Derivatives House and Credit Derivatives House: Citigroup

IFR Review of the Year 2013
9 min read
Helen Bartholomew, Christopher Whittall

From momentum to leader

The seemingly unending overhaul of banks’ derivatives businesses in response to a changing regulatory regime left the door wide open for those that were first-movers in post-crisis recovery. For defying its critics to finally surge into the top tier across regions and asset classes with a model built to embrace the new regime, Citigroup is IFR’s Derivatives House and Credit Derivatives House of the Year.

Regulatory intervention took a heavy toll on derivatives businesses in 2013 as the Dodd-Frank Act took effect, pushing over-the-counter swaps into central clearing and towards electronic execution, while tighter capital and leverage rules further depressed margins.

Nowhere was the squeeze felt more acutely than in fixed-income trading where industry revenues plummeted. But while many ran for the exits with scathing cuts across credit and rates, Citigroup seized the opportunity to stake its claim on a top-tier derivatives seat.

At US$10.8bn, the bank’s fixed-income markets revenues were down 5% over the first three-quarters versus the previous year, but with many of its rivals down 25%, the US house was a clear outperformer.

With its global reach, sound balance sheet, cross-asset capabilities and a business model tailored to the new regulatory regime, Citigroup was the house to watch in 2013 and finally made the seamless transition from momentum player to global derivatives leader.

“When people used to think of derivatives leadership, they traditionally thought of Barclays, JP Morgan or Deutsche Bank and probably didn’t think of Citigroup, but that has radically changed,” said Andres Recoder, head of EMEA markets at the bank. “There have been some massive changes in the competitive landscape and we have ‘derivatised’ a lot of our senior management. There has always been strong derivatives DNA at Citigroup and we’re gradually rebuilding that.”

Increased regulation and capital requirements saw derivatives activity consolidate to a handful of global players – something Recoder believes will continue to benefit the bank.

“One of the consequences of regulatory constraints is that the barriers to just staying in the business, let alone entering the business, are becoming higher. You need critical mass to be fluent across regions, products and institutions and we can sustain that better than others.”

The success reflects the bank’s swift action in the wake of the crisis, hiving off around US$850bn of toxic assets into Citi Holdings in early 2009 and leaving the firm to focus on a rebuilding its global capital markets business. Citi Holdings has now shrunk to US$122bn – down 29% in the past year.

The results speak for themselves, with the bank now boasting the solid foundations of a Basel III Tier 1 Common Ratio of 10.4% and a supplementary leverage ratio – a measure which clobbered many prominent European competitors in 2013 – of 5.1%.

“We did a very quick re-engineering coming out of the crisis and when European markets got hit even harder by the euro crisis, we were already beginning to rebuild. Even in the depths of the financial crisis in 2008 we had an unwavering commitment to our markets business,” said Recoder.

Credit boom

In rates, Citigroup transformed itself from local markets specialist into bulge-bracket player in the G-10 space, matching the trading prowess it had long shown in foreign exchange. But the real turnaround in its fixed-income division occurred in credit, where it cemented itself as one of the top dealers following the financial crisis.

The bank steadily accumulated market share in flow CDS trading on both sides of the Atlantic for single names and indices, while reducing Value-at-Risk by 74% since 2011.

Part of the success derives from a determination to be in the vanguard of the shift towards electronic execution. Citigroup launched fully-automated algorithmic market-making in the second half of 2012 for US indices, expanding into Europe in May 2013, which provided a notable bump in wallet share.

“The main goal is to attract high volume, low margin flow. We need to have the algo offering to absorb the commoditised flow in the market,” said Tim Gately, European head of credit trading. “We’re solidly in the top four dealers across every product having caught up in index in Europe. We now have that size and breadth.”

Much of the activity centred on the higher margin business as the reach for yield spurred demand for more structured trades. Citigroup was at the forefront of a re-emergence of European collateralised loan obligations, working on three deals worth over US$1bn in total.

Its structuring prowess was perhaps best demonstrated by a five-year credit-linked note in which an investor – which Citigroup declined to name, but previous media reports identified as Blackstone – sold protection on a first-loss tranche of a US$1bn shipping loan portfolio in June.

The bank opted for a pre-paid swap rather than an SPV-based structure so that the CDS was fully funded – a crucial aspect to ensure the deal didn’t merely exchange market risk for counterparty risk.

“We took a portfolio and designed a structure that our clients – who we were already active with in structured credit – and regulators were both comfortable with, in order to streamline our shipping loans and manage our capacity,” said Mickey Bhatia, global head of structured credit.

The firm’s structuring expertise was also central to its success in emerging markets credit, where it provided myriad synthetic funding solutions to its clients across the globe.

Equity rebuild

While fixed income suffered a rollercoaster 2013, equity derivatives delivered a bumper crop of revenues for those still standing, driven by a surge in global stock markets, led by Japan.

After kicking off in 2010, Citigroup’s equity derivatives rebuild delivered year-on-year revenue increases of around 90% and a return on equity of around 20%. At US$2.5bn, equity market revenues for the first three-quarters were up 24% on the previous year, driven largely by derivatives.

“Our aim was to bring the business back to where it had been in the past. Here was an opportunity to take something that had been very good and still had the potential to be good,” said Simon Yates, global head of equity derivatives.

Crucially, the business was built with a close eye on a future that saw more OTC products exchange traded. Around 45% of the bank’s EQD revenues were generated by exchange market-making compared to around 25% at other houses, ensuring that Citigroup drives initiatives to shift OTC products into the listed world.

“We’ve taken a strategic decision, and it depends on whether you believe that global regulators will be successful in putting OTC derivatives on exchanges,” said Yates.

Highlighting that belief, Citigroup drove open interest in Eurex-listed Russian Depository Index options from zero to US$920m, viewing the contract as a vital exchange-listed alternative to RTS futures that international investors can only trade synthetically via international banks.

“We’re strong in EM and our equity business is very global. It’s all about being able to offer the whole world to clients,” said Yates.

With a content-driven approach through its CitigroupEdge analysis, the bank was one of the first to call the European equity outperformance trade in early summer, bringing in leveraged bets from US investors.

“What’s different is our integration. We don’t look at desks, we’re one derivatives team – single stocks, delta one and index. Our derivatives risk books are some of the most centralised out there,” said Rory Hill, EMEA co-head of equity derivatives.

The diverse nature of its business saw the bank lead a US$1.7bn M&A margin loan for Liberty Media, while it saw almost US$600m of notional linked to its proprietary DynaVol index.

Commodity investment

While many US banks wilted under the regulatory scrutiny on commodities businesses in 2013, Citigroup stepped up its activities. Its strength in risk management and ability to finance physical commodities drew particular praise from clients.

In one hallmark trade, Citigroup’s commodity derivatives and trade finance teams funded a shipment of crude oil through the entire life cycle of each barrel being processed and stored.

“It’s been a year of remarkable achievement,” said Jose Cogolludo, global head of corporate sales. “Our investment in people, technology and infrastructure is coming together this year at a time when many competitors are retrenching.”

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