Amended regulation still does not adequately define systematic internalisers, despite the new type of venue coming into force in January, according to Steve Grob, director of group strategy at Fidessa.

Systematic internalisers were originally set up for equities under the MiFID regulations 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 prohibits broker crossing networks and the regulation 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, which comes into force into January, 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.

However there were concerns that “frequent” commitment of capital was not adequately defined and that again, firms could escape having to register as SIs. This week the EU Commission adopted regulation which was meant to clarify the definition of SIs:

.@EU_Commission adopts Delegated Regulation clarifying definition of systematic internalisers in #MiFIDII regime: https://t.co/WeteT7xKOe

— Hogan Lovells FIS (@HoganLovellsFIS) August 30, 2017

Grob said in a blog that that SIs will not be allowed to “regularly” engage in “pre-arranged matching of trades via de facto riskless back-to-back transactions” but there is still no definition of regularly.

“Presumably this will be interpreted differently according to the velocity of a stock and/or its underlying liquidity,” he added. “And, bear in mind, the SI regime stretches over OTC derivatives transactions too which are even broader in their trading scope – so, no chance for confusion there then.”

Grob continued there is no definition of “riskless”, which varies between different stocks and instruments. “So the only way I could absolutely prove that I was really taking on risk would be to hold onto a position (even if I had the other side) until the price did indeed move against me. Again, hardly a satisfactory outcome for anybody,” he added .

Consultancy Tabb Group estimated that up to 20 equity SI operators will be registered when MiFID II comes into force in a report last month.

Last month 13 venues in Europe received Swift market identifier codes for systematic internalisers according to a public data from ISO 10383, the organization which holds the database of the codes for trading venues. Eight of the SI codes were for the UK – Jane Street Financial, ANZ Banking Group, Credit Suisse, Deutsche Bank, HSBC,  RBC and Standard Chartered. The remaining four were from Italy (Fineco Bank), Germany (HSBC), France (Natixis, Exane BNP Paribas) and Luxembourg (RBC).

In addition, Vantage Capital Markets and Exotx Capital received codes as organised trading facilities, a new type of MiFID II venue which only relate to bonds, structured finance products, emission allowances or derivatives. OTFs are venues that cross client orders and that arrange transactions and facilitate negotiations between clients.

Tabb Group’s survey, MiFID SI Regime: A New Liquidity Source in Europe’s Equity Market, found that 60% of buyside institutions expect to use SIs from the start of MiFID II, albeit tentatively.

The majority of asset managers in the report 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.

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.

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.

Broker ITG said it expects brokers to continue to aggregate liquidity across SIs and other venues through smart order routing technology in a paper in June, MiFID II: Systematic Internalisers and Liquidity Unbundling,

“Regardless of the exact structures brokers implement, we think there is enough clarity to see that the resulting liquidity unbundling — the move from BCNs to some combination of SIs and MTFs — will lead to positive outcomes for the buyside through enhanced control and post-trade transparency,” added ITG.

The biggest concern over SIs from the Tabb 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.