What Are the Primary Risks for a Buy Side Firm When Interacting with Systematic Internalisers?

Concept

The decision to engage with a systematic internaliser (SI) introduces a series of complex, interconnected risks for a buy-side firm. At its core, the interaction with an SI is a strategic choice to trade against a single counterparty’s proprietary capital, a departure from the multilateral environment of a traditional exchange. This decision carries with it a set of risks that must be carefully managed to protect the interests of the buy-side firm and its clients.

A primary concern is the potential for information leakage. When a buy-side firm sends an order to an SI, it is revealing its trading intentions to a sophisticated market participant. The SI, in turn, can use this information to its advantage, potentially trading ahead of the buy-side firm’s order or using the information to inform its own trading strategies. This risk is particularly acute for large or illiquid trades, where the potential for market impact is greatest.

Another significant risk is adverse selection. This occurs when the SI, armed with superior information about market conditions, selectively fills the buy-side firm’s orders. For example, an SI may be more willing to fill orders that are less likely to be profitable for the buy-side firm, while rejecting or providing less favorable terms for orders that are more likely to be profitable. This can result in a systematic erosion of the buy-side firm’s trading performance over time.

The regulatory landscape surrounding SIs also presents a unique set of challenges. The MiFID II framework, which governs the operation of SIs in Europe, is complex and subject to ongoing interpretation. Buy-side firms must ensure that their interactions with SIs are fully compliant with these regulations, which can be a significant operational and legal burden. Failure to comply with these regulations can result in substantial fines and reputational damage.

Finally, there is the risk of counterparty default. While SIs are typically large, well-capitalized institutions, the risk of default is never zero. A default by an SI could result in significant losses for a buy-side firm, particularly if the firm has a large, open position with the SI. This risk is amplified by the fact that trades with SIs are typically conducted on a bilateral basis, without the benefit of a central clearinghouse to mitigate counterparty risk.

Strategy

A buy-side firm’s strategy for engaging with systematic internalisers must be built on a foundation of rigorous due diligence and a clear understanding of the associated risks. The first step in this process is to develop a comprehensive framework for evaluating and selecting SI counterparties. This framework should consider a range of factors, including the SI’s financial strength, regulatory history, and operational capabilities.

Engaging with systematic internalisers requires a strategic framework that balances the benefits of liquidity and price improvement against the risks of information leakage and adverse selection.

Once a set of preferred SI counterparties has been identified, the buy-side firm must establish clear rules of engagement for interacting with them. These rules should be designed to mitigate the risks of information leakage and adverse selection, while still allowing the firm to access the liquidity and price improvement that SIs can offer. For example, the firm might choose to limit the size of the orders it sends to any single SI, or to use a variety of different SIs to avoid becoming overly reliant on any one counterparty.

Mitigating Information Leakage

One of the most effective ways to mitigate the risk of information leakage is to use a “request for quote” (RFQ) process when interacting with SIs. This process allows the buy-side firm to solicit quotes from multiple SIs simultaneously, without revealing the full size of its order. This can help to reduce the risk of any single SI using the information to its advantage.

Another effective strategy is to use a “dark pool” or other anonymous trading venue to execute large or illiquid trades. These venues allow the buy-side firm to trade without revealing its identity, which can help to reduce the risk of information leakage. However, it is important to note that these venues are not without their own risks, and the buy-side firm must carefully consider the trade-offs involved.

The following table provides a comparison of different strategies for mitigating information leakage when interacting with SIs:

Managing Adverse Selection

Adverse selection is a more difficult risk to manage, as it is often difficult to detect in real-time. However, there are a number of steps that a buy-side firm can take to reduce its exposure to this risk. One of the most effective is to use a “transaction cost analysis” (TCA) system to monitor the quality of the executions it receives from its SI counterparties.

A TCA system can help the buy-side firm to identify any patterns of adverse selection, such as a tendency for a particular SI to provide less favorable pricing on certain types of trades. Armed with this information, the buy-side firm can then take steps to address the issue, such as by reducing the amount of business it does with the offending SI or by negotiating for better terms.

The following list outlines a series of steps that a buy-side firm can take to manage the risk of adverse selection:

• Implement a TCA system to monitor the quality of executions from SI counterparties.
• Establish clear performance metrics for evaluating the performance of SI counterparties.
• Regularly review the performance of SI counterparties and take action to address any issues that are identified.
• Negotiate for better terms with SI counterparties that are found to be engaging in adverse selection.
• Diversify the firm’s use of SIs to avoid becoming overly reliant on any one counterparty.

Execution

The execution of a buy-side firm’s strategy for engaging with systematic internalisers is a critical component of its overall risk management framework. A well-designed execution process can help to ensure that the firm is able to access the benefits of SI liquidity while minimizing its exposure to the associated risks.

A disciplined execution process, supported by robust technology and a clear understanding of the regulatory landscape, is essential for managing the risks of interacting with systematic internalisers.

One of the most important aspects of the execution process is the use of technology. A sophisticated order management system (OMS) or execution management system (EMS) can help the buy-side firm to automate many of the tasks involved in interacting with SIs, such as order routing, quote management, and trade reporting. This can help to reduce the risk of manual errors and to ensure that the firm is able to execute its trades in a timely and efficient manner.

The Role of Technology

A modern OMS or EMS should be able to support a variety of different order types and execution strategies, including those that are specifically designed for interacting with SIs. For example, the system should be able to support RFQ functionality, as well as the ability to slice large orders into smaller pieces and execute them over time. The system should also be able to provide the buy-side firm with real-time access to market data and analytics, which can help it to make more informed trading decisions.

The following table provides an overview of the key features that a buy-side firm should look for in an OMS or EMS for interacting with SIs:

Regulatory Compliance

Another critical aspect of the execution process is regulatory compliance. The MiFID II framework imposes a number of specific obligations on buy-side firms that interact with SIs, and it is essential that the firm has a clear understanding of these obligations and has a process in place to ensure that it is in compliance with them.

One of the most important of these obligations is the requirement to have a “best execution” policy in place. This policy must set out the steps that the firm will take to ensure that it is getting the best possible outcome for its clients when executing their orders. The policy must also be regularly reviewed and updated to ensure that it remains effective.

The following list outlines the key steps that a buy-side firm should take to ensure that it is in compliance with the MiFID II best execution requirements:

• Develop a comprehensive best execution policy that sets out the firm’s approach to interacting with SIs.
• Regularly review and update the policy to ensure that it remains effective.
• Monitor the quality of the executions that the firm receives from its SI counterparties.
• Take action to address any issues that are identified, such as by reducing the amount of business that the firm does with a particular SI or by negotiating for better terms.
• Keep detailed records of all trades that are executed with SIs, including the time of the trade, the price, and the identity of the counterparty.

Reflection

The decision to engage with systematic internalisers is a complex one, with a range of potential benefits and risks. By taking a strategic and disciplined approach to this issue, buy-side firms can position themselves to access the liquidity and price improvement that SIs can offer, while minimizing their exposure to the associated risks. Ultimately, the key to success in this area is to have a clear understanding of the firm’s own risk appetite and to develop a tailored strategy that is aligned with its specific needs and objectives.

How Can We Improve Our SI Engagement Strategy?

As the market for systematic internalisation continues to evolve, it is essential that buy-side firms regularly review and refine their engagement strategies. This should include a thorough assessment of the firm’s current SI counterparties, as well as an evaluation of new and emerging players in the market. By taking a proactive and forward-looking approach, buy-side firms can ensure that they are well-positioned to navigate the challenges and opportunities of this dynamic market.