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.
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.
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.
Broadly speaking, MiFID II divides the world into:
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.
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:
The SI concept was introduced back in 2007 under MiFID (the original one) and the rationale behind it still holds good under MiFID II:
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.
MiFID II significantly beefs up the SI role in three ways:
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.
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“.
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.
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:
There are three things:
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Financial services regulatory consultancy, specialising in MiFID II: resources, training & tips