What’s going to happen to market-makers that operate a mix of ‘principal’ and ‘risk-less matched principal’ after new Systematic Internaliser (SI) regime comes into effect next year under MiFID II?
Systematic Internalisers (SIs) must operate as a bi-lateral principal based business. Typically SIs will be market-making desks at banks and non-bank liquidity providers, that operate on a ‘frequent & substantial’ basis in the particular instrument for which they are being designated as an SI. An SI cannot connect to either an OTF, or MTF (see below for definition).
The key point about an SI, is that the trading entity must be the risk taking principal and counterparty to every trade. That means the SI must quote their client a risk transfer price, taking the clients position onto their books, and then look at risk managing the resulting position – which means they must fill and cover.
However, there are still plenty of market-making desks out there that operate as a mix of…principal (own-account) and what is called matched principal based trading. Which means sometimes they are act as principal as described above, and other times they will quote their client, and if the client trades, they will first look to cover the position with an external liquidity provider, and only after having confirmed the cover will they fill their client – this is what’s known as cover and fill, or back-to-back.
Under the new regime, SIs will no longer be able to operate as a matched principal on a ‘regular basis‘. The reason is that MiFID II is looking bring more trading onto regulated venues and create greater transparency in the market, and only genuine risk taking market-makers will be able to operate as an SI, otherwise it’s creating the illusion of liquidity which isn’t really there (liquidity mirage).
The SI regime provides precise threshold levels for each financial instrument above which a trading entity that trades on a ‘frequent & substantial’ basis would be required to register as an SI.
However, I have not seen anything in the technical standards that defines the ‘regular basis’ thresholds, above which an SI would not be allowed to trade as a matched principal.
So, trading desks operating a mix of principal and matched principal trading, will need to change their operating model.
The Matched Principal model cannot be used within the SI, but can be used by an Agency Sales desk, which will then be required to act in the best interests of the client, and subject to BestEx obligations. So, trading desks that register as SIs, will need to be very clear in their execution and risk management logic in how they manage client orders, and they will also need to be very clear with their clients under what basis they are quoting them.
In August, the European Commission issued an update to the SI regime to clarify this point.
Participation in matching arrangements
An investment firm shall not be considered to be dealing on own account for the purposes of Article 4(1)(20) of Directive 2014/65/EU where that investment firm participates in matching arrangements entered into with entities outside its own group with the objective or consequence of carrying out de facto riskless back-to-back transactions in a financial instrument outside a trading venue.”
For the Commission
The three new execution venues under MiFID II:
- MTF: Multi Lateral Trading Facility: Trading venues that bring together multiple buyers and sellers, with no discretion at point of execution. Owners capital cannot be
put at risk, instruments are mandated to trade, and must provide pre-trade transparency and execution quality reports
- OTF: Organised Trading Facility: Typical OTFs will be voice brokers, where they have discretion at point of execution. Client orders cannot interact with proprietary capital of the operator, and an OTF cannot operate in same entity as a SI
- SI: Systematic Internaliser: Operates a bilateral principal based business. Typically SIs will be market-making desks at banks and non-bank liquidity providers, that operate on a ‘frequent & substantial’ basis in the particular instrument. An SI cannot connect to either an OTF/MTF