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

 


 

 

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 definition of systematic internaliser is laid down in Article 4(1)(20) of MiFID II and specified in Commission Delegated Regulation (EU) No 2017/565 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.

 

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'.

 

 

“Execution of client orders” as an constituent element of the systematic internaliser’s definition

 

 

The reference to 'executing client orders' is integral to the definition of a systematic internaliser under both regimes MiFID I and MiFID II.

 

An investment firm will only constitute a systematic internaliser where it is proposing to execute a client order.

 

It is 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 (ISDA MiFID CP Submission, p. 6).

Systematic internaliser can stream prices to clients 

The circumstances when an investment firm should be considered as “executing client orders” when dealing on own account outside of trading venues have been explained by ESMA in more detail in the Questions and Answers on MiFID II and MiFIR transparency topics (Answer to the Question 7 updated on 3 October 2017, ESMA70-872942901-35).

 

For the purposes of the SIs’ determination, ESMA considers that in all circumstances where an investment firm is dealing with a counterparty that is not a financial institution authorised or regulated under Union law or under the national law of a Member State (‘financial institution’), the investment firm is deemed to be executing a client order and the transaction should count towards the calculations (both the numerator and the denominator).

 

Where the investment firm is dealing with a financial institution, ESMA considers that one party to the transaction will always act in a client capacity.

 

Therefore, in order to determine when an investment firm is “executing client orders” when dealing on own account outside of trading venues, investment firms need to assess which of the two parties to the transactions acts in the capacity of executing client orders.

 

Investment firms may determine this either on a transaction by transaction basis or by type of transactions or type of counterparties.

 

Different indicators could be used for determining which party executed a client order: e.g. whether an investment firm has classified the counterparty as a professional client, who initiated the trade or who received the instruction to deal and the extent to which the counterparty relied on the other party to conclude the transaction.

 

 

Delineation between systematic internalisers and trading venues

 

 

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 said Commission Delegated Regulation (EU) 2017/565 of 25 April 2016:

 

"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.

 

The European Commission reacted in June 2017 and issued the draft Commission Delegated Regulation amending Delegated Regulation (EU) 2017/565 as regards the specification of the definition of systematic internalisers for the purposes of that Directive.

 

In the said document the EU executive arm argues that the technological and market developments make it necessary to specify that a systematic internaliser is not allowed to engage, on a regular basis, in the internal or external matching of trades via matched principal trading or other types of de facto riskless back-to-back transactions in a given financial instrument outside a trading venue.


Therefore, the new Article 16a is proposed by the European Commission to be inserted into the Delegated Regulation (EU) 2017/565 with the following wording:

 

“Article 16a
Participation in matching arrangements

An investment firm shall not be considered to be dealing on own account for the purposes of Article 4(1)(20) of Directive 2014/65/EU where that investment firm participates in matching arrangements with the objective or consequence of carrying out de facto riskless back-to-back transactions in a financial instrument outside a trading venue".

 

Another aspect of the necessary distinction between systematic internalisers, multilateral systems and Approved Publication Arrangements (APAs) has been accentuated by ESMA in the Questions and Answers on MiFID II and MiFIR market structures topics of 7 July 2017 (ESMA70-872942901-38).

 

This time ESMA referred to a situation where APAs proposed setting up arrangements which, on top of their APA services, provide a suite of quote streaming and order execution services to SIs and their clients (in this set-up clients could not interact with more than one SI via a single message but could send multiple messages to multiple SIs participating in the service provided).

 

The context was of Articles 14(1) and 18(1) of MIFIR, which require SIs to make public firm quotes, which may be published through an APA.

 

In the ESMA opinion, a system that provides quote streaming and order execution services for multiple SIs is a multilateral system and is required to seek authorisation as a regulated market, MTF or OTF in accordance with Article 1(7) of MiFID II.

 

Continuing the thread of comparisons between systematic internalisers and trading venues it is useful to refer also to post-trade transparency issues.

 

Considering systematic internalisers are competing with trading venues over customers’ order flow and to provide for a level playing field, in the Answer to Question 8 (updated on 3 October 2017, Questions and Answers on MiFID II and MiFIR transparency topics, ESMA70-872942901-35) ESMA underlined that:

 

1. trading venues and systematic internalisers using similar technology and systems should process transactions for post-trade publication at the same speed;

 

2. real time post-trade transparency requirements, as expressed in Articles 6 and 10 of MiFIR and further specified in:


- Article 14 of RTS 1 (Commission Delegated Regulation (EU) 2017/587 of 14 July 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) and


- Article 7 of RTS 2 (Commission Delegated Regulation (EU) 2017/583 of 14 July 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);

 

apply equally to trading venues and investment firms (systematic internalisers including).

 

Consequently, ESMA expects that trading venues and investment firms, in particular systematic internalisers, that use expedient systems publish transactions as close to real time as technically possible.

 

 

SI as a risk-taking market actor

 

 

The element of risk-taking in the systematic internalisers' activities has been analysed by ESMA in the said Questions and Answers on MiFID II and MiFIR market structures topics (ESMA70-872942901-38) as updated on 5 April 2017.

 

It is stressed 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

 

 

 

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). 


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.

 

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.

 

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, and CTPs (Consolidated Tape Providers).

 

Recital 18 of the said Commission Delegated Regulation (EU) 2017/565 of 25 April 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) 2017/565 of 25 April 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 July 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 July 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 July 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

 

Recital 19 of MiFIR reads that the requirements for systematic internalisers “should apply to an investment firm only in relation to each single financial instrument, for example on ISIN-code level, in which it is a systematic internaliser”.

 

The SI's thresholds calculations as regards derivatives should be performed at the most granular class level as identified in the said Commission Delegated Regulation (EU) 2017/583 of 14 July 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).

 

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 RTS 2 for LIS and SSTI should be used.

 

As regards emission allowances according to ESMA the systematic internaliser threshold should be calculated at the level of the emission allowance type.

 

Both the numerator and the denominator must refer to the same sub-asset class level as identified in RTS 2.

 

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 2017/565 of 25 April 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 Commission Delegated Regulation (EU) 2017/565 of 25 April 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 the letter of 19 June 2017 (ESMA70-156-158) ESMA confirmed the necessary IT infrastructure is on schedule to meet this deadline).

 

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. 

 

Required content of the notification from systematic internalisers to their National Competent Authorities

 

In the Questions and Answers on MiFID II and MiFIR transparency topics (ESMA70-872942901-35) ESMA explained that the notification from systematic internalisers to their National Competent Authorities (NCA) should contain information that is at least provided at the level of the MiFIR identifier for the instruments and classes of instruments for which the investment firm is a systematic internaliser, as specified:

 

- in field 4 of table 2 of Annex III of RTS 1 (i.e. shares, depositary receipts, exchange traded funds, certificates and other equity-like financial instruments), and


- in field 3 of table 2 of Annex IV of RTS 2 (i.e. bonds, ETNs, ETCs, structured finance products, securitised derivatives, derivatives, and emission allowances).

 

This is without prejudice of the possibility for NCA to require the submission of more granular information if considered appropriate (Answer to the Question 6 updated on 31 May 2017).

 

Notification’s validity

 

In the same Answer to the Question 6 ESMA on 31 May 2017 (Questions and Answers on MiFID II and MiFIR transparency topics (ESMA70-872942901-35)) ESMA determined that the obligation of the investment firm to follow the obligations for systematic internalisers after crossing the relevant thresholds in a financial instrument will last for three months after crossing the relevant thresholds in a financial instrument at the relevant quarterly assessment.

 

The obligation period will be slightly shorter for the first assessment in 2018, which covers 1 September to 15 November 2018.

 

Notification of the systematic internaliser’s change of status

 

The above Answer to the Question 6 of 31 May 2017 also clarifies that investment firms are required to notify their NCA in case of a change in status, i.e. where an investment firm passed the thresholds for an instrument with a particular MiFIR identifier in the previous period, but did not meet the thresholds for any instrument with the same MiFIR identifier in the consecutive assessment period, it should notify its CA of its change of status.

 

Where there is no change in the systematic internaliser status from one assessment period to the next (i.e. where the investment firms is still above the threshold or decides to voluntarily opt-in as systematic internaliser for any instrument with the same MiFIR identifier), the firm does not have to notify its NCA thereof.

 

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 (EU) 2007/565 of 25 April 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.

 

 

Tick-size regime exemption

 

 

Systematic internalisers are exempt from the MiFID II tick-size regime, which means they are allowed to trade shares, depositary receipts and exchange-traded funds in different price increments than public markets.

 

In particular, the SIs have flexibility to set tick sizes, the advantage that the exchanges and dark pools do not possess.

 

That means that, for example, while a stock exchange might quote a share at $10.00, an SI might be able to quote it at $9.99999 (Bloomberg, “MiFID II may triple dark trading in Europe as new venues soar”).

 

This is perceived by some as an unlevel playing field, although, others argue that the SIs’ remaining tick-sizes flexibility can strongly contribute to a deeper market and tighter spreads.

 

However, ESMA reserved on 3 October 2017 (Answer to Question 23 in Questions and Answers on MiFID II and MiFIR market structures topics, ESMA70-872942901-38) that price improvements on quoted prices are only be justified when “they are meaningful and reflect the minimum tick size applicable to the same financial instrument traded on a trading venue”.

 

This is without prejudice to SIs’ ability to quote any price level when dealing in sizes above standard market size.

 

In the ESMA’s opinion “marginal price improvements on quoted prices would challenge the efficient valuation of equity instruments without bringing any real benefits to investors”.

 

Note, however, that in the Consultation Paper, Amendments to Commission Delegated Regulation (EU) 2017/587 (RTS 1) of 9 November 2017 (ESMA70-156-275) ESMA proposed to amend Article 10 of RTS 1 to clarify that, for equity instruments subject to the minimum tick size regime under Commission Delegated Regulation 2017/588 of 14 July 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards on the tick size regime for shares, depositary receipts and exchange-traded funds (RTS 11), SI quotes would only be considered to reflect the prevailing market conditions where those quotes reflect the price increments applicable to EU trading venues trading the same instruments.

 

 

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

 

 

"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

 

 

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."

 

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 are set by the secondary legislation in respect of each instrument.

 

Due to the complexity, the respective legal framework is described separately - see systematic internaliser’s pre-trade transparency requirements in respect of bonds, structured finance products, emission allowances and derivatives.

 

 

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 evidenced 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.

 

 

Migrating to the SI regime: perspectives

 

 

The firms listed on the ESMA SI‘s register did not represent under the MiFID I 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 and the said register extends systematically (see for example 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.

 

It is, moreover, noteworthy, the broker-crossing networks will be banned under MiFID II, forcing banks to find alternatives.

 

Some commentators observe (Bloomberg, “MiFIDʼs Controversial Dark-Trade Workaround Has Some Crying Foul”) that once MiFID kicks in, three-quarters of investment firms expect to trade via SIs, albeit “in a tentative fashion”.

 

They also underline the advantages of having SI status, in particular the fact that banks and high-speed traders will be able to do as many trades as they want via their SIs without those transactions counting toward MiFID II’s strict limits on dark-pool trading.

 

That provides an incentive to trade with SIs instead of conventional dark pools.

 

The time to comply with new requirements is tight - 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.

 

Firms, following the publication of the data of the first six months from 3 January 2018, will 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 Saturday, 11 November 2017 21:56
 

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