With MiFID II regulation now less than 12 months away, the race to ensure compliance is heating up. A recent letter penned by Steven Maijoor, European Securities and Markets Authority (ESMA) Chair, expressed concerns on the “potential establishment of networks of systematic internalisers (SIs) to circumvent certain MiFID II obligations.”
The implementation of MiFID I saw the introduction of systematic internalisers. They 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”. With this, some loopholes opened up for firms. MiFID II aims to close them but, unfortunately, the SI debate is yet unresolved.
What Is a Systematic Internaliser?
Traditionally, an SI would be an investment firm that could match ‘buy and sell’ orders from clients in-house, provided that they conform to certain criteria. Instead of sending orders to a central exchange such as the London Stock Exchange, a bank would then be able to match orders against its own book.
An SI firm is then able to compete directly with a stock exchange or automated dealing system. Following a trade, information about the transaction would also need to be made available in the same way a trading exchange would be subject to.
Should ESMA Be Concerned about SIs?
The answer is an emphatic yes. Steven Maijoor’s letter stated that he and his colleagues “are very concerned about this potential loophole. In its technical advice of 19 December 2014, ESMA already raised concerns that the SI regime may be used to circumvent the MiFID II provisions, in particular concerning the trading obligation for shares.”
The concern is that exploitation of this loophole to hinder the process of making share trading more transparent. To date, there are fewer than ten systematic internalisers in Europe; this number is set to rise considerably during preparations for MiFID II compliance as banks battle to stay one step ahead.
This increase in private venues goes against the good intentions of MiFID II regulation and would essentially result in more and more share trading conducted on these ‘private venues’ and away from the scrutiny of public exchanges. One measure to control SIs is for ESMA to require them, just as other market operators, to report according to RTS 27.
What Does this Mean for Firms?
Rather a lot. Currently, an SI is exempt from rules on tick sizes that put restrictions on minimum price increment on regulated markets, MTFs or OTFs. Sell-side firms will not be able at all to execute client orders against each other to a negotiated price if the double volume caps are hit.
Rather they need to execute them in the lit markets, which is one of the goals of MiFID II. Optionally, they might rely on the evolution of new market structures, such as periodic auction venues.
Also, MEP Kay Swinburne has made statements regarding the potential loophole, warning banks to try to circumvent the regulations through setting up networks of SIs. Swinburne claims this activity would tread the grey area and not giving the investors best price and, therefore, not fulfilling the spirit of MiFID II.
The Impact on Potential SIs
If the double volume caps are hit, an investment firm will need to become an SI to keep their competitive edge. However, firms will think twice should this loophole be closed. Those in breach of the limits of OTC trading must either become an SI or stop that specific part of their trading. Discussions will then focus on what the SI was intended for.
Ultimately, investment firms should surely have the common sense to understand whether or not their SI strategy is in line with the spirit of MiFID II.