In the UK Financial Conduct Authority’s (FCA) handbook, the definition of a systematic internaliser (SI) sounds simple enough: an investment firm which on an “organised, frequent, systemic and substantial basis, deals on own account when executing client orders outside a regulated market, UK MTF (multilateral trading facility) or UK OTF (organised trading facility) without operating a multilateral system”.
However, the quantitative measures used to define what constitutes “an organised, frequent, systematic, and substantial basis” vary from instrument to instrument and are subject to a quarterly review, meaning a firm may be considered a SI for one instrument, but not another, and as time goes on, for neither, or perhaps both.
Mifid II also allows firms to “opt-in to the systematic internaliser regime”, which expands the grey area of which firms are actually acting as SIs.
In practice, SIs are mostly investment banks that may choose to opt-in to the SI regime, even when they are beneath the quantitative thresholds, in order to take care of reporting requirements for buy-side firms as a service offering.
Despite the complexity of the quantitative, instrument-specific calculations and the various reporting requirements, the core business model behind a SI is relatively simple: taking incremental revenue by adopting small positions within the spread. For example, a SI might trade halfway between the tick, then trade it back off the other side of the tick. All those minor positions in the spread make a big difference as to how a SI operates and how profitable it can be. It can also place it in competition with trading venues.
Post-Brexit: quantitative or qualitative?
The UK is widely seen as more SI-friendly than the EU, which has the tendency to view SIs as not sufficiently transparent and would prefer more trading to happen on venues.
The soft UK approach has culminated with the recent treasury proposal to change the instrument-specific quantitative calculations, which traders often feel are cumbersome, with quantitative ones. Sources say that market participants have welcomed this proposal,except for venues, which do not like rule-changes that make it easier for firms to operate as SIs.
Reporting requirements have been a source of frustration for the industry ever since Mifid II went live in 2018. The three big questions that face market participants are: Where do I report? What do I report? And what is addressable liquidity?
Evidence of confusion in these areas regularly comes up in analysis of the SI venue type as part of Liquidnet’s ‘Liquidity Landscape’ reports. For example, in December 2021 there were 119 different condition code combinations used when reporting trades under the generic MIC SINT, making it hard for market participants to understand what liquidity is available via this venue type.
The condition codes determine how the trade was put together and whether it was addressable liquidity, i.e. liquidity that any market counterparty with a relationship with that firm could have interacted with. This is the main complaint of SIs reporting their trades using the generic MIC SINT: 1) its not possible for a market participant to understand which firm operating as an SI executed the trade and 2) whether or not it was a technical/reporting execution or real liquidity available to market participants.
A lack public record of the names of the firms operating the SI means the only way to get this information is by approaching each firm individually and asking them what SI they are using for what instruments. From a best execution perspective, this can make it difficult to understand the SI liquidity space.
With its push to enforce the MMT (market model typology) model on reporting, which makes it easier to understand what constitutes addressable liquidity, the EU's Mifir review could help tidy up this confusion. If there is consistency in the use of the MMT model for condition codes, market participants will know which condition code combinations are addressable and which are non-addressable, getting a more consistent picture on what available liquidity is present in SIs.
Who is an SI?
While SIs are commonly investment banks, any firm can be a SI in a particular instrument, if they meet the relevant thresholds, since a SI is an instrument rather than an entity dependent definition. As soon as a firm becomes a SI, there are requirements for the types of quotes it can provide.
The Mifir review proposes some changes around what size firms must provide quotes for, and how much they must quote.
The pre-trade quoting obligation for equities is proposed to increase from 1x SMS (Standard Market Size) to 2x SMS, meaning that more quotes, and importantly of higher value, will need to be made public by the SI, potentially resulting in less appetite by the SI to provide quotes.
For example, the SMS of Siemens (SIE GY) is €30,000, so under the new rules, a firm offering risk (all SI activity should technically be the SI operator offering principal capital) will have to make public any quotes in up to €60,000 in size. By way of comparison, the average trade size during continuous trading on the primary exchange yesterday was 100 shares, or ~€15,000in size. Therefore quotes made public by SIs will be 4x bigger than the average lit print. Markets think that's a lot of risk to make publicly available.
Most market participants face SIs indirectly through brokers that operate on an agency basis with SIs. As soon as a broker operates on an agency basis with the SI, it becomes the agent’s responsibility to do the transaction reporting. This effectively means the buyside can sidestep the SI reporting requirements. However, if a buyside firm decides to incorporate direct quotes from a SI into its trading infrastructure, on a bilateral basis, then it would be subject to the obligations. Only a few big buyside firms do this, according to Liquidnet.
Such firms have a large AUM [assets under management] and a lot of trading activity. Firstly, they need to onboard the SI operator (could be a broker or a market maker) from a legal/KYC basis, which can be onerous. Secondly they need to do the tech work to take in the quote feed and integrate it with their execution management system (EMS), which is easier than it was, as many EMS have IOI [indication of interest] capabilities into which SI quotes can often fall. Finally they need to be willing to face the SI directly, i.e. not be an anonymous counterparty to the SI operator.
The concept of an SI is here to stay for the foreseeable future. It is noteworthy that the UK has decided to calibrate the big Mifid concepts according to the interests of UK markets as opposed to get rid of them. This is largely for practical reasons. Any significant regulatory driven change to market structure comes with a large price tag for the industry, to say nothing of the costs of firms with both a UK and an EU presence having to follow a double playbook. The aforementioned proposal to go from quantitative to qualitative calculations for SIs is a good example of calibration as opposed to removal.
Moreover, once important concepts, such as a SI, become ingrained in the legal and trading framework, other pieces of legislation and obligations end up hanging off that definition. For example, the Benchmark Regulation determines instruments to be in scope if they are traded on a trading venue (TOTV), or a SI.
If UK regulators decide, say, to change SIs to an asset-by-asset as opposed to an instrument-by-instrument definition, it could create a serious ripple of consequences and reporting complications in various trading contexts.
This article was written in consultation with Liquidnet and KPMG
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