It’s easy, and perhaps convenient, to forget the mad scramble to be ready for MiFID II. Many firms struggled to interpret the operational implications of the 1.7 million paragraphs of text, turn them into policy and assess their potential business impact.
The ‘day 1’ priority was just getting compliant with the new regime, and few firms had the luxury to plan how best to optimise their businesses and exploit the changes. One of the key questions in this was whether to commit to becoming a Systematic Internaliser under the new regime or change business model to avoid inclusion. Larger firms and regional specialists, dominant in certain asset classes or instruments, had little choice but to embrace the new regulation, while others initially shied away from the stringent regulatory oversite and reporting obligations that came with adopting SI status.
Two years on and the post MiFID II landscape has become much clearer, and so have some of the consequences (both intended and unintended). As discussed in my previous article on the evolving shape of European market liquidity, Systematic Internalisers have become an increasingly valuable source of liquidity provision. According to data solutions provider, big-xyt, October saw a record €1.5 billion in daily notional turnover by ELP SIs across Europe. But what is driving this growth?
First, MiFID II extended the best execution regime to cover the buy-side as well as the sell-side. This means that asset managers must be able to evidence that they have their own best execution mechanics in place rather than just rely on their brokers. It also means that they have to be able to show why they selected one broker over another. The definition of best execution extends beyond simply price to include factors such as cost, speed, likelihood of execution and settlement, client characteristics and so on. So, where broker dealers can enhance execution quality (improving price, reducing cost and/or market impact) through internalising trades, then this is obviously beneficial to their clients.
On the face of it, this means asset managers can avoid burdensome trade reporting obligations when routing their flow to an SI. Obviously, this has to be in the context of best execution of the order. There is also the added complexity that sell-side firms may be SIs for some sub-asset classes but not others and the respective counterparties in the transaction need to understand who has the reporting responsibility at an instrument level. But where the trade reporting obligation does fall to the SI, then operational and administrative overheads are removed for the buy-side entity.
The number of registered SI’s has grown from just 14 in 2017 to over 200 today, which suggests that there are clearly benefits that outweigh the increased regulatory scrutiny, transparency obligations and organisational requirements. The broker dealer community is faced with thinner margins, increased costs of participation and a generally challenging economic environment. In response, many have concluded that investment in the right technology and operations is, in fact, the only way forward. So, for example, a mid-tier regional bank may be managing order flow from retail, wealth management and corporate customers as well as running its own institutional cash equity desk. Rather than always trading away to a lit venue or other liquidity platform, should they first be looking to match these orders internally?
Naturally, the challenge, as always, is to justify the ROI of the investment in technology, infrastructure and operations. But the right lightweight matching technology and an open platform solution can integrate the different systems in place across the firm and drive efficiency – ranging from aggregation of retail order flow all the way through to full internalisation. This helps improve the margin on individual trades, while increasing overall execution quality and so can attract more order flow.
The SI opportunity has also been fuelled by the unintended consequences from ESMA’s desire for greater transparency and attempts to limit the volumes traded on dark pools. The introduction of the dark pool Double Volume Caps was meant to constrain trading in non-displayed liquidity by introducing a limit on the use of two transparency waivers (the Negotiated Trade Waiver and the Reference Price Waiver). The aim was to push these orders onto lit venues, but research has shown that, in fact, the opposite happens. When dark pool volume caps are breached, liquidity actually shifts to other off-exchange execution constructs, such as SIs, rather than revert to lit markets as intended.
Currently, most SI trading remains large-in-scale (LIS), but those operating below the size threshold are carving out a useful niche for themselves. Sub-LIS firms come in different shapes and sizes but, whether they are brokers or ELP market makers, they all contribute to the overall liquidity that investment firms can use to achieve their execution benchmarks. A more granular level of liquidity sourcing is now possible, translating into more certain execution outcomes that directly impact the bottom line.
Question marks remain, however, regarding the negative impact of SIs on wider market transparency. Regulators are uncomfortable with the growth of internalised order flow, and their initial response has been to propose that SIs must adhere to the public tick regime in order to remove one of the advantages SIs have over lit venues. This will challenge the SIs ability to price improve on non-LIS trades, but will ESMA’s desire for transparency actually reduce execution quality in certain cases?
There is little doubt that the Systematic Internaliser regime under MiFID II is becoming an established part of the new liquidity landscape, with average daily value traded representing over 2% of total European turnover and poised to grow further. This would suggest that the buy-side are benefiting from improved execution quality by accessing broker dealers’ internal inventory.
The growth in the number of internalising firms also points to advantages for the sell-side, whether that is increasing incremental revenue, potentially attracting new order flow, or reducing exposure to counterparty risk. And for the sell-side firms that have not yet joined the SI club? They may well want to consider applying for membership soon before the regulators change the admission rules.