To SI or not to SI, that is the question

By Johannes Frey-Skött
June 13, 2017

With MiFID II regulation now less than 12 months away, the race to ensure compliance heats up. In a recent letter penned by Steven Maijoor ESMA Chair, Mr Maijoor expressed concerns on the “potential establishment of networks of Systematic Internalisers (SIs) to circumvent certain MiFID II obligations.

The implementation of MiFID I saw the introduction of Systematic Internalisers, meaning “an investment firm can on an organised, frequent and systematic basis may deal on own account by executing client orders outside a regulated market or an MTF”. With this a number of loopholes opened up for firms, and although the implementation of MiFID II is intended to close some of these, it would seem that the SI debate is one that is still outstanding.

So what exactly is a Systematic Internaliser and why would a firm go to the trouble of becoming one?

Traditionally, an SI would essentially be an investment firm that could match ‘buy and sell’ orders from clients in-house provided that they conform to certain criteria. Instead of sending orders to a central exchange such as the London Stock Exchange, a bank would then be able to match orders against its own book. So an SI firm is then able to compete directly with a stock exchange or automated dealing system. Following a trade, the information about the transaction would also need to be made available in the same way a trading exchange would be subject to.

Is ESMA right to be concerned about the rise in SIs?

The answer to this question is yes. In Steven Maijoor’s open letter he stated he and his colleagues “are very concerned about this potential loophole. In its technical advice of 19 December 2014, ESMA already raised concerns that the SI regime may be used to circumvent the MiFID II provisions, in particular concerning the trading obligation for shares.

The concern is exploitation of this loophole in order to hinder the process of making share trading more transparent. To date, there are fewer than 10 Systematic Internalisers in Europe; this number is set to rise considerably during preparations for MiFID II compliance as banks battle to stay one step ahead. This increase in private venues goes against the good intentions of MiFID II regulation and would essentially result in more and more share trading conducted on these ‘private venues’ and away from the scrutiny of public exchanges.

The one measure used to control SIs is that ESMA requires them, just as other market operators, to report according to RTS 27.

What does this mean for firms?

Quite a lot.

Currently an SI is exempt from rules on tick sizes that put restrictions on minimum price increment on regulated markets, MTFs or OTFs. Sell-side firms will not be at all able to execute client orders against each other to a negotiated price if the Double Volume Caps are hit. Rather they need to execute them in the lit markets, which is one of the goals of MiFID II, or optionally to rely on the evolution of new market structures, such as periodic auction venues.

MEP Kay Swinburne has also made statements regarding the potential loophole, warning banks against trying to circumvent the regulations through setting up networks of SIs. She claims that this activity would tread the gray area and not give investors best price, meaning it would not be fulfilling the spirit of MiFID II.

How does this affect firms planning on becoming an SI?

If the Double Volume Caps are hit an investment firm will need to become an SI to keep their competitive edge, although they will think twice should this loophole be closed. Those in breach of the limits of OTC trading must either become an SI or stop that specific part of their trading. Discussions will then go back to focus on what the SI was intended for and, with the deadline fast approaching, banks and firms looking at implementation projects will be left with more questions than answers. At the end of the day, investment firms are left to their common sense to understand whether their SI strategy is in line with the spirit of MiFID II or not.

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