The EU’s Markets in Financial Instruments Directive II (MiFID II) is characterized by a stress on transparency designed to realise the investor protections the regulation aims to enforce so as to avoid a repetition of the credit crisis of 2007/2008.

One new aspect of this push for transparency is an enhanced systematic internalisation regime, that takes the concept of the Systematic Internaliser (SI) from MiFID I and extends its scope and requirement. While the final rules around systematic internalisation remain subject to an ongoing market consultation process kicked off in June, it’s generally assumed the rules won’t diverge fundamentally from the definitions promulgated by the European Commission for the past several years. In short, investment firms need to decide whether they will qualify as a systematic internaliser based on the frequency and volume of the client orders they cross internally, and then choose whether to adhere to the obligations as outlined in the directive.

External factors may contribute to the decision as well. For example, in the post-MiFID II trading environment buy-side firms – particularly smaller ones – may decide to engage only with sell-side firms with SI status in order to benefit from ‘free’ reporting compliance. Based on current understanding as of the time of writing, firms may find they qualify as SIs come January 3, where previously they did not. Furthermore, the combination of MiFID II’s updated Trading Obligation and Double Volume Caps will increase the attractiveness of operating a Systematic Internaliser.

The current definition of SI – outlined in Article 4 of the MiFID II directive and Article 14 of its associated MiFIR regulation – will extend pre-trade transparency requirements to equity-like instruments where there is a liquid market, and other non-equity securities. Under the new rules, SIs necessarily handle bilateral transactions, with orders executed on a discretionary basis based on distinct categories of client. Many non-SIs and broker crossing networks (BCNs) will be forced to decide whether to become an SI or desist from matching client orders against proprietary capital. Their decision may take into account a number of factors, among them the business model they are pursuing.
However, the new regulation will force those opting to take the SI route to undertake a series of significant process and technology upgrades.

The situation is compounded by the fact that there were very few official systematic internalisers under MiFID I. Even where infrastructure from independent software vendors (ISVs) exists, the new legislation will force a reassessment of functionality, flexibility and performance requirements. Meanwhile, many firms operate as informal internalisers, matching client orders with proprietary orders, a process that is often handled manually.

Under MiFID II, qualifying activities will need to be automated, and the appropriate transparency requirements applied. Under MiFID II’s trade and transaction reporting rules, SIs must publish pre-trade prices (quotes) that form part of the SI offering to the marketplace, via a trading venue, web-site, Approved Publication Arrangement (APA) or some other publishing channel. Additionally, selling SIs must provide report post-trade details to an APA; so firms need to understand whether or not their counterparty is an SI in order to understand their potential reporting obligations.

Several factors are driving firms’ motivations for taking the SI route. For one thing, many firms plan to establish SIs merely because they feel they ‘have to’ under MiFID II in order to continue to cross trades internally because their activities exceed the regulation’s threshold of 0.4% market share. Whatever the case, those registering as SIs will need a number of additional capabilities in order to meet the associated regulatory requirements.

At its core, an SI needs an order-matching engine capable of reporting the trades and publishing the quotes to the appropriate APA, or to a trading venue, and it needs to be able to react to requests for quote (RFQs). From a regulatory standpoint, the firm needs to fully understand and execute on the quoting and reporting requirements under the new SI rules. It needs to incorporate a client order management function to ensure that all necessary information is captured for reconciliation purposes.

From a technology standpoint, the SI solution needs the kind of speed and accuracy required for publishing and adjusting quotes in fast market conditions. In short, firms will need to decide if and when they will be acting as an SI, and ensure they have the technological facilities and flexibility to react to each instance of their SI status. As such, the SI requirement is perhaps one of the most challenging for firms covered by MiFID II, even if much of it has been in place since MiFID I. 

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