MiFID II: Are you a systematic internaliser?

What is a systematic internaliser?

Under MiFID II^[1], a systematic internaliser ("SI") is an investment firm that deals on its own account on an organised, frequent, systematic and substantial basis when executing client orders outside a regulated market, multilateral trading facility (MTF) or organised trading facility (OTF), without operating a multilateral system.

Each investment firm should assess on a quarterly basis whether it meets the criteria for being an SI. Various obligations relating to pre- and post-trade transparency are imposed on SIs. Hence, it is crucial for each investment firm to cautiously calculate whether it falls under the SI regulation.

The SI regime is currently applicable to equity-like instruments such as depositary receipts, ETFs, certificates and other similar financial instruments, and non-equity instruments such as derivatives, bonds, structured finance products and emission allowances.

As indicated by the MiFID II definition above, an SI is determined by three criteria: (i) frequency; (ii) systematicity; and (iii) substantiality. The parameters of each criteria vary according to the type of instrument in question.

Recently, we assissted one of our clients with complex analysis regarding the SI’s criterias in respect of derivatives. Hence, we further scrutinise the individual elements of calculation regarding these specific financial instruments.

What are the SI criteria for derivatives?

In respect of derivatives, the investment firm internalises on a frequent, systematic and substantial basis under the criteria outlined below:

Steps for assessing an SI:

1. Determination of class of derivatives:

The calculation should be performed at the level of the most granular class of derivatives as specified in RTS 2.^[2] If an investment firm meets the thresholds for such a class, it should be considered an SI for all derivatives within that most granular class. The numerator and denominator refer to the same class of derivatives.

• Example: in the case of foreign exchange derivatives (table 8.1 of RTS 2), we should determine the sub-asset class (e.g. non-deliverable forward), underlying currency pair (e.g. EUR-USD) and time to maturity (e.g. one year). Derivatives so defined will form one class for the purposes of the calculation.

2. Determination of the existence of a liquid market:

The liquidity of the market is assessed in accordance with Article 2(1)(17)(a) of MiFIR[3] and with Annex 3 of its implementing regulation.[4]

• Example: foreign exchange derivatives are considered not to have a liquid market.

3. Determination of frequency and systematicity (as per the table above).

4. Determination of substantiality – with regards to the investment firm's own trading:

Calculation: [the size of the investment firm's OTC trading in the relevant class of derivatives on its own account when executing client orders] / [the total turnover in that class of derivatives executed by the investment firm on its own account or on behalf of clients and executed on a trading venue or OTC]

Numerator = the size of the investment firm's OTC trading in that class of derivatives on its own account when executing client orders.

• Trading on own account involves a situation where the investment firm becomes a party to a contract or trade and directly bears the economic benefit or loss from that trade. The investment firm also becomes the beneficial economic owner of the investment instruments or funds that are the subject of the transaction.
• An investment firm will be deemed to execute client orders in all cases where it deals with a counterparty that is not a financial institution. Where the counterparty is a financial institution, the ESMA will regard one of the parties as always acting on behalf of the customer (the specific position of the parties will have to be assessed separately for each case).

Denominator = the total turnover in that class of derivatives executed by the investment firm on its own account or on behalf of clients and executed on a trading venue or OTC.

• The denominator should include all trades (whether executed on own account or on behalf of customers) relating to the class of derivatives, whether executed over the counter or on trading venues.

5. Determination of substantiality – with regards to EU trading

Calculation: [the size of the investment firm's OTC trading in the relevant class of derivatives on its own account when executing client orders] / [the total turnover in that class of derivatives executed in the EU on a trading venue or OTC]

Numerator = see in point 4

Denominator = total turnover in that class of derivatives executed in the EU on a trading venue or OTC.

• The calculation is based on data regularly published by the ESMA on the following websites: https://www.esma.europa.eu/data-systematic-internaliser-calculations

What obligations should you comply with as an SI?

SIs must make public firm quotes in respect of those shares, depositary receipts, ETFs, certificates and other similar financial instruments traded on a trading venue for which they are SIs and for which there is a liquid market. Where those instruments do not have a liquid market, the quote should be disclosed to the SI's clients upon request.

In addition, SIs are subject to post-trade transaction reporting requirements, with a wide range of information in relation to the trades executed needing to be reported.

SIs need to have systems in place for gathering and reporting relevant data. Additionally, investment firms should create and maintain a list of all financial instruments for which they are an SI. This list should be made available any time a pertinent supervisory authority requests access to such information.

[1] Article 4(1)(20) of Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU. Accessible here.

[2] RTS 2, Annex 3. Accessible here.

[3] Regulation 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Regulation (EU) No 648/2012. Accessible here.

[4] Commission Delegated Regulation (EU) 2017/583 of 14 July 2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council on markets in financial instruments with regard to regulatory technical standards on transparency requirements for trading venues and investment firms in respect of bonds, structured finance products, emission allowances and derivatives. Accessible here