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Making MiFID II Work: When is an SI not an SI?

Understanding how Systematic Internalisers (SIs) will work in practice has dominated industry debate this year. ESMA’s Q&A provides some clarification on what SIs are and aren’t, and what characterises SI activity.

According to MiFIR, Systematic Internalisers should be defined as “investment firms which, on an organised, frequent, systematic, and substantial basis, deal on own account by executing client orders outside a trading venue”.

An SI can undertake bilateral matched principal trading provided it does so on an occasional and not a regular basis. If a firm trades an instrument OTC on an organised, frequent, systematic and substantial basis ­they must become an SI in that instrument. SIs must not bring together multiple third­ party buying and selling trading interests in the same way as a trading venue.

SIs are prohibited from operating an internal matching system for matching client orders. SI activity is characterised by risk-­facing transactions that impact the profit and loss account of the firm.

A firm is an SI in an instrument - not the firm itself

MiFIR cites: “It is important to ensure that trading in financial instruments is carried out as far as possible on organised venues and that all such venues are appropriately regulated. Under Directive 2004/39/EC, some trading systems developed which were not adequately captured by the regulatory regime. Any trading system in financial instruments, such as entities currently known as broker crossing networks, should in the future be properly regulated and be authorised under one of the types of multilateral trading venues or as a systematic internaliser under the conditions set out in this Regulation and in Directive 2014/65/EU”.

What must an SI NOT do?

ESMA is of the view that MiFIR does not just limit SIs from matching client orders internally via matched principal trading but “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”.

What characterises SI activity?

ESMA understands that the trading activity of an SI is characterised by risk-­facing transactions that impact the profit and loss account of the firm. The pre­-trade transparency provisions SIs can use are to avoid submitting the SI to undue risks, based on the assumption and understanding that SIs are indeed facing risks when trading.

When should a Trading Venue be used instead of an SI?

A Multilateral Trading Facility (MTF) and Regulated Market (RM) are considered trading venues, whereas an SI is an execution venue.

When is an SI operating like a Trading Venue?

ESMA has now outlined where they believe an SI would be functionally similar to a trading venue, when:

a) The arrangements would extend beyond a bilateral interaction between the SI and a client – such as:
i. Where an SI would have agreements with other liquidity providers
ii. Where a liquidity provider would be streaming quotes to an SI
iii. Crossing client trading interests with other liquidity providers’, via matched principal trading or another type of riskless back­ to ­back transaction

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:
i. The arrangement is underpinned by technological developments to increase speed and efficiency
ii. Legal agreements would be in place between the SI and liquidity providers
iii. Trade by trade hedging will be available on a regular basis

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’s view is that an SI would not be undertaking matched principal trading on an occasional and non-regular basis (and therefore should trade on a trading venue) if it meets any of the following criteria:

a) The investment firm operates one or more systems or arrangements intended to match opposite client orders

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

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

SIs are not prevented from hedging 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. Hedging transactions can be executed on a trading venue.

When OTC is not OTC but SI

A firm trading OTC could breach SI thresholds and be forced to register as an SI when its OTC trading in an instrument is both frequent & systematic and on a substantial basis at the same time:

a) Frequent & Systematic: how many OTC trades a firm executes relative to the EU market. ESMA considers a threshold of 0.4% (for equities) (and an average daily transaction count in the instrument) for liquid equities;

b) Substantial Basis: how much OTC turnover (price x shares) a firm executes relative to their other business. ESMA considers a threshold of between 15% (for equities) or where the firm is carrying out total turnover in the financial instrument OTC of 0.4%. Union­wide transactions (as in the above).

All thresholds are average values across the previous quarter and the SI test applies for each instrument separately. Firms will have to assess this on a quarterly basis using six months of "look back" data. ESMA intends to publish the information that a firm will use to carry out its "assessments" within a month after the end of each assessment period– i.e. by the first calendar day of months of February, May, August and November every year. After the first assessment, investment firms are expected to perform the calculations and comply with the systematic internaliser regime (including notification to their NCA) 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.


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