Dealers sour on Mifid’s systematic internaliser label

SI decisions will take account of tougher pre-trade rules, client demand and Brexit

Mifid systematic internalisers
Banks are starting to question the costs and benefits of the SI designation

Europe’s second Markets in Financial Instruments Directive (Mifid II) has thoroughly shaken up the financial industry, but one of the biggest changes – an explosion in the number of so-called systematic internalisers (SIs) – may be about to go into reverse.

Dealers deciding whether to volunteer for the SI status or, instead, adjust their trading to avoid the label will have to consider pre-trade transparency requirements, clients’ appetite for off-venue trading and Brexit. Those keen but unable to escape the designation will look for ways to reduce its impact and the buy side will not emerge unscathed.  

“The number of SIs will continue to grow in the short term and then in the future may start to decrease, because there will be disadvantages to trading as an SI bank and that is mainly around obligations to disclose quotes,” says a market structure expert at a European bank, itself an SI.

Many banks have taken on the label in order to attract buy-side clients, mainly because anyone transacting with an SI can leave the pesky job of post-trade reporting to the SI. But the tag also comes with an obligation to publish offered, executable quotes before a trade is executed – something dealers do not like and will dislike even more in the future as pre-trade transparency rules are tightened.

The advantage of the SI status for dealers is also fading as buy-side firms are trading increasingly via venues, leaving it to them to publish the details of executed trades, as well as pre-trade quotes.

Meanwhile, Brexit could force banks and other sell-side firms to register as SIs both in the UK and the European Union if they are big off-venue traders in both jurisdictions. For smaller dealers in particular, the cost of running such a dual infrastructure is likely to further dim the appeal of SI status.

Pre-trade troubles

Under Mifid II, which came into force in January, any dealer trading heavily off-venue using its own capital must become an SI for the relevant instrument. But it was only in August that regulators started publishing the market-wide data necessary to determine a dealer’s market share in different securities. While the data was not available, many firms volunteered to be classed as SIs, starting late last year.

Dealers will still be able to take on the label voluntarily but, with the remaining market numbers due to be released in February, they will no longer be able to opt out of it if their trading exceeds regulatory thresholds.      

So banks are reassessing whether the SI status is worth having or should be avoided.

Pre-trade transparency obligations top their list of concerns. Dealers fear competitors could use the information to front-run any hedges the SI may enter into after executing client trades.

andrew bowley
Andrew Bowley

“After we’ve done a 10-year euro interest rate swap, we would hedge that, for example, with a Bund future,” says a regulatory expert at a European SI bank. “If I publish a price on that swap [before the trade], there are a huge number of high-frequency trading firms on exchanges that are going to run us over on that hedge.”

At the moment, pre-trade transparency requirements apply to very few instruments, mainly because the European Securities and Markets Authority does not yet have enough data to assess whether most securities are liquid enough to warrant pre-trade disclosures.

However, this will probably change sooner or later. For example, Esma is receiving more data on the foreign exchange market thanks to Mifid II post-trade transparency requirements.

“All FX products are currently deemed illiquid, so anyone could be an SI in forex without any pre-trade transparency,” says Andrew Bowley, who oversees the development of Nomura’s global markets business in response to regulation. “But at some point in the future that determination will change and that may change the way people look at being SIs in FX derivatives.”

Some disagree, saying pre-trade information is too hard to access to be of much consequence and that Esma could relax the disclosure rules if it believes they are hurting SIs (see box: Pre-trade murkiness).  

Goodbye SI

However real the dangers of pre-trade disclosures, SIs are, at the same time, losing some of their appeal to clients. This is because buy-side firms increasingly transact on venues, which publish post-trade data on their behalf, just as SIs do.

Compared with voice trading used with SIs, automated processes on electronic venues enable faster trade execution and result in fewer errors. In addition, all on-venue transactions are time-stamped, helping firms fulfil a Mifid II obligation to maintain records of all transactions.

“Some of the larger buy-side firms are doing the reporting themselves, and so trading with a non-SI is not problematic for them,” says the market structure expert at the European bank. “Some of the smaller clients are transferring a lot of their voice execution on platform using the process trade methodology. So the SI label then becomes less of a necessity.”

Process trades, also known as pre-arranged trades, are negotiated off-venue and then executed through a venue. Buy-side firms often use the execution method as a stepping stone to trading fully on electronic venues.

Matthew Coupe, a director in market structure at Barclays, an SI, says the amount of process trades is small but “growing rapidly”.

Lastly, the impact of Brexit will also play a part in SI decisions.

The UK is planning to apply all existing EU laws, with only minor changes, for two years after Brexit day. The country’s departure will result in two separate jurisdictions, giving dealers two broad options: they will be able to volunteer to become an SI in one or both jurisdictions or, if they do not want to be an SI in at least one of those jurisdictions, they may have to roll back trading to avoid triggering the regulatory thresholds that will force them into SI status.

It might not make sense to set up SIs in both the UK and the EU, but there won’t be one answer to this for everyone
Christopher Morrison, Baringa Partners

When deciding whether it is worth being an SI in the UK or the EU or both, firms will carry out the usual cost-benefit analysis. In the case of dual SIs – one in the UK and one in the EU – dealers will have to bear extra costs for the same benefits because the overall client pool will not have changed. Smaller firms with fewer clients and less money to burn may well conclude that less is more when it comes to SIs.

“Many international banks trading out of London at the moment have small trading desks – for example, a foreign exchange desk could have two to five traders. It might not make sense to set up SIs in both the UK and the EU, but there won’t be one answer to this for everyone,” says Christopher Morrison, a senior manager at consultancy Baringa Partners.

The cost of being an SI is significant.

SIs must have systems in place to record all trade data. They must have a commercial relationship with an approved publication arrangement (APA) in order to publish post-trade information. Dealers also usually use APAs to publish pre-trade quotes, although some make them available on their websites. Thirdly, they must submit data on instruments traded through their SI to local regulators. And fourthly, they must publish reports on the quality of execution clients received, and these are “complex reports in terms of acquiring all of the data and making it fit the framework the regulators have specified”, says Thomas Kennedy, head of analytic services at technology vendor Refinitiv.

But the cost of avoiding the SI label can also be high, especially for those dealers whose trading activity is close to the regulatory thresholds – because they will need to invest in monitoring the frequency of their trades in specific instruments, the size of the deals and the share of their total trading done off-venue.

“You are going to have to have procedures in place because, if you do trip anything, then you have to become an SI in two weeks, and that takes longer than two weeks to implement,” says Morrison of Baringa Partners. “The costs from the [threshold] test are more the time and energy of staff running that test, and the contingency plans in place in case you do trigger the thresholds.”

Damage control

Dealers’ view of the SI status will affect those – still numerous – clients who like trading with them because SIs provide greater anonymity than platforms. SI trades are exempt from pre-trade transparency more often than on-venue trades because the waiver kicks in at lower instrument-specific size thresholds for the former. To put it simply, SIs do not have to publish pre-trade quotes for large transactions but, for the same exemption to apply to venues, the transaction has to be even larger. 

Some buy-side firms dislike pre-trade disclosure for the same reason SIs do: they worry it may affect their ability to hedge the just-executed trade.

If a bank is willing but unable to escape the SI designation, it may take steps to limit the perceived damage from the label.

Matthew Coupe_Barclays
Matthew Coupe

“If our ability to hedge is going to be impacted, then [SI] firms will either retrench from offering principal liquidity on those risks or there will be an increase in price to the end-investor, which is not a great outcome,” says Coupe at Barclays.

One option could be to set internal limits on the size of trades for which the SI is happy to quote prices publicly. Morrison of Baringa Partners gives an example: if an SI must broadcast quotes for trades of up to €5 million but does not feel comfortable doing that for trades larger than €3 million, it could simply stop quoting at €3 million. By extension, the SI would not execute any trades between €3 million and €5 million.

The buy side will also be hit if there is a drop in the number of SIs. Many SIs may decide the label is not worth keeping and de-register, provided they are below regulatory trading thresholds. The number of SIs may also decline naturally, as a result of Brexit.

“If you assume the basic bank has one entity in the UK and is going to set up a second entity somewhere on the continent, then they are trading out of two entities post-Brexit,” says Bowley of Nomura, an SI. “If they maintain the same market share but split it over two entities, they are less likely to actually hit the threshold to become an SI in each entity, subject to how the UK and EU look at the overall market sizing post-Brexit.”

Fewer SIs means fewer opportunities for buy-siders to offload post-trade reporting. Investment firms, as they are called in Mifid II, must disclose the details of executed transactions themselves if their counterparty is a foreign firm or venue, or if they are the seller in a trade with another EU investment firm. 

Pre-trade murkiness

When it comes to pre-trade transparency, SIs might be worrying about nothing, some sources say. They cite two main reasons. 

Even when Esma deems many more instruments liquid enough to warrant quote disclosures, the information may still be hard to access. 

“I know some banks are worried about the pre-trade exposure, but it is a joke,” says a regulatory implementation manager at a European SI bank. “If you think it is difficult to find post-trade information, try finding pre-trade information. It is somewhere on our website and even I would struggle to find it.”

Many other banks publish pre-trade data via approved publication arrangements (APAs). However, research by Risk.net published in May showed that APAs do not always make the data available to the public for free as Mifid II requires – provided it is delayed – but rather as a free add-on to expensive vendor packages. Much of the information is also hard to use. Esma has since pushed for improvements.

But, for over-the-counter derivatives, liquidity data may remain patchy for quite some time, meaning very few instruments will be subject to pre-trade transparency in the foreseeable future.

Secondly, Christopher Morrison of Baringa Partners believes Esma will step in if it thinks pre-trade rules are affecting SIs’ hedges and hence their ability to make the market.

The regulator could do that most easily for bonds. At present, a bond is considered liquid and so requiring pre-trade disclosures only if it trades at least 15 times a day – not many bonds trade that often.

The liquidity threshold is supposed to be lowered every year as part of a phased implementation of pre- and post-trade transparency for bonds, but Esma can extend each stage indefinitely for more gradual implementation. That is exactly what the regulator could do to spare SIs from having to publish quotes for bonds.

There is no equivalent transitional regime for equities and derivatives. So, to relax pre-trade rules for those asset classes, Esma would have to announce some form of forbearance or ask EU legislators to amend Mifid II in the next review, due to start in March 2019.

This article first appeared on sister website Risk.net.

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