When the oil-dependent economy of Nigeria was hit by the sudden collapse in global crude prices in the summer of 2014, many international lenders pulled back from offering dollar financing to the country, fearing the sharp devaluation of the naira that followed would result in severe contagion. Citi was not one of them.
Thanks to a carefully executed collateral management strategy and a neat offshore hedging solution, the bank had the confidence to stand its ground, pumping hundreds of millions of dollars’ worth of liquidity into the market over the months that followed. In the process, it became the major foreign bank provider of dollar financing to the nation’s economy.
The bank’s stance was predicated on its longstanding onshore presence in the West African nation, its positive view of the country’s official sector, and its loyal client base among local banks. It was also an affirmation of the bank’s confidence in its ability to profitably manage complex cross-border risk transfer challenges.
Oil’s 40% fall during the second half of 2014 sparked a sudden and sustained drain in dollar liquidity in Nigeria over the 18 months that followed – a problem for the nation’s banks, which rapidly found themselves unable to meet their local dollar funding obligations.
Citi’s plan was simple: to extend loans to local Nigerian banks to help meet domestic needs for dollar financing. That meant it had to get comfortable with two sizeable risks: its exposure to a sudden devaluation in the naira, and the counterparty credit risk of the lenders it was offering dollar funding to.
While central banks in other oil-dependent countries such as Mexico and Russia responded to the price slump by allowing their currencies to adjust, the Central Bank of Nigeria pegged the Naira at 198 to the dollar in February 2015, not letting it devalue. This created a significant difference between the onshore naira-dollar exchange rate and the offshore non-deliverable forwards (NDF) market – a dislocation Citi’s risk management team later took advantage of to monetise its exposure.
“As the market evolved and the pricing dislocation started occurring in different markets, we identified a better way of monetising the long dollar position we acquired through these collateral management activities,” says Elbek Muslimov, Emea head of emerging markets credit trading and structuring at Citi in London.
“At a certain point midway through these transactions, we observed very big dislocations in the offshore NDF market, where implied yield at certain points went up to 200% per annum. This was the time when market fear was at its peak level, but also the best moment for capturing the resulting basis between the onshore and offshore rates markets,” he adds.
Ultimately, what we can pride ourselves on is the fact we were able to foresee and build the mechanics in such a way that when worse scenarios did materialise, we were able to rely on the mechanisms we incorporated in advanceElbek Muslimov, Citi (far right)
The strategy worked strongly in Citi’s favour: the bank was also able to lock in an overall positive carry on the trades, in line with the risk assumed.
Citi’s lending activities faced a significant peg risk, with the central bank liable to remove the naira’s fix to the dollar without warning – the naira tumbled 30% when the peg was removed later in June 2016. Citi managed this risk by collateralising its transactions using local currency government bonds, which were still very liquid in the domestic market at the time. The bank’s risk management team was very selective in terms of counterparties, and careful in its sizing of specific transactions.
The counterparty risk was managed with the option of using incremental top-up margin payments in dollars during sharp devaluations. The risk management team also ran multiple stress test scenarios to set over-collateralisation levels in case of extreme moves.
“When we were entering into these transactions, the situation wasn’t as bad as it subsequently proved to be. Ultimately, what we can pride ourselves on is the fact we were able to foresee and build the mechanics in such a way that when worse scenarios did materialise, we were able to rely on the mechanisms we incorporated in advance,” says Muslimov.
An additional layer of protection was afforded via a contingency plan to sell the collateral the bank was receiving in case of very sharp devaluations – something that did end up happening in late 2015. Citi entered into total return swaps (TRS) with the counterparties on the bonds lodged as collateral to effectively create a title transfer of the bonds to Citi, allowing the bank to liquidate the bonds if certain risk limits were breached.
We have a systematic process of managing country risk and crisis management, holistically throughout the bankColin Church, Citi
“What the TRS allowed us to do was gain the right level of comfort on [the] legal enforceability [of] title transfer of the underlying collateral, the ability to dispose of it as the situation evolved,” says Muslimov. “Also, we had to introduce mechanical features in the contract, where we retained certain flexibility in our obligations to return the collateral.”
The proceeds from the collateral sale generated a negative local currency position in Citi’s books.
Around this time, the offshore NDF market was pricing in a 50% devaluation on the naira – predicting a fall from 200 naira per dollar to 300 – which meant Citi was able to hedge its short currency position from the TRS by going long naira and short dollar in the offshore NDF market.
A common reason for such dislocations, says Muslimov, is a divergence of views among the dominant players in a market at a given time. The naira fixed-income markets – comprising an offshore NDF market and an onshore T-Bill and spot forex market – was split along precisely these lines.
“The offshore market was dominated by corporate hedgers and offshore investors with very limited risk appetite. The domestic market, on the other hand, was dominated by local banks that remained more sanguine with the help of the proactive local regulator,” recalls Muslimov.
Citi’s clients credit the bank’s financing operation with, in effect, keeping the in-country dollar economy moving during the entire episode: “The transaction helped us open letters of credit for our customers, and also support the central bank in making dollars available for the entirety of the economy… it was significant in terms of oiling the economy of Nigeria,” says a treasurer at one Lagos-based bank.
Citi’s unique geopolitical risk management strategy was another reason it was able to get comfortable on the trades, says Colin Church, chief risk officer for Emea at Citi. The firm runs extensive internal stress tests that simulate the impact of scenarios such as an oil price crash or political upheaval on local economies, giving it a blueprint to turn to when a crisis occurs.
“We have a systematic process of managing country risk and crisis management, holistically throughout the bank,” says Church. “We are more active; we have much larger local footprints, which gives us more options than other institutions, and we have developed an effective process for institutionalising those learnings over time, literally over decades.”
This was also evident in the Nigeria episode: the collateral sale strategy the bank ended up using was considered as a contingency plan in the event of large devaluation on the naira in advance of the trade.
The lender also brought the same tactics to bear ahead of the UK’s Brexit referendum last year. While misplaced confidence in a remain vote left some banks with unhedged positions on the day – with several forced to hedge at the last minute as volatility spiked – Citi had been running internal stress tests and modelling the outcomes of a leave vote as early as March 2016. In the event, the outcomes of its stress test aligned with actual moves on the day – and it even turned out to be profitable for Citi.
When markets opened on the day of Brexit, we were pretty much spot on with all the analysis we laid down as far back as the first week of MarchRahman Khan, Citi
“When markets opened on the day of Brexit, we were pretty much spot on with all the analysis we laid down as far back as the first week of March,” says Rahman Khan, Emea head of market risk and global head of foreign exchange local markets and equity market risk at Citi in London.
The bank’s customised Brexit stress tests gained admirers among regulators, some of whom even adopted elements of Citi’s approach. “We got told by a lot of regulators [they] were pleased with how we managed the Brexit scenario,” says Church.
Even during the eurozone crisis, Citi was able to reduce its exposure by running stress tests ahead of time and acting earlier than most others in the market.
“During the Greece debt restructure, when there was a 70% haircut on the country’s debt, we were the first movers in late 2009. We identified the deterioration early on, and were able to reduce our risks while remaining committed to local clients and our franchise,” says Citi’s Church.
“We built a unique construct [by] literally going through every transaction in the firm and mapping it to where, legally, it would go in the event of a restructuring. We then built an effective stress test process off those numbers, then we managed the portfolio accordingly. Subsequently, other market participants did that; [even] other regulators did that – pretty much adopting the same fundamental construct.”