The transformation of Europe’s financial markets under the new MiFID II rules that took effect Jan. 3 will be accompanied by swathes of new jargon. Two words will be more important than most: systematic internalizers. That’s the name that banks and algorithmic trading firms will now go by when they trade directly with clients. Regulators created the category to impose some rules on the unregulated trading that happens away from public markets, yet exchanges complain that SIs are likely to increase the amount of over-the-counter trading. Banks aren’t complaining.
1. What does a systematic internalizer do?
Any firm that trades with clients using its own capital can register as a systematic internalizer, or SI. In contrast to traditional exchanges or other venues that match multiple client orders, SI venues are designed to fill clients’ buy or sell orders directly. SIs have to use their own capital to meet customers’ demands. It’s old-fashioned market-making, but within a new regulatory framework. Most of the big global banks plan to register as a systematic internalizer in at least one asset class.
2. Why were SIs created?
The category came into existence under an earlier round of reforms called MiFID I. But almost no one used them because banks were able to run unregulated dark pools called broker-crossing networks to match their customers’ orders of stocks and other securities. Alarmed by the rise of dark trading -- where prices are not displayed before a trade takes place -- the writers of MiFID II banned broker-crossing networks and put caps on other forms of dark pools. The banks need a new home for their customers’ trades. The SIs, which are unaffected by the dark-trading caps, could meet that need.
3. Why would anyone trade with an SI?
Thanks to MiFID II, SIs have some big advantages over conventional markets, such as stock exchanges and the electronic platforms where bonds and derivatives are increasingly traded. SIs are attractive to bond investors because it means they won’t be burdened with MiFID’s onerous trade-reporting rules; the SI does it for them. Even better, anyone using an SI no longer needs to submit personal data when they place an order. That’s a big deal for funds based outside the EU where in some cases (hello Switzerland and South Korea), it’s illegal to send personal information, such as your passport number, to a commercial organization.
4. Why are SIs controversial?
Stock exchanges thought they were getting a great deal with MiFID II. Then they read the rules on SIs. And now they’re not so happy. Euronext NV and Deutsche Boerse AG both argue that SIs could siphon trades away from stock exchanges because the rules give them greater flexibility in how they price orders. As MiFID also compels fund managers to prove that they are getting the best prices for clients, stock exchanges fear that SIs will offer slightly better prices to win business.
5. What are the critics of SIs doing about them?
Responding to lobbying by exchanges, lawmakers and even some proprietary trading firms, the EU’s markets regulator, the European Securities and Markets Authority, jumped into action just two months before MiFID went into force. ESMA proposed making SIs abide by the same so-called tick-price regime as everyone else, a move that would end the new venues’ ability to price securities more flexibly. Unfortunately for the critics of SIs, the planned change cannot take effect until May at the earliest.
6. Does that mean SIs will fail?
No. The tick-size complaint was always a convenient stick with which to beat the SIs. Several firms that registered to become SIs, including Sun Trading LLC, have already said that they never want to use the greater pricing flexibility to win business. It will take months before fund managers are comfortable with using SIs, but when they do, they are likely to find that SIs are able to offer them a better price than other venues.
7. Why would that be?
For a very simple reason: an SI always knows who it’s trading with, while traders in a stock market never know who they’re trading with. Not needing to price defensively means that a bank or a speed trader working as an SI should be able to provide keener prices. That’s the theory. Whether it becomes the reality will not be apparent for many months to come.
8. Who’s signing up to be a systematic internalizer?
Below is a list of some of the companies that will become SIs and which securities they will trade using the new status:
- Algorithmic traders that will operate SIs to trade equities under MiFID II include Virtu Financial Inc., Tower Research Capital LLC, Sun Trading, XTX Markets Ltd., Jane Street Financial Ltd. (which will also trade ETFs via its SI), and Citadel Securities LLC (which will also trade fixed income)
- JPMorgan Chase & Co., Deutsche Bank AG, UBS Group AG, and Goldman Sachs Group Inc., have all confirmed plans to become SIs for equities, fixed income and derivatives. Most large banks are expected to use the SI umbrella for at least one asset class
- Barclays Plc, Nordea Bank AB and Mizuho International are among banks saying they plan to be SIs for fixed income; BNP Paribas SA for some non-equity instruments and ETFs; Bank of New York Mellon Corp. for currency derivatives
- Europe’s largest ETF trader, Flow Traders NV, has said it will not become an SI, as has fellow Amsterdam giant Optiver BV
- Bloomberg LP, the parent of Bloomberg News, offers bond-trading systems, and services for transaction reporting and best execution to meet the new rules.
The Reference Shelf
- A QuickTake Q&A on how dark trading will still thrive under MiFID II.
- QuickTake explainers on dark pools and MiFID.
- An interview with the head of the EU’s markets regulator.