The majority of buyside traders expect to use systematic internalisers from the start of January and regard increasing employment of the SI regime as positive for European equity markets.
Consultancy Tabb Group said in a report, MiFID SI Regime: A New Liquidity Source in Europe’s Equity Market, that 60% of buyside institutions expect to use SIs from the start of MiFID II, albeit tentatively. The survey included equity market makers and banks which intend to register as SIs, agency brokers, and 20 buyside heads of equity trading.
Systematic internalisers were originally set up for equities under MiFID in 2007 for all off-venue trading in the European Union. However only nine banks became SIs and very few trades took place on the back of an SI quote as off-venue trading moved to broker crossing networks.
As a result MiFID II extends SIs to other asset classes, including fixed income, as regulators aim to capture over-the-counter trading activity, increase transparency and ensure that the internalisation of order flow does not undermine price formation on regulated trading venues. MiFID II makes it compulsory for firms committing capital on a frequent basis, or that accounts for more than 0.4% of trading in a stock to register as an SI. They will have pre-trade transparency requirements and must continuously publish competitive, two-way quotes up to the standard market size for each stock.
The majority of asset managers in the study regard a wider use of the SIs as being positive for European equity markets due to access to liquidity/risk capital, price improvement and the ability to select specific trading counterparts. The SI rules allow the buyside to identify their trading counterparty through the use of market identifier codes.
All respondents who said they would use SIs implied they would do so tentatively to begin as they conducted execution quality analysis.
“Of those who said they would not use the regime, most said they planned to make an assessment of SIs in the second half of 2018, once more data was available on execution quality,” added Tabb. “This limited usage initially, combined with restrictions on dark pools, implies activity will shift back to lit markets during early 2018.”
SIs do not have to publicly display prices for trades larger than the standard market size and Tabb said the ability of SIs to exercise discretion on pricing will be very advantageous. For larger trades SIs can quote on a client-by-client basis, and these prices can be adjusted, or price improved, without having to abide by the minimum tick sizes that apply to other regulated venues as they put capital at risk
“This opens up the possibility that SIs could offer potentially negligible price improvements compared to other venues in order to offer best execution and attract order flow,” said Tabb.
The consultancy said most prospective SI operators in their survey said they saw little commercial value trading in order sizes below the standard market size. The report gave the example of agency broker Instinet and Virtu Financial establishing a bilateral trading relationship as the electronic liquidity provider Virtu plans to register as an SI.
Tabb said: “Virtu streams quotes that are accessible by Instinet clients and trades are then completed off-exchange. Since going live in the second quarter of 2017, the arrangement has seen fill rates in the high 90s in percentage terms, with order sizes several times larger than those on lit markets, according to Instinet.”
Octavio Marenzi, Opimas
However Octavio Marenzi, founder and chief executive of consultancy Opimas warned of the unintended consequences of MiFID II at a City & Financial Global Conference in June. Marenzi said systematic internalisers do not have requirements for a minimum tick size and so could post quotes inside the spread on multilateral trading facilities and regulated markets.
“High-frequency traders are are knocking on the door of the buyside and offering to get a price improvement in return for interacting with their flow,” Marenzi added. "There will be increased volumes in SIs to the detriment of lit markets, which is the opposite of the regulatory intent."
Tabb estimates that up to 20 equity SI operators will be registered when MiFID II comes into force. Rob Boardman, European chief executive of electronic equities broker ITG, has said the market could very be underestimating how many SIs will emerge under MiFID II, and there could be between 20 and 30, or even more.
As a result of the liquidity fragmentation, 70% of respondents said they would use broker smart order routers to sweep multiple SIs, rather than connecting to each individually.
Investment banks will offer liquidity in larger size while electronic liquidity providers will offer market-making strategies directly to clients for smaller-sized orders. “In reality, only a handful of these SIs will offer competitive prices,” said the report.
Therefore, nearly half of buyside institutions expect their broking lists to shrink under MiFID II.
The biggest concern over SIs from the survey was the lack of clarity being provided by brokers on their SI plans, including how they propose to access other SIs and how their order flow would be routed within the regime. “There was specific concern among many respondents as to how brokers would tag and segment client order flows, a process which determine which quote stream they would be offered from each SI,” added the report.
Tabb concluded there will be limited use of the SI regime during the early part of 2018, but volumes will increase over time and may end up representing a sizeable proportion of the European equity market. For example, in the US internalisation accounts for around 25% of equity volume.
“There is a clear appetite among UK and European buyside firms to utilise the regime, for various reasons, including the potential for price improvement and greater transparency,” said Tabb.
