Derivatives house of the year: Citi

Strong leverage ratio gives Citi the flexibility to stick with full-service model

Paco Ybarra, Citi: "We decided we would continue as a full-service house"

Risk Awards 2016

A conversation with senior traders at Citi is like a window into a parallel universe. They talk enthusiastically about growing the credit derivatives and commodity businesses that have become a source of pain at other houses, about their appetite for long-dated, uncollateralised trades or large block transactions, about their commitment to the derivatives clearing business.

Words and phrases falling into disuse elsewhere are still bandied around. Citi is committed to being a full-service investment bank, and sees derivatives as a core, and growing, part of the offer – not just in the flow businesses where it has always had a presence, but also in the episodic, risk solutions business that traditionally gravitated towards a smaller pool of dealers.

It is a long way from the dark days of the crisis, when Citi racked up huge losses, and placed almost $900 billion in assets into its bad bank. That presented senior management with a choice about what model to rebuild the firm around.

"We decided we would continue as a full-service house," says Paco Ybarra, who has been sole head of global markets at Citi since 2011 and added responsibility for securities services in 2013. "It was the right strategy for us, given our footprint, history, and skills. And it's something we're committed to. We don't look at ourselves in the mirror every day and ask whether we want to be in equities or foreign exchange. We have no doubts."

In those ambitions, the bank now only has JP Morgan for company – and in terms of raw notional size, Citi's derivatives business last year matched that of its rival, ending the third quarter with a $53 trillion book, compared with $51.4 trillion at JP Morgan, according to the most recent stats from the US Office of the Comptroller of the Currency (OCC).


We've come through the hard times with a franchise that is strong in all the core products. We are profitable in all the core businesses, including commodities and equities
Paco Ybarra, Citi


None of that would qualify the bank for an award if the strategy was not working – but the numbers suggest it is. According to the OCC's quarterly reports, Citi booked $2.7 billion of revenue in cash and derivatives rates trading during the first three quarters of last year, and $1.4 billion in foreign exchange, making it the second-biggest earner among the top four US derivatives dealers. For the full year, the markets and securities services business earned $16.3 billion in revenues, down slightly on 2014, according to Citi's fourth-quarter report, published on January 15.

Citi also scores highly in the regulatory metrics that now determine how much strategic freedom a bank has. As of the end of last year, Citi boasted a common equity Tier 1 ratio of 12%.

"We've come through the hard times with a franchise that is strong in all the core products. We are profitable in all the core businesses, including commodities and equities. That is not a given, it's not easy to achieve, but we had the strategic determination, the right tactics – and a bit of luck. Our returns are above our cost of capital and we're ready to do significantly better," says Ybarra.

Clients that spoke to Risk journalists for the three other awards Citi scooped this year describe the bank as smart and reliable – one of a small number of dealers able to execute big flow trades across the full range of asset classes and products, as well as devote time to solutions and advisory work (see here, here and here).

In other words, full-service at Citi really does mean full-service. Take the credit derivatives business, for example. Since peaking in 2008 at $15.4 trillion, the notional amount of single-name credit default swaps (CDSs) outstanding had fallen to $7.1 trillion at the end of 2015, with trading volumes falling almost a third year-on-year. In contrast, Citi's US-based CDS desk posted a 15% increase in single-name CDS volumes last year.


We consider single-name CDSs to be an integral part of our overall credit business. A large number of our biggest clients still want to trade the product and use it to move risk
Brian Archer, head of global credit trading at Citi


The amount of credit protection sold by Citi increased during the first three quarters of 2015, while that of its main US rivals fell, according to data disclosed in the banks' quarterly reports – it was down a whopping 32% at JP Morgan, while Citi's 17% increase saw it overtake Bank of America Merrill Lynch and Goldman Sachs to become the US market's second-biggest protection seller.

"We consider single-name CDSs to be an integral part of our overall credit business. A large number of our biggest clients still want to trade the product and use it to move risk," says Brian Archer, head of global credit trading at Citi in New York. "We have the appropriate resources in place to service that demand."

In recent quarters, the bank has demonstrated its appetite for the credit business by acquiring portfolios from other dealers – leaning heavily on what Ybarra calls its "optimisation engine". That engine means each new acquisition is not straightforwardly additive: a central team focuses on constraining notional growth via netting, compression, clearing and the recycling of risk to other participants in the market.

Famously, Citi was the buyer when Deutsche Bank decided to get out of the market for non-cleared single-name CDSs, buying a $250 billion portfolio in the third quarter of 2014. Last year, the bank's traders say it completed a number of other transactions – none of them rivalling the Deutsche trade individually, but comfortably exceeding it in aggregate.

"We have been very active in helping other banks get rid of CDS and correlation books. We thought it would make sense for us because we have a bigger book and can get more netting, but also because other banks may not have the time needed to optimise the positions – they need to get out quickly. We've done it a number of times – not just in credit, but also in commodities. We're dealing with a lot of the banks that are exiting those businesses," says Ybarra.

In commodities, Citi snapped up at least a dozen portfolios during 2014 – including a little over $100 billion in notional value in transactions with Credit Suisse and Deutsche Bank – and there were further transactions last year. As in credit, the idea is not to bulk up, but to acquire raw material, managing the capital carefully and seeking healthy returns. OCC data shows the bank earning $294 million in revenue during the first three quarters of last year from cash and derivatives commodities trading.

One analyst that tracks the success of bank trading businesses says his firm's data ranked Citi fourth by revenues for all commodities in 2014 and third in 2015.

"Building a commodities business organically took patience," says Ybarra. "At first, we were marginal players, had difficulty attracting talent, and we were not making money. But we didn't want to leave the room when clients raised the subject of commodities, so we stuck it out and built a business that is focused on serving our clients. In some respects we were lucky, as regulators are now pushing those with prop-centric, physical businesses towards our model."


A healthy SLR allows us to do business that generates good returns elsewhere but might have poor SLR optics – so we can get closer to our optimal position. Other banks are more constrained
Paco Ybarra, Citi


That regulatory push, of course, takes various forms, but one of the most violent is the leverage ratio, which sets minimum equity capital requirements without reference to risk. For derivatives, exposure is a function of notional size, maturity and underlying asset class, with credit and commodities generating the highest numbers.

Although the ratio is part of Basel III and was defined and agreed internationally, different jurisdictions have moved at their own speeds towards implementation and are setting different minimum equity requirements.

Citi's capital-to-exposure ratio of 7.1% as of December 31 comfortably beats the minimum level of 5% for the US supplementary leverage ratio (SLR), as well as its peers' ratios: 6.5% at JP Morgan; 6.4% at Bank of America; 5.9% at Goldman Sachs; and 5.8% at Morgan Stanley. The bank's clearing business has played a part in that, by keeping around $4 billion of client assets off Citi's balance sheet and out of its leverage exposure total – an approach other banks are now trying to copy.

"A healthy SLR allows us to do business that generates good returns elsewhere but might have poor SLR optics – so we can get closer to our optimal position. Other banks are more constrained," says Ybarra.

Bank analysts make the same point: "What differentiates Citi from some of its peers is that the leverage constraint is less onerous, and because its ratio is so strong, it's in a position to add additional derivatives exposure or to grow in areas like prime brokerage. It's a nice opportunity for Citi given how strong its SLR is today," says Steve Chubak, an analyst with Nomura Securities in New York.

"The issue is returns"

Citi has its own constraints, of course. Carrying a lot of equity capital means it has to deliver healthy returns on its various businesses – a point Ybarra makes repeatedly. "Our issue has not been the availability of capital – the issue is returns. If we find the right returns, we don't have a problem," he says.

That helps explain the bank's decision to expand in businesses others are exiting – in theory, Citi will have more pricing power where it has a bigger share of the market. It also sheds light on Citi's barbell trading strategy: at one end, the bank aims to grow the volume of low-margin products it can execute, where staff costs and capital consumption is limited; at the other, it has a renewed focus on what's generally known as the risk solutions business, providing analysis and advice for complex transactional or strategic problems.

Solutions work can tie up experienced sales and trading staff for months, but it pays off as well – margins are fatter, and it earns the respect and trust of senior executives at big clients. At least, that is what happens when it's done well – and Citi has not always done this kind of work well in the past.

"We've historically been a big emerging markets bank, a big capital markets origination house and in many areas a significant flow house – but we have not been known for derivatives fluency or creativity," says Andres Recoder, who stepped into his New York-based role – global head of corporate sales and client solutions – when it was created in April 2014.

"When we looked around, it was clear there was a lot of business model transformation happening in the financial sector; huge stresses for banks, insurers and also parts of the real economy. That is fertile ground for episodic, big transactions, and it meant we needed to organise ourselves better to capture that opportunity," he adds.

Roughly 20% of the derivatives salesforce in Europe is now dedicated to solutions, says Recoder, with headcount remaining stable while it has been shrinking for many other businesses: "It's an important activity for us. There is a massive amount of upside."

Shipping deals

As one of its big successes in recent years, he points to the various ways Citi's sales and trading business has been able to get involved in the market for shipping loans – a process of "joining the dots between isolated areas", Recoder says. It started with the purchase of around $1 billion in loans from Societe Generale in 2012, which then enabled the bank to look at how those loans could be sold, securitised and traded – in a similar fashion to Citi's portfolio acquisitions in credit and commodities.

A year later, Citi did what Recoder believes was the first synthetic securitisation to be backed solely by shipping loans – with the first-loss risk being transferred to investors via a credit-linked note and funded CDS. The bank has since started trading non-performing shipping loans, and in 2014 and 2015 completed two more securitisations.

"We have been a leading agent in the transformation of shipping finance from predominantly a bank lending business to one that involves the capital markets and synthetic risk transfer. It is becoming a much more fluid activity," he says.

If the bank can focus this maturing solutions capability on its big, existing base of corporate customers, it will add another string to Citi's bow.

Broadly, analysts accept Ybarra's point about the bank's footprint – particularly the base of around 15,000 core corporate clients that Citi believes have most to benefit from its product offering and global reach. Corporates have a need for a wide range of commercial and investment banking services, and can be expected to give more of their business to banks that are able to provide all of those services – and that can offer support in all of the markets where the company is active.

"Citi has refocused its franchise on the corporate side around multinationals and those that can really benefit from their global scale and their presence in over 100 countries," says Jason Goldberg, an analyst with Barclays in New York. "There's inherent value in that. It's a lot more profitable to deliver an additional product to an existing customer than to go out and find a new customer."

Nomura's Chubak sees it similarly: "It has become very challenging to earn returns that are above your cost of capital when you have a primarily institutional investor clientele. Citi has the largest payments network in the world – it does a lot of bread-and-butter foreign exchange, treasury and cash management work for big multinationals across the emerging markets, and that throws off a lot of fixed-income business. One of the things Citi executives have highlighted in the past is that, historically, nearly one third of their total fixed-income revenue has come from its stable local markets business."

For Recoder and his solutions salesforce, the idea is that the bank can now go to corporate customers and talk about risk management, financing and hedging, but can also open up the conversation to include "excess liquidity, cross-border funding, the funding of emerging market subsidiaries – taking into account onshore and offshore rate differentials, tax treaties and other frictions – as well as pension liabilities and a host of other big challenges," he says.

The full-service logic applies on the institutional side, too, as one of Citi's big prime brokerage clients makes clear. Speaking about her preference for Velocity, Citi's single-dealer platform, a foreign exchange trader at one algorithmic trading firm argues she gets a better all-in price and a simpler service in which there are fewer pairs of hands touching the trade. Citi's decision to expand Velocity beyond forex should broaden that appeal.

Ybarra makes the point simply: "Business has not become less global, and our customers' needs have not become less specific. Full-service providers that are good at their job simplify life and are desirable counterparties for corporates and investors."

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