MiFID and Systematic Internalization

An Approach Paper

Authors:
Shravan Bharathulwar, Rajshekhar Purandare, Anand Hingway
 Table of Contents
1. Introduction ....................................................................................................... 1
1.1 MiFID ........................................................................................................... 1
1.2 Systematic Internalizers .............................................................................. 1
2. Systematic Internalizers .................................................................................... 2
2.1 Who is a prospective SI? ............................................................................. 2
2.2 What are ‘liquid shares’? ............................................................................. 2
2.2 Obligations of SI under MiFID ..................................................................... 3
2.2.1 Intention of being an SI ......................................................................... 3
2.2.2 Transparency Rules: Publishing quotes................................................ 3
2.2.3: Transparency Rules: Obligation to execute orders at quoted price ..... 3
2.2.4: Client Order Handling and Display of Client Limit Orders .................... 4
2.2.5 Transparency Rules: Post trade transparency ...................................... 4
2.2.6 Best Execution Rules ............................................................................ 6
2.3 Impact of obligations on firms ...................................................................... 6
2.3.1 Effect of pre and post trade transparency ............................................. 6
2.3.2 Impact of Best Execution Practices ...................................................... 7
3. Pros and Cons of being an SI ........................................................................... 8
3.1 The Pros ...................................................................................................... 8
3.1.1 Revenue ............................................................................................... 8
3.1.2 Benefits to SIs vis – a – vis Market Makers .......................................... 8
3.2 The Cons ..................................................................................................... 9
3.2.1 Credit Risk ............................................................................................ 9
3.2.2 Risk associated with publishing quotes in real time .............................. 9
3.2.3 Risk of best execution compliance ........................................................ 9
3.2.4 Investment in IT Systems...................................................................... 9
3.2.5 Client classification / Investor Protection............................................. 10
3.2.6 Compliance Reporting ........................................................................ 10
3.2.7 Conflict of Interests ............................................................................. 10
4. Conclusion ...................................................................................................... 12
5. Appendix ......................................................................................................... 13
6. References ..................................................................................................... 13

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 ABSTRACT
MiFID is a new market directive for the European Markets. This
whitepaper evaluates the implications of MiFID on Systematic Internalizers (SI).
The paper studies the pros and cons of being an SI in the post-MiFID era. It
critically examines the MiFID articles and the effect of the articles from a systems
viewpoint.

iii
 1. Introduction

1.1 MiFID
The ‘Markets in Financial Instruments Directive’ or MiFID is new a directive for
the financial markets in the European Union which comes into effect from November
2007. This directive replaces the earlier Investment Services Directive ((Directive
93/22/EEC) implemented in circa 1993.

MiFID – Value Proposition:

With the creation of European Union, the regulatory authorities saw a need for
harmonization of financial markets across the EU in terms of uniform regulatory
structure, ease of cross border trades, rationalized transaction costs and increased
transparency. MiFID is seen as a big leap towards the same.
The financial industry envisages a huge impact on the macrostructure of the
market as a result of the directive. The evolution of new execution venues for client
orders, emergence of new data reporting venues, convergence towards straight through
processing, stricter regulatory compliance and increased client protection are few of the
many far reaching changes that MiFID promises.

1.2 Systematic Internalizers

The new directive lays a path towards a structured evolution of newer order
execution avenues for the clients. This includes Multilateral Trading Facilities
(MTF’s)/Alternative Trading Systems (ATS’s) and Systematic Internalizers. We are
particularly interested in the latter.
The MiFID directive defines a systematic internalizer as “an investment firm
which on an organized, frequent and systematic basis, deals on own account by
executing client orders outside a regulated market or an MTF” [Directive 2004/39/EC
of European Parliament of 21 April 2004 Article 4 (7)].

1
 2. Systematic Internalizers

2.1 Who is a prospective SI?

A firm wishing to be recognized as an SI under MiFID must meet the following
requirements as stated in Article 4(1)(7) of Directive 2004/39/EC):
1. The internalizing activity must be performed on an organized and frequent basis in a
systematic manner;
2. The activity has a material commercial role for the firm, and is carried on in
accordance with non-discretionary rules and procedures;
3. The activity is carried on by personnel, or by means of an automated technical
system, assigned to that purpose, irrespective of whether those personnel or that
system are used exclusively for that purpose;
4. The activity is available to clients on a regular or continuous basis.
Investment firms which do not internalize on a regular basis, but carry on the activity
irregularly, or in an ad-hoc manner, or which do no deal with liquid shares, are not be
recognized as SIs.

2.2 What are ‘liquid shares’?

The article 27 of Directive 2004/39/EC deals with the formal definition of ‘liquid
shares’. The essential points covered under the article are stated below:
i. The share is traded daily
ii. Has a free float1 of not less than € 500 million.
iii. One of the following conditions are satisfied2:
 The average daily number of transactions in the share are not less than
500
 The average daily turnover of the share is not less than € 2 million.

1. Free Float are shares of a public company those are freely available to the investing public.
2. Member states of the EU may choose to enforce both conditions while defining liquid shares.

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2.2 Obligations of SI under MiFID

2.2.1 Intention of being an SI

Firms must state their intent of acting as Systematic Internalizers for the
securities they intend to internalize to the regulatory authority.
The relevant home regulator keeps a list of all systematic internalizers and which
is made public by CESR3.

2.2.2 Transparency Rules: Publishing quotes

The SI firm must publish quotes for the shares that it internalizes.
It is obliged to publish quotes only for those shares for which the transaction size
is up to `standard market size’**. This provision has been introduced in order to
protect the wholesale broker – dealers from significant risks in their role as market
makers. In addition, the SI firm needs to publish the quotes only for liquid shares as
defined previously.
The quotes need to be published on a continuous and commercially reasonable
basis. SI’s retain the right to withhold this information under exceptional
circumstances as defined by the directive.

2.2.3: Transparency Rules: Obligation to execute orders at quoted price

As per the directive# the SI may not improve on the quotes for the retail investors
on trades that are at or below the standard market size. It may improve the quotes
published for their professional clients on the trades that are above standard market
size. The improvement may happen only to the extent that it remains in the range
close to market price. In case of the trade being a part of a portfolio trade comprising
of more that 10 individual trades on securities, the SI may improve on the quotes for
its professional clients. The obligation to execute the orders at quoted price
exposes the SI to credit risk4 from unknown counterparties.

3. CESR: Committee of European Securities Regulators

** Orders greater than standard market size are defined as per table 1 in the Appendix
#
Article 27(3) and Article 27(6) of Directive 2004/39/EC – Subparagraph 5

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Article 27(5) aims to remove this shortcoming by allowing the SI firm to choose its
clients based on its commercial policy, with certain restrictions to avoid discrimination
within clients.
The transparency rules calls for Systems with capability of matching client orders
with the firm quotes. Configurability of such systems is important, where the firm can
choose its clients indiscriminately on the basis of its Commercial Policy.

2.2.4: Client Order Handling and Display of Client Limit Orders

As per the Article 22(2) of directive the investment firm shall be considered to
disclose client limit orders* unless specifically advised otherwise by the client. The SI
should make public the order in a way that is easily accessible to the market
participants. SI may withhold this information in case it is large in scale as compared
to market(Appendix, Table 1 ).
The means for making public the orders are not specified by MiFID but Article 31
stresses that any arrangement to make public such information, must also
consolidate the data with similar data from other sources.
This implies a need for a Consolidated Information System (on lines of CQS5 and
CTA6 of US Markets). In absence of such a system, SI s will need systems to
transmit this information to Regulated Markets or MTF s.

2.2.5 Transparency Rules: Post trade transparency

Reporting Trade Information
One of the key requirements on post-trade transparency is that trade information
needs be disclosed by the SI as soon as possible after the trade,

3. Credit Risk: Credit risk is the risk of loss due to a debtor's non-payment of a loan or other line of
credit (either the principal or interest (coupon) or both). (Source:
http://en.wikipedia.org/wiki/Credit_risk)
* limit orders: an order to trade ‘at the best price available’, but only if it is no worse than the limit price
specified by the trader, as opposed to market order that is an instruction to trade at the best possible
price currently available in the market.
5. CQS: Consolidated Quotation System: provides quotation data for listed securities
6. CTA: Consolidation Tape Association: provides ‘last sale’ information for all listed trades in the
market

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 and not longer than 3 minutes, irrespective of the trading system used. The SI can
choose to either set up autonomous post trade publication arrangement or disclose
trade information to the most liquid Regulated Market for that trading instrument
(irrespective of whether the firm is a member of that market or not). The SI firm is
also responsible for making available the information at reasonable costs on a
commercial and non discriminatory basis to the public.
The Commission Regulation currently states that the following details need to be
published as part of a trade report:
 trading day
 trading time
 instrument identification
 unit price
 price notation
 quantity
 venue identification
 Transaction reference number: It is unique identification number for the
transaction provided by the trading venue.
 Buy/Sell Identification

In case of large transactions (Block trades), the publication of transactions executed off-
exchange for the clients against the company’s own book can be delayed under MiFID.

Maintaining Quotes and Trade Data

In their role as systematic internalizers, investment firms have to keep records of
their quotes for at least twelve months.
SI ‘s are authorized in exceptional cases in their post-trade transparency data to
use the abbreviation “SI” – instead of their actual identifier for the place of execution.
This is subject to the prerequisite that the SI provides the general public with
aggregate quarterly data for the transactions that it executed in its capacity as a
systematic internalizer for the share in question.

Best Execution Compliance

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 The firm will have to be able to ensure best execution compliance with respect to
the execution policy it chooses.

2.2.6 Best Execution Rules

The SI firm is obliged under the directive to ensuring best execution for its client’s
orders. SIs must establish and implement an Order Execution Policy (OEP) for the
client orders. OEP must include information on different trading venues where the SI
executes its client orders and factors affecting the choice of the order execution
venue. The formulation of the best execution policy for a particular client must take
into account the price, cost, speed, likelihood and other relevant criteria.

2.3 Impact of obligations on firms

2.3.1 Effect of pre and post trade transparency
Pre and post trade reporting has brought in issues previously not faced by
investment firms. The SI firms will have to undergo a critical thinking process to chalk
out a definite plan for data reporting. Some of the key issues to be addressed are:

Choosing Reporting Venues

The SI firms may choose to use single or multiple data reporting venues for post
trade reporting. Reporting to multiple venues will remove the dependency on venues
in turn ensuring a strict adherence to the 3 minute reporting requirement even if a
venue fails to deliver. The choice of reporting venues will be governed by ease and
speed of connectivity, MiFID compliance by the vendor, revenue sharing model
offered by the vendor as well as the acceptability of the reporting venue as a
reasonably popular medium for post trade reporting

Systems
SI firms will have to invest in technology to create a robust platform for MiFID post
trade compliance. The technology will be centered around these capabilities:
 Data dissemination to reporting venues(Speed, Connectivity, Volume)
 Data Warehousing (Storage of trade information – quotes, price etc.)
 Business Intelligence – Data analytics around the trade data generated
inside SI

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  Post trade compliance reporting
 Risk Management – Existing systems may be leveraged by SI’s

2.3.2 Impact of Best Execution Practices

Best Execution compliance promises to be an expensive affair for the investment
firms. For a systematic internalizer in particular, this requirement will create a need
for investment in front, middle and back office systems
The functional impact at various logic levels could be illustrated as below:
 Front Office: Order routing systems
o Best Execution Algorithms : Given the scale of data to be processed
(execution venue information, price data, speed, transaction costs etc.),
SI’s will need to put in place systems which can electronically ensure best
execution for the clients
o Best Execution Routers: Connectivity to multiple execution venues in
addition to its own internalizing systems to ensure the choice of execution
venues to clients.
 Middle Office: Reference data on venues, instruments and customer profiles,
Analytics, Risk Management
 Back Office: Best execution reporting systems.

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 3. Pros and Cons of being an SI

3.1 The Pros

3.1.1 Revenue
As an SI, the investment firm can access a larger market and be able to serve
customers across Europe. Once registered with a home regulator, the SI can
internalize the said security across EU member nations.
Internalization has been recognized as an efficient system since the firm itself
acts as the broker and counterparty. This means a faster execution for the clients.
The firm in turn saves on the transaction and brokerage charges which it would have
to pay to a regulated market / market maker. The firm also stands to make some
profit on the price spread, thus enhancing its revenue.
In the pre-MiFID era, exchanges enjoyed a monopoly over the trade data for the
market, since it was mandatory for the alternative execution venues to report the
trade data to the exchanges. Post MiFID, the SI’s will be free to disperse this data to
public through alternative trade reporting venues. SI’s can benefit by having a
revenue sharing model with the reporting venues so as to benefit from the business
value of the trade data that they provide.

3.1.2 Benefits to SIs vis – a – vis Market Makers

Firms can choose to become market makers, instead of taking up the role of an
SI. However, the market makers are not exempt from MiFID rules either. Rather they
face more strict regulations and hence SIs stand to get more benefits as compared
to market makers.
Some of the key points which illustrate these are:
 Market Makers are not exempt from MiFID. They have to comply with regulatory
requirements too.
 In case an Institution (as a Market Maker) wants to market make securities listed
in different regulated market they may have to seek authorization from all the
regulated markets. On the other hand, SI deals only with the home regulator

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  Like an SI, Market maker is not exempt from transparency rules as well as the
Best Execution Rules.
 SI can create a market in a specific financial instrument, create its own business
hours and trading rules. Market makers will have to operate through a regulated
market and only during the market business hours.
 SIs can stimulate a market in instruments not listed in the 'local' market (for
instance Euronext shares in London or German Shares in Milan).

3.2 The Cons

3.2.1 Credit Risk
3.2.1.1 From Unknown counterparties: When a firm makes it quotes public, it can
face credit risk from unknown counterparties. The regulation tries to remove this problem
by allowing firms to choose their customers based on their commercial policy, within
certain restrictions.

3.2.1.2 Multiple Hits: Risk of multiple transactions with the same client (called multiple
hits): "Article 27 (6) allows systematic internalizers to limit, in a non-discriminatory way,
the number of transactions with the same client and the total number of transactions with
different clients at the same time."

3.2.2 Risk associated with publishing quotes in real time

Firm will face this risk if they use a single venue for reporting their public quotes;
with respect to the clause that requires firms to report their quotes within 3 minutes. This
risk could be mitigated using backup/multiple venues.

3.2.3 Risk of best execution compliance

There are chances that the SI trades are not compliant with the Best Execution
policy that it decides for it clients. This may happen for various reasons depending on
Order Routing Rules, Trader Strategies. This could be mitigated by having robust risk
management systems.

3.2.4 Investment in IT Systems

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 Firms will have to allow for a huge sum to put the systems in place. The trend
that may ensue is that some SIs may straight away invest money in building these
systems internally. Otherwise, they may wait for some time before such systems are
built and tested by other SIs. Third option is using Vendors products/services to
implement these systems. The investment in IT systems can also be seen as risk. Firms
may want to take their time before tested systems are available.

3.2.5 Client classification / Investor Protection

SIs are required to classify clients according to their risk appetite, financial goals
etc into different categories before offering the services. This categorization is mentioned
as an Article in the Directive. The incorrect classification of clients may land the SI in
breach of MiFID regulations. This risk could be mitigated using clearly defined categories
and corresponding services for the prospective/present clients.

3.2.6 Compliance Reporting

In case an SI chooses to outsource its compliance reporting, it faces the risk of
the third party not adhering to MiFID requirements. Similar risk is faced if the SI does the
reporting by itself. It needs systems wherein the Reporting Tools can be adapt to
changes in the Execution Policy for different clients

3.2.7 Conflict of Interests

Systematic internalizers may have inherent conflicts of interest, for example
obtaining best prices for themselves or clients or maintaining cash flow for their own
trading against maintaining liquidity for clients. This could be taken care of by listing the
possible conflicts of interest to the clients. SIs may need ongoing procedures to identify
these risks as they arise.

10
Figure 1: A representation of SI systems under MiFID obligations

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 4. Conclusion

MiFID regulation aims at creating a single European financial market. It has

abolished concentration rules everywhere, hence giving a boost to Internalization,
SIs need to comply with a large number of new regulations which entails a shift in
the investment firms’ current business strategies, investment in systems for compliance,
trade reporting amongst others. Depending on its size, scale of operations, cross border
presence, adaptability – the move to act as an SI may create a lot of value for a firm. As
stressed over and over again, the success of an SI may depend greatly on the
robustness and configurability of its IT systems.
To sum up a comprehensive SI solution must have:
 Matching the complete/partial client order with the Books of the Internalizing
firm. Access to Liquidity Pools - internal as well as external.
 Pre Trade Compliance Capabilities: Data feeds to reporting venues for
Displaying in the Best Limit Order Quote by the client, and making public
Quotes in securities being internalized in compliance with Display Rule and
Quote Rule.
 Best Execution capabilities: Comparison based on factors including but not
limited to: Account Prices, Costs, Speed, likelihood of execution and
settlement, Size, Nature and any consideration relevant to execution of order.
Routing capabilities to multiple venues based on execution quality, Credit
Worthiness, Market Impact, Transaction costs and Settlement Costs.
 Post trade compliance: Reporting Best Execution.
 Data Warehousing: Analysis of SI Data, venue information, client information,
market impact of SI. With increase in liquidity SI system may give deep
insights with respect to internalized security, client preferences, venue
information etc.(Business Intelligence)

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 5. Appendix

Table 1:
(in EUR)

Class in terms 500000< ADT 1000000 < 25000000

ADT < 500 000
of average < 1000000 ADT < ADT
< 25000000 < 50000000 ADT < 50000000
daily turnover
(ADT)

Minimum size of
order qualifying
as large in scale
50 000 100 000 250 000 400 000 500 000
compared with
standard market
size
Table1 : Defining large market orders based on standard market size

6. References

13
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15