Systematic internaliser (SI) is not a new term. It was first introduced under MiFID in 2007, but the system has remained dormant over several years. There are currently 11 firms registered as an SI, including the likes of Goldman Sachs, Citi, UBS and Credit Suisse. Although this figure will grow substantially under MiFID II due to come into effect on 3 January 2018.
An SI under MiFID II and MIFIR is considered to be an investment firm that deals on its own account by executing client orders - on an organised, frequent and systematic basis - outside of a regulated market, multilateral trading facility (MTF) or organised trading facility (OTF).
MiFID II has widened the scope of firms deemed to be an SI - something which caused a lot of confusion among market participants when first announced - and virtually all financial instruments are now included under the regime.
Quantitative thresholds have been introduced by the European Securities and Market Authority (ESMA) and firms will be required to carry out assessments based on these thresholds to determine whether they are in fact an SI.
The thresholds aren’t necessarily a problem for firms, in fact it should be quite straight forward to determine if an institution is an SI or not. The problem is the potential ‘unintended consequences’ following the implementation of the regime.
“What we don’t know is the impact and how the regime will play out in practice,” Joe McHale, head of EMEA regulatory strategy at Bloomberg LP, said at The TRADE’s MiFID II pop-up event in London in February. “There are operational challenges firms will encounter and there will always be the question for ESMA of how it will police this,” he added.
JP Urrutia, European general counsel for ITG, explains how many envisage a re-concentration of liquidity once the regime is in place, but the implications could include further fragmentation in markets.
“I think the outcome is going to be far from being a re-concentration of liquidity. We will have exacerbated the fragmentation because now, instead of having a few MTFs and a spattering of broker-crossing networks, the majority of which are large bulge brackets, there is likely to be new entrants that become SIs,” he says.
Rebecca Healey, Liquidnet’s head of EMEA market structure and strategy, told delegates at The TRADE’S event the challenge is taking the current model of broker-crossing networks and moving it to a new environment.
“SIs have to be a bilateral business, but it’s a two-way trade. So how do we move from one model to another when the whole network is interlinked?”
ESMA sought to answer the many lingering questions via a Q&A in November last year, but instead seemed to create ‘new unknowns’ for the industry. The European regulator stated buy-side firms should carry out SI assessments by 1 September 2018, ultimately delaying implementation of the regime. The Q&A response explained a lack of data would mean the regime could not be fully applicable until there is at least six months of data available.
“ESMA will publish the necessary data (EU wide data) for the first time by 1 August 2018 covering a period from 3 January 2018 to 30 June 2018,” the response said.
The potential for some firms to opt into the regime in January 2018, as others choose not to could see an industry split over becoming an SI, causing further unintended consequences.
Prior to the publication of the Q&A, different market participants were trying to figure out how to understand if they met the threshold or not. Many firms are still scratching their heads. Those on the borderline of the threshold are trying to weigh up the cost benefits of becoming an SI.
McHale said that sitting back and not advancing regulatory programmes, despite the delay to the regime, would not benefit anyone.
“I would expect people to continue to progress and use extra time to implement more strategic solutions. Maybe when rules are more holistic, interactions with share trading or best execution, that’s the key as people tend to focus on one part,” he said.
However, Geoffroy Vander Linden, head of transparency solutions at Trax, countered by saying the data is crucial for the assessments.
“We need the data to assist the regime…but expect side effects for the buy-side,” he said. “You have to live with that uncertainty and go with a decision. Another impact is that the trader needs more information to understand if the instrument being traded is subject to pre- and post-trade transparency.”
The challenges, potential impacts and unintended consequences of the SI regime pose another question for market participants. Is there any benefit to registering as an SI?
The buy-side is notorious for its wait-and-see regulatory approach and it would appear this has not changed with regards to SIs. The reporting and transparency requirements are a hot topic for asset managers who historically haven’t been burdened with the task.
“For the buy-side guys who are hesitant on the issue, the point we try to make, because the buy-side does have a burden they want to minimise, is they should consider the regime strategically and from the perspective of a revenue opportunity as opposed to the defensive perspective,” says Dermot Harriss, senior vice president at OneMarketData.
A political failure
Industry experts have also suggested the regime could bring about improvements to price, meaning a newly established dose of healthy competition based on the allure of quotes for different instruments.
“If the SI regime really does take off through 2018 we could start to see competition based on the attractiveness of the quotes. SIs offering price improvement could potentially have an advantage over trading venues restricted by a harmonised minimum tick size,” says Anne Plested, head of the EU regulation change programme at Fidessa.
However, Mark Pumfrey, head of EMEA at Liquidnet, says the regime will not only cause price improvement but also benefit the analysis of trading venues. The regime will produce useable data on the depth of liquidity and price quotes and offer an insight into how each SI operates, ultimately helping meet compliance for MiFID II’s best execution requirements.
“In the end it comes back to venues analysis, SIs can quote on what they want but it’s the execution that matters. That’s all we will be interested in if we go to SI venues,” Pumfrey says.
Kay Swinburne MEP addressed delegates in a keynote speech at the TRADE’s MiFID II pop-up event and explained institutions should consider the spirit of the regulation and the principle of the rules when exploring the specifics of SIs.
She said it’s easy to focus on the details and forget the overarching principle of MiFID II and best execution is at the heart of this.
“The compromise is clear…we are trying to persuade people to move onto the lit space and we would expect more transparency rather than less. It would be deemed as a political failure otherwise.
“MiFID II should be making markets more transparent and providing a better environment for all investors,” she said.