The structured products business can be notoriously boom-and-bust – a single volatility event can suddenly wipe out years of profit.
But, coming off a bonanza year in 2021, Citi aims to break that cycle. Having emerged unscathed from a tumultuous 2020, the US dealer sought to future-proof its growing franchise by crafting a new breed of structured products to neutralise risks that almost toppled rivals.
“We’ve revamped the primary offering to make it more risk-friendly and sustainable, while also expanding the full risk-recycling piece,” says Alexandre Isaaz, Citi’s global head of equity and hybrids payoff structuring. “This is a full ecosystem and we worked on both sides to keep growing the franchise with the same risk awareness that made us stronger in 2020.”
It’s the strategy that led to Citi capturing greater market share in 2021, says Isaaz.
When corporates axed dividends, delivering a crippling blow to exotics desks in 2020, the firm issued autocallable notes referencing next-generation decrement indexes on individual stocks. When punitive borrow costs beset the rest of the industry, Citi linked products to ‘rolling futures’ versions of mainstream benchmarks.
Its clients welcome the creativity. “It’s not only new payoffs – they come up with stories as well,” says a European investment management client. “Whether inflation or value/growth rotation, they come up with some very smart ideas.”
And these innovations have helped power growth in the business. In 2021, the bank issued $50 billion notional of structured products, a 65% increase on 2020, which contributed to a 25% climb in equity trading revenue.
“We managed to differentiate at all levels, whether client penetration, risk management, monetisation or product innovation,” says Quentin Andre, Citi’s global head of derivatives sales. “The sum of all these together, with some decent tailwinds and some interesting alpha, led to a decent revenue outcome and franchise improvements.”
The bank also climbed client rankings, in many cases displacing competitors that stepped back from riskier exposures, such as worst-of autocalls and longer-dated instruments. Clients heap praise on its pricing, coverage and after-sales service.
“They’re the most consistent in their ability to price anything, in any tenor and with any type of payout,” says a US distribution client. “They can do almost every structure, whether it’s income or growth, and they can go out further in tenor than anyone.”
This unstinting appetite reflects a strategy of diversification – something of a buzzword across Citi’s equity derivatives division.
“I’m a big believer in diversification,” says Fater Belbachir, global head of equities. “We have not made our year focusing on longer-dated trades. We made our year and designed our strategy through serving clients across their needs,” he adds, emphasising that clients’ needs span the maturity spectrum.
From the short-dated Asia market to the US and Europe, where tenors can exceed 10 years, structured products revenue was evenly divided. This avoidance of concentration has helped keep risk in check through the extreme backdrops of a turbulent 2020 to a buoyant 2021, says Belbachir.
“If I look at our risk inventory, we are running pretty much the same footprint we were running a year ago, which shows the framework is the Walmart of structured products – we’re able to match different interests. We’re not piling up risk, we’re able to recycle it to meet different client demands.”
The bank found new partners to share risks from structured products, such as correlation and variance, replacing some large pension funds which retreated after suffering in 2020. Around 40% of Citi’s risk transfer trades were made with new counterparties in 2021.
“Shareholders will not accept these volatile P&L quarters and it comes with a lot of attention from regulators, so you’ve got to be very sensible about how you manage risk,” says David Haldane, Citi’s global head of derivatives trading.
“Our approach is to stay humble and recycle as much as we can. We’re not going to get delusions of grandeur just because we’ve had a couple of very good years. It continues to be the plan going forward, especially as we enter into what could potentially be a huge rotation as rates start to pick back up.”
If 2020 was a year of survival, 2021 was for safeguarding against risks that crippled exotics desks during the Covid-19 pandemic. Chief among them was dividend risk.
Autocall issuers typically hedge long-dated dividends, but exotics desks buckled when corporates took the unprecedented step of axing pre-announced 2020 payouts.
The fiasco sparked a rush to tried-and-tested ‘decrement’ indexes; these synthetic versions of mainstream benchmarks, such as Euro Stoxx 50 and CAC 40, reinvest paid dividends and subtract a fixed payout from the performance. Already common for index autocalls sold in France and the Benelux countries, attempts to extend the concept to single names had faltered – in part because the synthetic dividend is written into deal term-sheets – resulting in products that are too complex to be distributed within insurance contracts.
Citi set out to redesign the product for industrial-scale rollout.
The bank collaborated with Deutsche Boerse-owned index provider Stoxx, to create a set of single-name benchmarks for exclusive use.
They’re the most consistent in their ability to price anything, in any tenor and with any type of payout. They can do almost every structure, whether it’s income or growth, and they can go out further in tenor than anyone
US distribution client
The suite of over 100 indexes comprises 36 global names and four dividend assumptions: a five-year low, five-year average, five-year high and last payout. Launched in May, more than $500 million in autocalls were linked to these underlyings.
Clients welcomed the flexibility. “For us, Citi brought fire into these kinds of products,” says a European insurance client. “They were able to bring this payoff to a lot of different distributors, given the flexibility they provide.”
Another distributor says the structure was accepted by 80% of insurers he works with – critical for success. “It was a very smart idea for Citi to include these underlying indexes because it’s easier for insurance companies to accept indexes than single stocks. It’s a small detail, but very important.”
Mono autocalls on these indexes delivered coupon improvements of up to 40%, says Citi. In worst-of autocalls, which use correlation to cheapen the embedded put option and boost the coupon, use of these synthetic indexes allowed investors to meet their return targets with two rather than three constituents, cutting risk for the bank.
Competitors appear to have given the thumbs-up. In October, Euronext began publishing its own single-name decrement indexes on popular underlyings, including Total, Orange and EDF. Goldman Sachs has sold autocalls on these indexes, filings show.
Including single names and indexes, Citi issued more than $3.5 billion of decrement products, expanding sales from six to 15 countries, including Germany, Switzerland, US and Korea.
“One of the massive strengths of Citi is the scalability,” says Isaaz. “We are truly global and this makes a difference because whenever we have an initiative or a strategic idea, we can push it across all regions. Whether it’s primary issuance or risk recycling, we have global alignment.”
What’s more, he adds: “Whenever we have an axe, we look at clients globally and are very careful when we distribute this risk to make sure we have the diversification we want and need.”
Decrements accounted for around a third of Citi’s European autocall issuance, up from just 5% a year prior. In November, decrement products outpaced standard benchmarks for the first time.
In an effort to mitigate the punitive long-term borrow cost associated with autocalls, Citi decided to offer products linked to ‘rolling futures’ versions of popular benchmarks.
Autocall issuers typically hedge their equity delta via total return swaps. These over-the-counter instruments reflect the long-term cost of synthetic equity financing and are primarily driven by hedging of exotic autocall risk. Hedging can be particularly punitive in worst-of products – issuers tend to become exposed to a non-performing index at the same time, triggering a scramble for hedges and driving borrow costs higher. This happened in 2020 when the FTSE 100 became the worst performer in many worst-of baskets, resulting in hedging losses for some desks.
By linking products to synthetic versions of benchmarks, which roll short-term futures on a regular basis, issuers replace long-term borrow with more liquid short-term borrow. Citi worked with index providers to create synthetic versions of popular benchmarks including the Euro Stoxx 50, S&P 500, and FTSE.
These alternative benchmarks reflect the roll cost in index performance. On the Euro Stoxx 50, this averages 10 to 15 basis points per year. Long-term borrow can be 1% per year.
By applying a strategy which has been monetised by institutional investors for a decade, autocall investors can achieve a 15–20% coupon improvement on a six-year instrument, says Isaaz.
The risk for clients is that short-term borrow rises above the long-term measure, driving negative performance of the synthetic index – a scenario rarely seen since the 2008 financial crisis.
“Highly liquid and showing a more consistent balanced supply-and-demand, short-term equity financing for Indices like S&P 500 or Euro Stoxx 50 structurally trades below long-term, which is supported by the continuous demand for long-term forwards from structured product dealers,” adds Isaaz. “Combining a cheaper financing and higher transparency results in better economics and risk-reward for our end-investors in our view.”
Flying too high?
The first-world problem of sky-high equity valuations means that clients fear for what happens when an 18-month rally runs out of steam. Against this backdrop, autocall buyers began to demand more defensive features. In sideways or falling markets, the chance for products to redeem is low, given annual or semi-annual observation dates. Redemption prospects can be increased by reducing the knock-out barrier or increasing observation frequency. Both can quickly corrode the target yield.
Citi’s answer: the Doppler autocall. The structure increases the observation frequency as it heads to maturity. A typical three-year structure would begin with semi-annual observation. If the instrument is not autocalled after the first year, observations would be made quarterly, rising to monthly and daily for the latter months prior to maturity.
While a daily observation from the start can slash coupons by two-thirds compared to semi-annual observations, the Doppler structure can shave them by less than 10%.
Citi also kept its appetite for worst-of index products alive with its Gemini structure, which aims to neutralise the correlation exposure for the bank and improve redemption opportunities.
Worst-of autocalls struggle to redeem in range-bound markets as the laggard must hit the upper barrier for the structure to pay out.
Like a typical worst-of autocall, a Gemini structure redeems after the first year if all stocks are trading above the barrier. If no stocks are above the barrier, the product continues. The twist takes place if at least one stock is above the barrier. In this scenario the embedded put option knocks out, leaving the structure 100% principal protected. At maturity, if the structure has not been autocalled, investors receive principal plus a coupon if all stocks are above the barrier. If at least one stock is above the barrier, an investor receives the principal. Investors receive the performance of the worst stock only if none is above the barrier.
For investors it’s a low-cost opportunity for capital protection – typically eating up just 5%-10% of the total coupon. Analysis shows that on 50% of occasions when worst-of structures are not called in the first year, the Gemini effect would have been beneficial for buyers.
In 2021, the bank sold over $300 million in Gemini and Doppler structures.
Hybrid model citizens
In the US, Citi spearheaded the expansion of hybrid products to retail clients, garnering a mammoth share of more than 80% of the growing market.
These trades typically enhance product coupons by combining directional or curve views on interest rates with foreign exchange or equity exposure.
Already popular in Europe and Asia, these investments have been largely limited to macro hedge funds in the US. In 2021, Citi sold over $250 million of the products to retail buyers, a 50% year-on-year increase.
Despite relatively low notional, risk and revenue for the business is significant, given the long-dated nature of trades, which can easily go beyond 10 years.
Citi puts its dominance down to a cross-asset hybrid risk book, which sits within the equity division.
“We’re lucky to have a single hybrid risk book, which makes it much more efficient to warehouse risk and be more aggressive in pricing. With a larger book, there’s a lot of netting that happens between traditional hybrid users such as hedge funds, pension funds and insurers and this new retail hybrid space,” says Guillaume Flamarion, co-head of Citi’s multi-asset group in the Americas.
“We can provide competitive pricing and our hybrid desk is not afraid to put risk on. They know that combining all this exposure with clients, a lot of these risks will net each other out and it’s a true circle, whereby you put positions on, you create axes, and you can recycle some of those with macro players. It’s self-fulfilling.”
Clients are effusive but urge greater dealer participation. “No one comes close to Citi,” says a US distributor client. “It’s a big trade and Citi is the one driving this bus. It’s good because they create some amazing structures, but you can quicky get full on credit limits.”
Citi concurs. “We want more players to commit because a market is more productive if you have more players. We’re not shy for our clients to try to get other dealers quoting because it will expand the market for hybrids, which is a good thing for everyone,” says Flamarion.
It’s future-proofing the market for everyone.
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