Systematic Internalisers: Where are we now?

Rob Boardman, Managing Director, Chief Executive Officer, EMEA

On 28th August 2017 the European Commission published a delegated regulation amending the definition and allowed behaviour of systematic internalisers. But what does it mean for traders?

Systematic Internalisers were originally conceived in MiFID I in 2007, but have been little used thus far, as banks and brokers were able to cross orders in Broker Crossing Networks (BCNs). Under MiFID II, however, systematic internalisers are expected to play a much bigger role in the European equity trading landscape as BCNs will be banned, and the dark caps of 4% per platform and 8% overall are expected to curtail dark MTFs’ use of the reference price waiver. So under MIFID II the new tools offered to institutional equity traders will be:

  • Revamped systematic internaliser platforms brought to market by bank, brokers and electronic market-makers, which publish principal quotes to the market,
  • Block trading MTF platforms (such as POSIT Alert) that use the large-in-scale waiver and are completely dark, often utilising conditional orders, and
  • Periodic Auction platforms (such as BATS Periodic Auction) which feature limited pre-trade transparency during a auction process

Some lobby groups expect banks to reconfigure their BCN platforms as systematic internalisers and have been urging the European policymakers to limit the behaviour of systematic internalisers.

Some examples of potential SI concerns are:

1. Banks will direct client flows through their systematic internalisers, but actually trade back-to-back in the public markets, creating the illusion of adding liquidity, but actually just effecting pass-through agency trades.

2. Bank will find ways to cross client orders in their SI platforms, creating a mulitlateral BCN-type service without a specific MTF licence.

3. A variation of (2), banks could interconnect their systematic internaliser platforms with other banks. This means that client A entering through SI #1 can then trade with client B, who enters via SI #2. This could potentially bring the BCNs back via a back door.

4. Lobby groups still object that systematic internalisers are exempt from the MiFID II tick-size rules, which must be respected by public exchanges and MTF platforms.

5. Unlike exchanges, banks operating systematic internalisers have up to 60 seconds to report trades to the market, at their discretion.

6. Systematic internalisers are only required to be transparent up to standard market size.

The EC’s published ruling attempts to address the first three concerns. The modifications to article 4(2) of the directive policymakers clarify that systematic internalisers must provide liquidity on a principal basis and not “de facto riskless back-to-back transactions …”. This partially addresses concerns (1) & (2) above, although it provides an exemption for risk transfer to another firm in the same group. It can also address concern (3) as the systematic internalisers would not be able to seek the other side of a trade from another platform outside their firm.

The tick size rule (4) is not addressed and looks now to be locked in place under MiFID II as an advantage for systematic internalisers, who are now free to offer sub-tick price improvement versus other public quotes. It seems now too late for the European Commission to address other fundamental objections to systematic internalisers (5) and (6).

The ITG view

Our view is that this new ruling will be mostly effective at reducing phantom liquidity and client-client crossing in systematic internalisers. Elimination of client-client crossing will not worry the independent electronic liquidity providers, but it will limit banks, who might otherwise have found riskless ways to supply liquidity to clients.

We should also consider whether it is practical for policymakers to completely limit the ability of any market-maker to hedge their positions with external liquidity. How long must a systematic internaliser be on risk before they are allowed legitimately to trade out of their unwanted positions? No explicit rule is given here, and we doubt it will be easy for regulators to supervise this point. The answer for an illiquid ETF will surely be different from a highly liquid mega-cap stock. As ever, banks are expected to take different views, although we anticipate that the largest global firms will be wary of running significant regulatory risk.

ESMA maintains a database of registered systematic internalisers, which number 68 at the time of writing, of which only a limited subset will offer electronic streaming liquidity suitable for electronic trading. When considering which to use, we believe best practice will require an understanding of each systematic internaliser platform at a quantitative level. The most sophisticated systematic internalisers offer highly customised liquidity, with quoted price/size varying by new factors such as:

  • Fill rate required
  • Strategy of the parent algorithm
  • Level of client alpha (negative selection for the systematic internaliser),

… in addition to the usual factors (volatility, country/sector, liquidity, time of day etc.). The risk of information leakage and opportunity cost can be higher with systematic internalisers. For example, if a smart router sends an IOC order to a systematic internaliser and it is not filled the platform operator still has the information about the client’s trading intent (unlike a public venue where information is protected) AND you have missed the opportunity to trade.

ITG has no plans to register as a systematic internaliser, as it is incompatible with being an agency broker. However, we accept that systematic internalisers will add value if they provide genuinely alternative liquidity. Our approach is therefore to understand these platforms at a quantitative level and then work with clients to offer access to a select number systematic internalisers in an optimal way.