While the directly applicable supervisory framework is already in place in the form of the EU legal acts (Level 1) and the delegated legislation deriving from it (Level 2), supervisors and the industry are still involved in an intensive dialogue on a whole range of issues of interpretation and implementation (Level 3). This article reflects the current status of this dialogue.

When is an investment firm regarded as a systematic internaliser?

Under Article 4(1) no. 20 of MiFID II a systematic internaliser is defined as an investment firm which on an organised, frequent systematic and substantial basis, deals financial instruments traded on trading venues on own account when executing client orders outside a regulated market, an MTF or an OTF without operating a multilateral system.

Systematic Internaliser

Systematic Internaliser BaFin

The key point here is the new quantitative criteria that will apply to the notion of “organised, frequent systematic” on the one hand and “substantial basis” on the other. Investment firms acting as internalisers must perform calculations for every financial instrument they internalise. Their own account trading volumes over a defined period in a particular financial instrument outside of a trading venue (numerator) is divided by the EU-wide trading volumes in this financial instrument (denominator). The Commission Delegated Regulation (EU) 2017/565 contains details regarding these calculations for each financial instrument.

The result of this calculation determines whether an internaliser’s trading activities meet the two criteria. This is the case if the ratio meets or exceeds the threshold stipulated by the Delegated Regulation for the financial instrument in question. The investment firm is then considered a systematic internaliser for this financial instrument.

The legislation also contains a voluntary “opt-in” clause. An investment firm can therefore decide to voluntarily comply with the rules for systematic internalisers with effect from 3 January 2018.

Legal consequences

If an investment firm which has its registered office in Germany is a systematic internaliser, it must notify BaFin of this. The notification procedure is still being developed.

BaFin will forward the necessary information to the European Securities and Markets Authority ESMA. ESMA already has a register on its website of all systematic internalisers who operate in the European market. ESMA will also include in the register information on the asset class in which an investment firm is deemed to be a systematic internaliser.

Investment firms which are considered to be systematic internalisers are also required to follow special rules on pre-trade transparency in addition to the MiFIR rules on post-trade transparency that apply to all investment firms.

First threshold calculations from September 2018

Since there are no transitional provisions, the rules for the calculation of thresholds will apply from 3 January 2018. However, the data for the relevant financial instruments at EU level required for this calculation will only be collected from this date onwards for the particular calculation period. They will be available from 1 August 2018 for the first time for the period 3 January to 30 June 2018. Based on this data, and in the interests of a level playing field, investment firms concerned will then have to carry out their first threshold calculations by 1 September 2018.

However, there are currently still a whole range of outstanding questions on the interpretation of the new rules in practice. The discussions between supervisors and market participants include the precise way in which the thresholds should be calculated, as well as the new transparency obligations for systematic internalisers. Answers to these questions can be found primarily in a list of questions and answers on transparency topics provided by ESMA on its website.

Individual questions on threshold calculations

On the question of how the thresholds should be calculated for investment firms belonging to a group, for example, ESMA clarifies that they should be carried out separately for every investment firm. Only an investment firm’s own trading activities will therefore be attributed to it. Following this logic, all trading activities by its EU branches will also be included. However, it is yet to be decided how branches in non-EU countries will be treated.

The question of what types of transactions systematic internalisers need to include when calculating the thresholds also needs to be discussed. In line with the aims of the legislation to make OTC trading more transparent, in any case, the systematic internaliser rules always apply where an investment firm engages in trading, i.e. carries out a transaction on the secondary market. However, according to ESMA, primary market transactions such as initial public offerings are not to be included in the calculations. However, the guidance so far is limited to shares and exchange-traded funds, as the distinction between the primary and secondary market is not always as clear as for these instruments.

If a systematic internaliser enters into an OTC transaction with a client but has to obtain the underlying financial instrument on a trading venue first (back-to-back transaction), the question is whether in fact two transactions need to be included in the threshold calculation for a particular financial instrument:

• the transaction with the client, to be counted as a trade by the investment firm for the purposes of calculating the OTC transactions carried out by it;
• the transaction on the trading venue to be counted as part of the total trading volumes in the EU.

In such cases the investment firm has not actually executed the transaction on the trading venue in the manner of a systematic internaliser against its own trading book. Furthermore, the two transactions are to be treated economically as a single trade if the investment firm resells the instrument it has bought to its client at the same time and at the same price. ESMA therefore stipulates that such trades should only be counted in the denominator for determining total EU trading, but not in the numerator as part of the investment firm’s own account trading.

The definition of a “class” of bonds and other financial instruments

Article 13 of Commission Delegated Regulation (EU) 2017/565 sets out how the threshold above which an investment firm is regarded as a systematic internaliser for bonds is calculated. If a firm is a systematic internaliser for a bond issued by an entity, it is also regarded as a systematic internaliser for all bonds belonging to the same class issued by the entity itself or any entity within the same group. This is also referred to as the trigger mechanism.

In its questions and answers ESMA clarifies what constitutes a class of bonds with reference to the bond classes defined in Annex III of Commission Delegated Regulation (EU) 2017/583. The bond classes are defined as sovereign bonds, other public bonds, convertible bonds, covered bonds, corporate bonds and other bonds.

ESMA has also provided guidance on the definition of a “class” for structured finance products (Article 14 of the Delegated Regulation) and derivatives (Article 15).

Non-equity instruments

If an investment firm qualifies as a systematic internaliser for a particular financial instrument, the main legal consequences are set out in Art. 14ff. of MiFIR. One of these is the obligation contained in Article 18 to publish firm quotes for non-equity instruments, which was introduced by MiFID II for the first time.

Under this obligation a systematic internaliser must make public firm quotes for liquid non-equity instruments, provided they are prompted for a quote by a client and agree to provide one. For illiquid non-equity instruments, systematic internalisers must disclose quotes to their clients on request if they agree to provide a quote.

Systematic internalisers may update their quotes at any time and withdraw them under exceptional market conditions. They may decide which clients they give access to their quotes, but must apply objective non-discriminatory criteria in doing so. They may also establish limits on the number of transactions they will enter into with clients on the basis of a given quote.

Liquid non-equity instruments

What is a “firm” quote? This is an example of the questions supervisors and the industry have been discussing in interpreting the quoting obligation for liquid non-equity instruments. One of the questions here is whether investment firms can meet their quoting obligation via quote streaming. This refers to the publication of continuous pricing information on tradable financial instruments in real time in the manner of a web stream, irrespective of whether a client enquiry has been received or not. In ESMA’s view this meets the quotation obligation in principle, provided the client can actually order the instruments at the published price and in the quantity offered.

Moreover, buyers of securities often use automated order routing systems to find the best price for a financial instrument. Based on the automated price comparison carried out by these systems they expect to be able to order the security on the trading venue offering the lowest price at a particular point in time. The question for systematic internalisers is whether, when they receive an automated order of this kind from one of their clients, they must publish the firm quote provided. This is because the order has not come, as in the wording of MiFIR, from the client itself, but from an automated electronic system. However, such an interpretation of the legislation would be unrealistic in the current trading world. There is no indication that the wording of the legislation was intended to exclude certain technologies widely used in securities trading. ESMA therefore assumes that the provisions in Article 18 are neutral concerning the technology used for prompting quotes.

Under Article 18(1) of MiFIR systematic internalisers are required to publish firm quotes. Legally speaking, this represents an offer that the recipient is free to accept or reject. An important question is how long the quote needs to be valid for once it has been provided, i.e. for how long the investment firm is bound by the quote. The only mention of the length of time for which price quotes need to be valid is contained in Article 18(3) of MiFIR. This states that price quotes can be updated at any time and may be withdrawn under exceptional market conditions. An interpretation that is fair to all market participants has to balance the interests of clients, who want to trade against a firm quote, with the interests of systematic internalisers, who do not want to be bound by their quote indefinitely.

On this basis ESMA has recently stated in its guidance that published quotes must remain valid and executable for a reasonable period of time. Of course, this still leaves room for interpretation. But the criterion is that the client must actually have an opportunity to accept the published quote. Systematic internalisers must therefore not abuse their right to update the quotes at any time in a way that discriminates against individual clients and makes it impossible for them to actually accept the offers. Time will tell whether this quite general guidance will have to be fleshed out in greater detail in future.

Illiquid non-equity instruments

The wording in Article 18(2) of MiFIR on the quotation obligation for illiquid non-equity instruments is unclear for two reasons. Firstly, it is not sufficiently clear who exactly needs to be given access to a quote. The legislation states that quotes must be disclosed to clients, but it is unclear whether this means all clients or only clients who actually request a quote.

It is also unclear which clients the published price quote must be binding for. One possible interpretation of the wording of the regulation is that it only needs to be binding for the client making the request, but not for other clients to whom the price quote is to be made available subsequently, if applicable on their request. Alternatively, the wording could be interpreted to mean that the price quote must be binding for all of the systematic internaliser’s clients. These questions have not yet been clarified unequivocally.