is a profound exercise in institutional self-awareness. It forces a firm to articulate its own risk appetite, its operational capabilities, and its strategic vision for liquidity sourcing. The frameworks, checklists, and quantitative models are the external manifestations of this internal calculus. They are the tools through which a firm defines its own standards of excellence and holds its counterparties to them.
Ultimately, the decision to connect with a new SI is a decision about the kind of firm you want to be. Is your operational framework robust enough to handle the complexities of a bilateral relationship? Is your technological architecture agile enough to integrate a new liquidity source seamlessly? Is your risk management culture strong enough to continuously monitor and manage the associated exposures?
The due diligence process provides the answers to these questions. It is a mirror that reflects the firm’s own readiness to compete in an increasingly complex and fragmented market landscape. The real value of the process lies not just in the selection of a counterparty, but in the strengthening of the firm’s own internal systems and controls.
Glossary
Executing Client Orders
Systematic Internaliser
Due Diligence Process
Due Diligence
Mifid Ii
Best Execution
Diligence Process
Risk Appetite
Operational Resilience
Financial Stability
Counterparty Risk Framework
Ongoing Monitoring
Financial Stability Analysis
Financial Health
Execution Quality
Comparative Analysis Model
Risk Framework
Comparative Analysis
Best Execution Obligations
Under Mifid
Operational Playbook
Execution Phase
Credit Rating
Fix Protocol
Counterparty Risk Management
Liquidity Sourcing
