What the devil is a systematic internaliser?

No MiFID II concept causes more nose-wrinkling and brow-furrowing than the horribly named systematic internaliser: ‘SI’ to save time and seven syllables. Under MiFID, the SI concept wasn’t well understood but there were only around a dozen SIs in the whole of the EU (most in the UK). Under MiFID II, however, SIs have been given a starring role and over 150 are listed by ESMA. So if you're wondering what the heck an SI is, here’s the low down.

What the devil is a systematic internaliser?

The reason for this article is that a while ago I did some training on MiFID II. I explained what pre and post trade transparency is using the housing market (read here). Then it came to the thorny subject of systematic internalisers (SIs). “The housing market comparison was great” one person said, “do you have a similar comparison for SIs”. Darn it, I didn’t. This multi-syllabic construct isn’t something that lends itself easily to pithy sum-ups. But I’ve been mulling it over ever since and here’s my breakdown.

Who are SIs?

In short, investment firms. So the big names such as HSBC, BNP Paribas, Morgan Stanley all operate SIs as well as many other trading houses. ESMA publishes a list of SIs in the EU, 152 SIs listed as at 28 Oct 2018, in its database here.

How is an SI different to a trading venue?

Broadly speaking, MiFID II divides the world into:

  • multilateral trading’, which is trading on trading venues (Regulated Markets, MTFs and OTFs in MiFID II speak) such as the London Stock Exchange, ICE, Euronext, Turquoise, Liquidnet, etc., and
  • bilateral trading’ which is when two counter-parties (could be you and me, could be two banks) trade directly with each other. This is where SIs come in

The ebay analogy – trading venues

Let’s start with what a trading venue is under MiFID II: it’s a platform that brings together buyers and sellers in financial instruments – bonds, shares, derivatives etc. Trading on a trading venue is known as “multilateral trading” because trading venues bring together multiple buyers and sellers.

In the world outside finance, ebay is a type of trading venue: it offers a platform which brings together multiple buyers and sellers of goods.

Here’s the important point: whether you buy/sell goods on ebay, or financial instruments on a trading venue, you’re not buying or selling directly with ebay or the trading venue itself: you are using its platform/ technology to find a match for your sale/purchase. The operators of ebay and trading venues do not engage in the actual trading…

…well, there is one small caveat here (there’s always a small caveat right?). For trading venues known as Organised Trading Facilities (OTFs), the OTF operator may engage in trading in limited circumstances. Read my article ACRONYMS AHOY! MiFID II – Part 1: rules, trading, and transparency if you want to know more about this and what trading venues are under MiFID II…

Back to the non-caveated world.

The operator of ebay/a trading venue is not putting its (the firm’s) own money (capital) at risk when a trade takes place: its revenue comes from members/users paying to use the platform.

An SI is not so much a trading venue as a trading counter-party, meaning that you buy from, or sell to, the SI itself.

An SI is different: it’s not so much a trading venue as a trading counter-party, meaning that you buy from, or sell to, the SI itself. The SI uses its own capital for trading and takes on risk in trading positions. For example, an SI buys shares from you at £20 per share but can only offload them for £19 per share, that’s a loss which hits its profit line.

The antique dealer analogy – SI or Broker?

To make the concepts of SI and bilateral trading more concrete by looking at the tangible world of “things”, let’s take a scenario where you want to sell a family heirloom (mint condition Barbie still in its box, art deco lamp, you name it…) so you go to an antique dealer who specialises in this type of item.

The dealer has a couple of options:

  • S/he could make you a price and buy your heirloom off you directly: the antiques dealer uses his/her own capital and takes the risk that s/he can then sell it on at a profit. In this scenario, the dealer is acting like an SI, i.e. where the client sends an order to the firm and the firm fills the order from its own books.
  • Alternatively, the art dealer could put your heirloom in an auction or on ebay for you and take a commission for this service. In this scenario, the dealer is not taking any risk on what the heirloom sells for or indeed, whether it actually sells. This is analogous to how an investment firm receives a client order and routes it to a trading venue for execution: here, the investment firm is not acting as an SI but as an intermediary/ broker, taking a fee for finding a buyer but is not the buyer itself.

What’s the purpose of the SI regime?

The SI concept was introduced back in 2007 under MiFID (the original one) and the rationale behind it still holds good under MiFID II:

  • to make over-the-counter (OTC) trading activity – i.e. trading which takes place outside a trading venue – more transparent, and
  • to level the playing field so that rules followed by trading venues and investment firms which trade on their own books outside a trading venue, are reasonably similar.

As the first MiFID was being drawn up, policy makers realised that when investment firms received client orders to buy/sell shares, often they didn’t send them to, say, the London Stock Exchange for execution. Instead, investment firms bought or sold the shares for/from their own “warehouse” of stock, their books. Policy makers were concerned there was a lack of visibility on this activity conducted by investment firms because there was no pre-trade transparency around prices, unlike on exchanges. In effect this was dark trading.

What changed under MiFID II?

MiFID II significantly beefs up the SI role in three ways:

  1. Under MiFID, the SI regime only applied to shares. Now, the SI regime applies to share-like instruments (exchange traded funds, depository receipts and certificates) and non-equity instruments (bonds, derivatives, emission allowances and structured finance products) as well as shares.
  2. There are now quantitative thresholds, meaning firms need to calculate whether their trading reaches these thresholds and if they do, they’re in the SI club. Under MiFID, firms had to undertake a qualitative assessment only, which was, well, a bit fuzzy, a bit subjective and meant there were very few SIs around.
  3. SIs are one of the places where share trading can take place, under the brand-new-MiFID-II share trading obligation (which may be a topic for another day).

Taken together these three changes mean the SI moves from being a bit-player to having a starring role in the EU trading landscape post MiFID II. Just take a look at the figures as evidence: whereas there were around a dozen SIs across the whole of the EU under MiFID, there are now approximately 120 under MiFID II.

How do you know if you’re an SI?

The starting point to determine whether you are an SI is to ask “do I execute client orders using own capital rather than sending those orders to a trading venue?” If the answer is yes, the next question to ask is “on what scale? because the SI regime is interested in capturing firms which trade against their clients in significant volume and regularly, not on an ad hoc basis.

To quote the rules, MiFID II defines an SI as an investment firm which “on an organised, frequent, systematic and substantial basis, deal on own account when executing client orders outside a regulated market, an MTF or an OTF“.

  • Frequent & systematic is measured by the number of OTC trades in the financial instrument carried out by the SI on its own account by executing client orders.
  • Substantial is measured by the:
    • Firm’s OTC trading volume in a specific instrument/class of instrument versus its total trading volume in that instrument OR
    • Firm’s OTC trading volume in a specific instrument/class of instrument versus total trading in the EU on this instrument

Firms have to do regular calculations to determine if the scale of their activity means they fall within the SI regime. If a firm crosses both the relevant frequent and systematic threshold and one of the substantial thresholds it is classed as an SI. The thresholds are set out in level 2 rules and ESMA publishes the data required for the calculations.

Firms are SIs in a specific instrument not a class of instruments. For example, a firm could be an SI in Vodafone shares only. For non-equities, a firm is an SI at the most granular level of the asset class, as set out in the rules.

Worth noting

Getting the data that sits behind the quantitative thresholds hasn’t been the easiest task for the powers-that-be so the introduction of the SI regime on a mandatory basis has been staggered:

  • A number of firms decided to become SIs from the 3 January 2018 when MiFID II first kicked in: however, 1 September 2018 was actually the earliest mandatory date by which firms had to comply with the SI regime.
  • In Summer 2018, ESMA announced it had decided to delay the implementation of the SI regime for derivatives, exchange traded commodities, exchange traded notes, structured finance products, securitised derivatives and emission allowances to 2019. ESMA will publish SI calculations for derivatives in February 2019. See its announcement here.
  • Firms can opt into the SI regime even if they are below the thresholds.

What do you have to do if you’re an SI?

  • The SI has to notify its home regulator that it is an SI.
  • Comply with additional requirements, for example, pre-trade transparency obligations, publishing quarterly reports showing the quality of execution when trading with clients, potentially providing reference data to the national competent authority for certain instruments.

Any thing else I ought to bear in mind?

There are three things:

  • Brexit, of course. There’s no third country regime for SIs which means when the UK leaves the EU, well… watch this space.
  • Extension of tick sizes to SIs. In September 2018, after some back-and-forth, ESMA sent an Opinion to the European Commission, proposing that the tick size regime, which currently only applies to trading venues, is extended to SI quotes for shares and depositary receipts. Read ESMA’s Opinion here.
  • MiFID II does not allow the operation of an OTF and SI within the same legal entity. This isn’t news, it’s always been part of the rules, but worth noting as a big driver for MiFID II is keeping multilateral trading distinct from bilateral trading.

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