Systematic Internalisers Become a Cause for Concern

Around eight months have passed since the European Union implemented the Markets in Financial Instruments Directive (MiFID 2), and some early results are starting to come in. Just this past June, Autorité des Marchés Financiers (AMF), the French market regulator, expressed its disappointment about the legislation's impact on transparency in the market, which was one of its key aims. What may be even more disappointing was the fact that this is the result many stakeholders involved in the legislation's process predicted.

Systematic Internaliser (SI) is introduced

At the center of the issue is the legislation's goal of boosting market transparency and reducing the amount of trading that goes on off-market. Since broker-crossing networks are not allowed because they are not transparent in pre-trade price, there is a Systematic Internaliser (SI) that allows for bilateral trading between a broker or market maker (the principal) and the client. The SI is a firm that deals with its own account on a systematic, organized and frequent basis, namely by executing the client orders outside of a regulated market like an exchange or a multilateral trading facility.
The idea behind SIs was that it will allow firms to complete some transactions with certain clients in private, which is important in large block trades or other situations where the client needs to hide trading intent. Its rule on tick sizes, reporting obligations and trading increments are more relaxed in comparison to the rules for non-SIs.
However, the SI system is proving to be a problem. It's all too easy to create an SI that has an automated quoting system with quote feeds from multiple sources - including other SIs - going into an engine for execution, one that automatically selects the most ideal trade outcome for the client order. By connecting to each other, the SIs create a type of multilateral trading venue, which could lead to a recreation of border-crossing networks, something MiFID 2 was meant to prevent. 
Unfortunately, early results indicate this is what has happened, with AMF's recent report noting that the new legislation is not boosting transparency in the market. While dark pool volumes have gone down, order flow is either being aggregated and executed using the exemption for large-in-scale or moving to SIs. Over 100 firms are now on the books as SIs, compared to just 14 that were registered before the implementation. Order flow is not going to public markets as intended. Instead, AMF is suggesting that at least 30 percent of the total market share has now gone to trading on SIs.
Rule clarification fails
The European Securities and Markets Authority (ESMA) was previously aware of this SI "loophole" and has made attempts to close it. Because there was not enough time left to address the issue of SIs via legislation, ESMA released clarifications of the rules instead, but this has had little impact.
As more results come to light, there may be more legislation for those in the market to contend with down the road.