Systematic internaliser (SI) in MiFID II - a counterparty, not a trading venue

 


 

 

Pursuant to MiFID II and MiFIR systematic internalisers (SIs) are investment firms which, on an organised, frequent, systematic and substantial basis, deal on own account by executing client orders outside a regulated market, MTF or OTF without operating a multilateral system.

 

The systematic internaliser (SI) regime was introduced by MiFID I in 2007. Under MiFID I, systematic internaliser meant 'an investment firm which, on an organised, frequent and systematic basis, deals on own account by executing client orders outside a regulated market or an MTF'.

 

As follows, "the reference to 'executing client orders' is integral to the definition of a systematic internaliser under both regimes. Accordingly, an investment firm will only constitute a systematic internaliser where it is proposing to execute a client order" (see ISDA MiFID CP Submission, p. 6).

 

ISDA, moreover, consequently argued that if the investment firm is not proposing to execute client orders, the obligations under the systematic internaliser framework in Article 18 MiFIR (obligation for systematic internalisers to make public firm quotes in respect of bonds, structured finance products, emission allowances and derivatives) do not apply even where the thresholds are met.

Systematic internaliser can stream prices to clients 

Formal definition (which in itself is not changed by the MiFID II significantly) notwithstanding, one may ask, what is the key feature differentiating this legal vehicle from other commonly known types of market places.

 

The said distinction appears to lay in the fact a systematic internaliser is a counterparty and not a trading venue. This means, while trading venues are facilities in which multiple third-party buying and selling interests interact in the system, a systematic internaliser is not allowed to bring together third party buying and selling interests in functionally the same way.

 

Making this more clear, for instance, a so-called single-dealer platform, where trading always takes place against a single investment firm should be considered a systematic internaliser, were it to comply with the requirements.

 

However, a so-called multi-dealer platform, with multiple dealers interacting for the same financial instrument, should not be considered a systematic internaliser.

 

This has been underlined in the Recital 19 of the Commission Delegated Regulation (EU) 2017/565 of 25.4.2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive:

 

"Pursuant to Directive 2014/65/EU, a systematic internaliser should not be allowed to bring together third party buying and selling interests in functionally the same way as a trading venue. A systematic internaliser should not consist of an internal matching system which executes client orders on a multilateral basis, an activity which requires authorisation as a multilateral trading facility (MTF). An internal matching system in this context is a system for matching client orders which results in the investment firm undertaking matched principal transactions on a regular and not occasional basis."

 

On 3 April 2017 ESMA has clarified in closer detail how to interpret the reference to the “occasional basis” used in the said Recital (19) of the Commission Delegated Regulation (EU) 2017/565.

 

ESMA is of the view that a SI activity is characterised by risk-facing transactions that impact the Profit and Loss account of the firm.

 

Where an SI would receive, and execute, two potentially matching buying and selling interests from clients as one matched principal trade or where it would try to find the buyer for a sell order (or the other way around) and execute the first leg contingent on the second leg, those transactions would not qualify as risk facing transactions.

 

As such, they could only be executed by an SI on an occasional basis, as provided for by Recital (19) of the Commission Delegated Regulation (EU) 2017/565.

 

ESMA is of the view that an SI would not be undertaking matched principal trading on an occasional and non-regular basis if it meets any of the following criteria:

 

a) the investment firm operates one or more systems or arrangements, be they automated or not, intended to match opposite client orders. The investment firm may accidentally receive two opposite matching buying and selling interests and match them but it should not have systems in place aimed at increasing opportunities for client order matching;


b) when executing client orders, non-risk facing activities account for a recurrent or significant source of revenue for the investment firm’s trading activity;


c) the investment firm markets, or otherwise promotes, its matched principal trading activities.

 

The problem of blurred delineation between trading venues and systematic internalisers has become the subject of the ESMA's letter of 1 February 2017 to the European Commission on MiFID II systematic internalisers operating broker crossing networks (ESMA70-872942901-19), where ESMA has expressed its concern over the potential establishment of networks of systematic internalisers by investment firms to circumvent certain MIFID II obligations; in particular, the requirements for investment firms operating internal matching systems and executing client orders on a multilateral basis to be authorised as trading venues, and the trading obligation for shares.

 

 

SI as a risk-taking market actor

 

 

In the same vein ESMA has issued on 5 April 2017 the document Questions and Answers on MiFID II and MiFIR market structures topics, ESMA70-872942901-38, where the element of risk-taking in the systematic internalisers activities has been strongly accentuated.

 

It is stressed in the said document that the aforementioned Recital 19 of the Commission Delegated Regulation (EU) 2017/565 is not limited to internal matching of client orders through matched principal trading but more generally prevents SIs from operating any system that would “bring together third party buying and selling interests in functionally the same way as a trading venue”.

 

According to ESMA, the prohibition for an SI to operate an internal matching system for matching client orders is just one example, as opposed to the unique circumstance, under which an SI would actually be operating functionally in the same way as a trading venue and would be required to seek authorisation as such.

 

Based on the SI definition provided in Article 4(1)(20) of MiFID II, ESMA understands that the trading activity of a SI is characterised by risk-facing transactions that impact the Profit and Loss account of the firm.

 

By undertaking such risk-facing transactions, SIs are a valuable source of liquidity to market participants.

 

In that regard, ESMA notes that the MiFIR pre-trade transparency provisions for SIs seek to avoid submitting SI to undue risks based on the assumption and understanding that SIs are indeed facing risks when trading.

 

In contrast to the above, ESMA is of the view that arrangements operated by an SI would be functionally similar to a trading venue where they meet the following criteria:

 

a) The arrangements would extend beyond a bilateral interaction between the SI and a client, with a view to ensuring that the SI de facto does not undertake risk-facing transactions. This would be the case, for instance, where an SI would have agreements with other liquidity providers so that the SI would do a riskless back-to back transaction with one of those liquidity providers whenever a transaction is executed with a client, or where it would only execute one transaction contingent on another one. A similar outcome would be reached from the reverse situation where one or more liquidity providers would be streaming quotes to an SI. The quotes would then be forwarded by the SI to its clients to be executed against, resulting again in no risk back-to-back transactions which could involve multiple parties.


By crossing client trading interests with other liquidity providers’ quotes, via matched principal trading or another type of riskless back-to-back transaction, so that it is de facto not trading on risk, the SI would actually organise an interaction between its client orders on the one hand and the SI or other liquidity providers’ quotes on the other hand. The SI would be bringing together multiple third party buying and selling trading interests in a way functionally similar to the operator of a trading venue.


b) The arrangements in place are used on a regular basis and qualify as a system or facility, as opposed to ad-hoc transactions. The existence of a system would be easily identified where, for instance, the arrangement in place would be underpinned by technological developments to increase speed and efficiency and legal agreements would be in place between the SI and liquidity providers. The operation of a system could also include circumstances where there is an understanding with third parties that trade by trade hedging will be available on a regular basis. ESMA recalls that MiFID II/MiFIR is technology neutral and applies to voice systems as well as to electronic and hybrid systems;


c) The transactions arising from bringing together multiple third party buying and selling interests are executed OTC, outside the rules of a trading venue.

 

ESMA highlights that the above does not prevent SIs from hedging the positions arising from the execution of client orders as long as it does not lead to the SI de facto executing non risk-facing transactions and bringing together multiple third party buying and selling interests.

 

ESMA is of the view that an SI would not be bringing together multiple third party buying and selling interests as foreseen in Recital 19 where hedging transactions would be executed on a trading venue.

 

 

Systematic internaliser's legal regime - key points

 

 

The fact that may potentially be in the centre of business analysis is that MiFID II changes current systematic internaliser regime in two significant ways:

1) the asset classes within the scope of the regime (see box); and

2) the pre-trade transparency requirements.

 

 

Asset classes within the the scope of the SI regime

 

MiFID II extends the systematic internaliser regime so that from applying solely to shares, as is the case under MiFID I, it will apply to a much broader range of asset classes:

 

- equity-like instruments (depositary receipts, ETFs, certificates and other similar financial instruments), and

 

- non-equity instruments (derivatives, bonds, structured finance products and emission allowances). 


Systematic internalisers may decide on the basis of their commercial policy and in an objective, non-discriminatory way the clients to whom they give access to their quotes, distinguishing between categories of clients.

 

It needs to be underlined the requirements for systematic internalisers apply to an investment firm only in relation to each single financial instrument, (e.g. on ISIN-code level), in which it is a systematic internaliser.

 

Systematic internalisers are not obliged to publish firm quotes, execute clients' orders and give access to their quotes in relation to equity transactions above standard market size and non-equity transactions above the size specific to the instrument.

 

 

Quantitative criteria 

 

 

 

"Investment firms will need to determine whether they are acting as SIs in a wide range of equity, fixed income and derivative financial instruments. This will be a particular issue for the fixed income and OTC derivatives markets, which currently operate as dealer markets with firms trading on a bilateral basis as principals."

 

MiFID II: Markets, Freshfields Bruckhaus Deringer

 

MiFIR recitals stress, in order to ensure an objective and effective application of the definition of systematic internaliser to investment firms, there should be a pre-determined threshold for systematic internalisation containing an exact specification of what is meant by frequent, systematic and substantial basis.

 

As observed in MiFID II: Markets, Freshfields Bruckhaus Deringer, following implementation of MiFID I, a smaller number of firms became SIs than the European authorities had expected.

 

The qualitative nature of the criteria that defined an SI made the assessment highly subjective and many firms concluded that they did not meet the criteria. 

 

Mindful of the above circumstances, MiFIR introduces quantitative criteria to supplement the qualitative ones to make the definition more objective. For determining whether an investment firm is a systematic internaliser, financial authorities are granted powers to require information from trading venuesAPAs (Approved Publication Arrangements), and CTPs (Consolidated Tape Providers).

 

Recital 18 of the said Commission Delegated Regulation (EU) 2017/565 of 25.4.2016 stipulates pre-set limits "should be set at an appropriate level to ensure that OTC trading of such a size that it had a material effect on price formation is within scope while at the same time excluding OTC trading of such a small size that it would be disproportionate to require the obligation to comply with the requirements applicable to systematic internalisers."

 

When it comes to concrete criteria, the frequent and systematic basis is measured by the number of OTC trades in the financial instrument carried out by the investment firm on own account by executing client orders.

 

In turn, the substantial basis is measured either by the size of the OTC trading carried out by the investment firm in relation to the total trading of the investment firm in a specific financial instrument or by the size of the OTC trading carried out by the investment firm in relation to the total trading in the European Union in a specific financial instrument.

 

Both pre-set limits, first for the frequent and systematic basis and the second for substantial basis, should be crossed in order to be defined as a systematic internaliser.

 

The preliminary issue may arise with respect to the calculations' methodology, in particular, whether the calculations should be carried out on the group level or an individual entity level. Another ambiguous point were branches.

 

On 31 January 2017 ESMA, using the Questions and Answers instrument (Q&As), has presented the stance that the definition of systematic internaliser under MiFID II refers to "investment firms" established in the EU and, therefore, the calculations should be carried out at legal entity level and not at the group level.

 

Moreover, for EU investment firms operating branches in the Union, the activity of those branches would need to be consolidated for the purpose of the systematic internaliser calculations.

 

To check frequent, systematic and substantial criteria for particular asset classes see the table and boxes below.

 

 

Systematic internaliser thresholds for non-equity financial instruments 

 

The conditions set out in the Table below are to be assessed on a quarterly basis on the basis of data from the past 6 months.

 

The assessment period shall start on the first working day of the months of January, April, July and October.

 

Newly issued instruments shall only be considered in the assessment when historical data covers a period of at least six weeks in the case of bonds, structured finance products and derivatives (three months in the case of shares, depositary receipts, ETFs, certificates and other similar financial instruments).

 

Legal base:

 

- Articles 13 - 17 of the Commission Delegated Regulation (EU) of 25.4.2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive

 

- Questions and Answers on MiFID II and MiFIR transparency topics, 4 November 2016, ESMA/2016/1424 

 

 

Criterion  Description 

 

Bonds

belonging to a class of bonds issued by the same entity

or

by any entity within the same group

(Article 13)

 

SFP

belonging to a class of structured finance products issued by the same entity 

or 

by any entity within the same group

(Article 14)

Derivatives

 (Article 15)

Emission allowances

(Article 16)

Frequent and systematic

basis threshold

(liquid instruments)

- Number of OTC transactions executed during the past 6 months by the investment firm on own account when executing client orders / total number of transactions in the same financial instrument in the EU on any trading venue or OTC 

- Minimum trading frequency during the past 6 months for transactions on own account when executing client orders (on average)

2.5 %

and

at least once a week

 4 %

and

at least once a week

2.5 % 

in the relevant class

and

at least once a week  

 

4 %

of the relevant type of emission allowances

and

at least once a week

Frequent and systematic
basis threshold

(illiquid instruments)

Minimum trading frequency during the past 6 months for transactions on own account when executing client orders (on average)

at least once a week

at least once a week  at least once a week  

at least once a week

Substantial basis threshold

Criterion 1 

 

Number of OTC trading by investment firm in a financial instrument on own account when executing client orders during the past 6 months / total volume in the same financial instrument executed by the investment firm on own account or on behalf of clients and executed on a trading venue or OTC (in nominal amount)

 

25%

30%

25%

of the relevant class

 30%

of the relevant type

Substantial basis threshold

Criterion 2

 

Number of OTC trading by investment firm in a financial instrument on own account when executing client orders during the past 6 months / total volume in the same financial instrument in the European Union, on a trading venue or OTC (in nominal amount)

 

 1 %

 2.25 %

1 %

of the relevant class

 2.25 % 

of the relevant type

 

 

 

Specific rules for calculating systematic internaliser thresholds

 

 

numbering blue   Transactions that are not contributing to the price formation process and/or are not reportable

 

Transactions that are not contributing to the price formation process and/or are not reportable should not be part of the calculations for the purposes of the definition of the systematic internaliser regime, both for the numerator and the denominator of the quantitative thresholds.

 

The above stance is reasoned by ESMA by referring to provisions, which exempt investment firms from reporting certain types of transactions for the purposes of post-trade transparency i.e.:

 

- Article 13 of Commission Delegated Regulation (EU) 2017/587 of 14.7.2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council on markets in financial instruments with regard to regulatory technical standards on transparency requirements for trading venues and investment firms in respect of shares, depositary receipts, exchange-traded funds, certificates and other similar financial instruments and on transaction execution obligations in respect of certain shares on a trading venue or by a systematic internaliser (RTS 1),

 

and

 

- Article 12 of Commission Delegated Regulation (EU) 2017/583 of 14.7.2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council on markets in financial instruments with regard to regulatory technical standards on transparency requirements for trading venues and investment firms in respect of bonds, structured finance products, emission allowances and derivatives (RTS 2).

 

The aforementioned exempted transactions encompass:

 

(a) transactions excluded from MiFID II reporting in Article 2(5) of Commission Delegated Regulation (EU) of 28.7.2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council with regard to regulatory technical standards for the reporting of transactions to competent authorities;


(b) transactions executed by a management company as defined in Article 2(1)(b) of Directive 2009/65/EC or an alternative investment fund manager as defined in Article 4(1)(b) of Directive 2011/61/EU which transfer the beneficial ownership of financial instruments from one collective investment undertaking to another and where no investment firm is a party to the transaction;


(c) 'give-up transaction' or 'give-in transaction' which is a transaction where an investment firm passes a client trade to, or receives a client trade from, another investment firm for the purpose of post-trade processing;


(d) transfers of financial instruments such as collateral in bilateral transactions or in the context of a central counterparty (CCP) margin or collateral requirements or as part of the default management process of a CCP.


In the ESMA's view, the above types of transactions are technical and cannot be characterised as transactions where an investment firm is executing a client order by dealing on own account.

 

ESMA observes, however, that the lack of a reporting obligation for those types of transactions would be a considerable challenge for competent authorities to supervise and for investment firms to comply with the systematic internaliser regime.

 

numbering blue   Primary market transactions, creation and redemption of ETFs'

 


Primary market transactions in securities as well as creation and redemption of ETFs' units should not be included in the calculations when determining if the investment firm is a systematic internaliser.

 

numbering blue   Off order book trades that are reported to a regulated market, MTF or OTF under its rules

 

Only off order book transactions that benefit from a waiver from pre-trade transparency are considered as executed on a trading venue, and do not count for the numerator when determining whether an investment firm is a systematic internaliser.

 

numbering blue   Calculations granularity

 

The SI's thresholds calculations should be performed at the most granular class level as identified in the said Commission Delegated Regulation (EU) 2017/583 of 14.7.2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council on markets in financial instruments with regard to regulatory technical standards on transparency requirements for trading venues and investment firms in respect of bonds, structured finance products, emission allowances and derivatives.

 

Where an investment firm meets the thresholds for such a class, it should be considered as a systematic internaliser for all derivatives within that most granular class.


With respect to equity derivatives, the sub-classes as defined in Table 6.2 of Annex III of the aforementioned Commission Delegated Regulation of 14.7.2016 for LIS and SSTI should be used.

 

numbering blue   Calculations' level for structured finance products (SFPs)

 

For SFPs, systematic internaliser calculations should be performed at ISIN level and where, for a specific ISIN, an investment firm is above the thresholds prescribed, it should be considered a systematic internaliser for all SFPs issued by the same entity or by any entity within the same group.

 

Source of data, assessment periods and notification requirement 

 

 

To carry out necessary calculations information about the total volume of trading or total number of transactions in the same financial instrument in the European Union are needed.

 

The access to such data was problematic and ESMA (the European financial regulator) initially expected such services will be developed in the MiFID II implementation phase.

 

However, in the Questions and Answers on MiFID II and MiFIR, Transparency topics of 4 November 2016 (ESMA/2016/1424) ESMA communicated, it intends to publish the necessary information within a month after the end of each assessment period as defined under Article 17 of the Commission Delegated Regulation of 25.4.2016 – i.e. by the first calendar day of months of February, May, August and November every year.

 

 

Article 15(1) MiFIR, second subparagraph

 

Member States shall require that firms that meet the definition of systematic internaliser notify their competent authority. Such notification shall be transmitted to ESMA. ESMA shall establish a list of all SIs in the Union.

 

Given that Article 15(1) MiFIR requires that firms that meet the definition of systematic internaliser notify their competent authority, ESMA stressed that after the first assessment, investment firms will have to perform the calculations and comply with the systematic internaliser regime (including notification to their National Competent Authorities) no later than two weeks after the publication by ESMA – i.e. by the fifteenth calendar day of the months of February, May, August and November every year.

 

Transitional rules

 

In the absence of transitional provisions in the aforementioned Regulation of 25.4.2016, ESMA specified the necessary timelines in the said Q&As document of 4 November 2016.

 

Accordingly, ESMA will publish the necessary EU wide data for the first time by 1 August 2018 covering a period from 3 January 2018 to 30 June 2018.

 

In that case investment firms will have to perform their first assessment and, where appropriate, comply with the systematic internaliser obligations (including notifying their National Competent Authority) by 1 September 2018. 

 

Illiquid instruments

 

The above timeline applies also to investment firms trading in illiquid instruments.

 

While it is possible for those firms to carry out part of the test based on data at their disposal, the complete determination of the SI activity necessitates an assessment of the investment firms OTC-trading activity in a particular instrument in relation to overall trading in the Union.

 

In order to ensure a consistent assessment and to ensure that all investment firms are treated in the same manner, for all instruments, irrespective of their liquidity status, the assessment should therefore be performed by 1 September 2018.

 

Newly issued instruments

 

Similarly, although Commission Delegated Regulation of 25.4.2016 allows shorter look-back periods for newly issued instruments compared to the six months described above, ESMA considers that it is important to ensure a level playing field between all instruments and, therefore, suggests to apply the schedule proposed above also to newly issued instruments - i.e. first publication by ESMA of the necessary EU-wide data by 1 August 2018 and earliest deadline to comply, where necessary, with the SI regime set on 1 September 2018.

 

 

OptionalityOpt-in to the systematic internaliser regime

 

 

Distinctive feature of the new MiFID II definition of the systematic internaliser is that it allows an investment firm to choose to opt-in under the systematic internaliser regime even when it doesn't meet all or any of the quantitative criteria, provided it complies in full with the applicable requirements.

 

Investment firms will be able to opt-in to the systematic internaliser regime for all financial instruments from 3 January 2018, for example, as a means to comply with the trading obligation for shares.

  

 

Systematic internaliser and an OTF interrelations - connectivity forbidden 

 

 

The operation of an OTF and systematic internalisation within the same legal entity is not allowed under MiFID II.

 

An OTF is also not allowed to connect with a systematic internaliser in a way which enables orders in an OTF and orders or quotes in a systematic internaliser to interact.

 

 

Systematic internaliser as the option for the execution of the trading obligation for shares

 

 

According to MiFIR, trading obligation requires investment firms (with some exceptions) to undertake all trades in shares including trades dealt on own account, and also trades dealt when executing client orders, on a regulated market, MTF, systematic internaliser or equivalent third-country trading venue (note that MiFIR trading obligation for derivatives - as opposite to shares - does not include systematic internaliser as an approved type of marketplace).

 

The option for trades to be done on a systematic internaliser assumes that if the investment firm itself meets the relevant criteria specified in MiFIR to be deemed a systematic internaliser in that particular share, the trade may be dealt in that way; however, if it is not deemed a systematic internaliser in that particular share, the investment firm may still undertake the trade on another systematic internaliser once it is in conformity with its best execution obligations and the option is available thereto.

 

 

Obligation for systematic internalisers to make public firm quotes in respect of bonds, structured finance products, emission allowances and derivatives pursuant to MiFIR

 

 

The main purpose of the systematic internaliser regime is said to ensure that internalisation of order flow by investment firms does not undermine the efficiency of the price formation process for shares admitted to trading on a regulated market (ESMA's Discussion Paper on MiFID II/MiFIR of 22 May 2014, ESMA/2014/548, p. 94).

 

Also the Commission Staff Working Document Impact Assessment Accompanying the document Commission Delegated Regulation supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council with regard to definitions, transparency, portfolio compression and supervisory measures on product intervention and positions {C(2016) 2860 final} {SWD(2016) 156 final}, 18.5.2016, SWD(2016) 157 final (p 73) underlines the purpose of the systematic internaliser legal framework is to "ensure that firms which deal on own account of a large magnitude by executing client orders are also subject to trade transparency requirements on a level playing field with trading venues (while at the same time taking into account the different market participants' characteristics). This is because such trade execution has a material impact on price formation."

The extent of the obligation for systematic internalisers to make public firm quotes in respect of bonds, structured finance products, emission allowances and derivatives is dependent on the liquidity of the market at issue.

 

"MiFID also introduced transparency provisions for investment firms trading the most liquid shares when acting as market-makers outside an RM or MTF. Investment firms acting in this capacity on a frequent, systematic and organised basis (something to be assessed on the qualitative basis) had to inform their national regulator that they were 'systematic internalisers' (SIs). In respect of shares deemed to have 'liquid market' in size up to 'standard market size' SIs have to publish quotes which are visible to the market as a whole. Business can only be done at prices away from these quotes where the transaction being conducted is larger than that customarily undertaken by a retail investor, and where the client they are dealing is a professional client. ...

 

MiFID II significantly revises this regime. For trading in shares, the determination of whether an investment firm is SI will be based on whether a firms trading crosses certain quantitative thresholds. This will increase the number of SIs (there are currently 9 in the UK). Price improvement will also be allowed for dealings with retail clients in justified circumstances. The regime is also being extended to exchange traded funds and other instruments that resemble shares, and bonds and derivatives. In respect of the latter the transparency requirement will apply to dealings in the liquid instruments below the Size Specific to the Instrument (SSTI), which will be set in a technical standard, and the obligation will be to quote in response to a request to a client, with the posted quote being available to other clients of the firm to the extent possible with good risk management when trading on risk in this manner. For bonds and derivatives there will also be quantitative criteria to identify SIs."

 

UK HM Treasure MiFID II Consultation Impact Assessment, p. 8

 

 

In the case of liquid markets as defined in MiFIR investment firms must make public firm quotes in respect of bonds, structured finance products, emission allowances and derivatives traded on a trading venue for which they are systematic internalisers when the following conditions are fulfilled (Article 18(1)(a) of MiFIR):
(a) they are prompted for a quote by a client of the systematic internaliser;
(b) they agree to provide a quote.

 

The above requirements are neutral concerning the technology used for prompting quotes.

 

A systematic internaliser can be prompted for and provide quotes through any electronic system, client orders routed by an automated order router (AOR) including.

 

In relation to the above products traded on a trading venue for which there is not a liquid market, systematic internalisers must disclose quotes to their clients on request only if they agree to provide a quote.

 

This obligation may be waived where the following conditions are met:

 

(a) orders that are large in scale compared with normal market size and orders held in an order management facility of the trading venue pending disclosure;

 

(b) actionable indications of interest in request-for-quote and voice trading systems that are above a size specific to the instrument, which would expose liquidity providers to undue risk and takes into account whether the relevant market participants are retail or wholesale investors;

 

(c) when it comes to derivatives which are not subject to the trading obligation specified in Article 24 and to other financial instruments for which there is not a liquid market.

 

Systematic internalisers may update their quotes at any time. They may also withdraw their quotes under exceptional market conditions.

 

Systematic internalisers must make the firm quotes published available to their other clients.

 

Notwithstanding, they are allowed to decide, on the basis of their commercial policy and in an objective non-discriminatory way, the clients to whom they give access to their quotes.

 

However, to that end, systematic internalisers must have in place clear standards for governing access to their quotes.

 

One may ask how these procedures and policies should look like, whether systematic internalisers can meet their quoting obligations 
for liquid instruments by providing executable quotes on a continuous basis, whether there are some closer closer regulatory guidance in that regard, etc.

 

Yes, there are some. On 31 January 2017 ESMA explained that the systematic internaliser regime for non-equity instruments is predicated around a protocol whereby the systematic internaliser provides a quote or quotes to a client on request.

 

However, nothing prevents the systematic internaliser, especially in the most liquid instruments, to stream prices to clients.

 

Where those prices are firm, i.e. executable by clients up to the displayed size (provided the size is less than the size specific to the instrument), the systematic internaliser would be deemed to have complied with the quoting obligation under Article 18(1) of MiFIR.

 


ESMA referred specifically to the issue for how long the quotes provided by systematic internalisers should be firm or executable.

 

The authority's answer was that "the quote should remain valid for a reasonable period of time allowing clients to execute against it."

 

ESMA added that a systematic internaliser may update its quotes at any time, provided at all times that the updated quotes are the consequence of, and consistent with, genuine intentions of the systematic internaliser to trade with its clients in a non-discriminatory manner.

 

The systematic internaliser can, in justified cases, execute orders at a better price than the streaming quote.


MiFIR clearly stipulates that systematic internalisers may refuse to enter into or discontinue business relationships with clients on the basis of commercial considerations such as the client credit status, the counterparty risk and the final settlement of the transaction.

 

Systematic internalisers are required to enter into transactions under the published conditions with any other client to whom the quote was made available in accordance with the above rules when the quoted size is at or below the size specific to the instrument determined by the regulatory technical standards.

 

Systematic internalisers are not subject to the obligation to publish a firm quote, as provided for above, for financial instruments that fall below the threshold of liquidity determined by the national competent authority in accordance with MiFIR.

 

Systematic internalisers are allowed to establish non-discriminatory and transparent limits on the number of transactions they undertake to enter into with clients pursuant to any given quote.

 

MiFIR requires that the quotes published are made public in a manner which is easily accessible to other market participants "on a reasonable commercial basis".

 

The quoted price or prices are also required to be such as to ensure that the systematic internaliser complies with its obligations under Article 27 of the MiFID II (obligation to execute orders on terms most favourable to the client), where applicable, and must reflect prevailing market conditions in relation to prices at which transactions are concluded for the same or similar instruments on a trading venue.

 

However, in justified cases, they may execute orders at a better price provided that this price falls within a public range close to market conditions.

 

Systematic internalisers are not be subject to the provisions on making public firm quotes in respect of bonds, structured finance products, emission allowances and derivatives, when they deal in sizes above the size specific to the instrument determined by the regulatory technical standards.

 

To conclude, when it comes to the pre-trade transparency obligations imposed by MiFIR on systematic internalisers in respect of bonds, structured finance products, emission allowances and derivatives, the key issue are the thresholds, which set by the secondary legislation in respect of each instrument. 

 

 

Compliance costs

 

 

As a result of modified SI requirements under MiFID II a wider range of firms will need to put in place arrangements for making quotes publicly available and for managing the risks associated with providing liquidity.

 

Moreover, the increase in costs for liquidity provision might lead to some firms withdrawing from liquidity provision (Financial Conduct Authority, Markets in Financial Instruments Directive II Implementation – Consultation Paper I (CP15/43), December 2015, CP15/43, p. 57).

 

The said costs come, however, in exchange for the benefits of greater transparency of the SI framework.

 

 

ESMA's register of systematic internalisers

 

 

Under current arrangements of MiFID I, according to Article 21(4), of Commission Regulation 1287/2006 of 10 August 2006 (Level 2 legislation), each competent authority has to ensure the maintenance and publication of a list of all systematic internalisers, in respect of shares admitted to trading on a regulated market, which it has authorised as investment firms, and review the list at least annually.

 

According to Article 34(5) of the said Regulation ESMA has to publish on its website the consolidated list of every systematic internaliser.

 


The list published by ESMA represents the consolidation of national lists communicated by national competent authorities. The list is regularly updated.

 

Systematic internalisers were not popular form of business venture so far.

 

The ESMA register of systematic internalisers as visited on 7 May 2016 evidences the following actors:

- Danske Bank,

- FINECOBANK s.p.a.,

- Goldman Sachs International,

- Nordea Bank Danmark A/S,

- Knight Capital Europe Limited,

- Citigroup Global Markets Limited,

- Citigroup Global Markets U.K. Equity Limited,

- SOCIETE GENERALE,

- UBS Ltd,

- UBS AG (London Branch),

- Credit Suisse Securities Europe Ltd.

 

As of 13 May 2017 the said list was literally the same, with the exception of Societe Generale, which was substituted by the Societe Generale Option Europe - SGOE on 1 June 2016.

The firms listed above did not represent a large proportion of equity trading within the European Union (Commission Staff Working Document Executive Summary of the Impact Assessment Accompanying the document Commission Delegated Regulation supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council with regard to definitions, transparency, portfolio compression and supervisory measures on product intervention and positions {C(2016) 2860 final} {SWD(2016) 156 final}, 18.5.2016, SWD(2016) 157 final, p. 3).

 

However, the market situation evolves dynamically (media report Morgan Stanley and Denmark’s Spar Nord Bank join the SI's list - see Morgan Stanley registers as SI ahead of MiFID II).

 

Given the significantly extended scope of asset classes within the reach of systematic internalisers under MiFID II, as well as the paradigm shift from qualitative to quantitative SI's criteria, it can be expected with high probability the said list becomes more spacious soon.

 

As the aforementioned ESMA's Q&As document of 4 November 2016 underlines, in accordance with Article 94 of MiFID II, the systematic internaliser definition and the transparency regime applicable to internalisers in shares admitted to trading on a regulated market under MiFID I will be repealed by MiFID II by 3 January 2018.

 

Those firms, following the publication of the data of the first six months from 3 January 2018, will also have to determine whether their activity is frequent, systematic and substantial on the basis of the available data published in accordance with the rules in the said Q&As.

 

 

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Last Updated on Monday, 22 May 2017 20:31
 

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