OTC client clearer of the year: Citi

Clearing businesses are under growing pressure, but Citi - so far - is finding ways to stay healthy, while keeping clients happy

Jerome Kemp, global head of futures and OTC clearing, Citi

"Most clearers have something horrible about them," says the operations head at one New York-based hedge fund. It could be hitches in trade reporting, mistaken calls for margin when there is already excess in the firm's account, inaccessible business heads, clunky onboarding or a failure to stay on top of regulatory changes. The specific complaints vary from client to client, but the story is basically the same – clearing members have blind spots and they make mistakes.

Citi makes fewer. The hedge fund operations head, for example, sets the US bank apart from the other clearers used by his fund and feedback from other clients is equally glowing.

"Day to day, the service provision from Citi has been very good," says Michael O'Brien, director of global trading at Eaton Vance. "That's the most important thing to me. I need to be able to clear trades seamlessly, and when there is a problem, I need to have access to the right person quickly and to get it resolved. Citi has done that."

Ultimately, this is what matters to clients, particularly those subject to US rules, which took effect for many firms in June 2013. But client clearing is new enough in over-the-counter markets for providers of the service to face a different challenge – the shifting regulatory environment, which could still make or break the entire business.

Citi accepts client clearing was initially offered too cheaply. As capital rules have begun to crystallise – including the leverage ratio – so has the true cost of clearing. In mid-2012, Citi was one of the first banks to introduce a basis-point fee on initial margin, known as a maintenance charge, to help cover the ongoing cost of clearing after a trade is accepted on to the books.

We enter into relationships with both eyes wide open, fully aware of the costs

Reduced capital footprint

Since then, the bank has been focused on reducing capital-related costs. Over the course of 2014, Citi's clearing business claims it has reduced its capital footprint by five times. Much of that reduction has come from internal efforts, such as changes to the firm's residual interest model, but cuts have also come from working with clients – and where capital cannot be reduced, costs have increased to cover it.

"We engage with our clients in a way that is transparent and is hopefully seen as constructive," says Jerome Kemp, global head of futures and OTC clearing at Citi in London. "When we need to talk about cost drivers, when we need to go into what actual cost is arising for intermediating or clearing a client, we do it in the spirit that knowledge is power. And, I think, by and large, our clients appreciate that approach, rather than being told we can do whatever they want and then not fulfilling that promise six months later. We enter into relationships with both eyes wide open, fully aware of the costs from our perspective and what the potential evolution of those cost structures could be," he says.

The process begins with an assessment of how much capital each client represents. In particular, Citi analyses the contribution a client portfolio makes to the bank's leverage ratio, under both the current exposure method (CEM) – the methodology in place – and the standardised approach for counterparty credit risk (SA-CCR), which the bank expects regulators to adopt before the leverage ratio becomes binding in the US in 2018.

At this point, there are various things clients can do to mitigate the cost to the bank. Clearing houses began rolling out compression services for buy-side clients in 2014. Specific services work in slightly different ways, but the general principle is to take a set of trades with the same maturity but differing coupons, tear them up, and replace them with a smaller number of trades with the same interest rate sensitivity as the original transactions. For all practical purposes, the resulting exposure is the same, but the gross notional can be cut significantly. This is important because gross notional feeds into the leverage ratio, with netting constrained.

"Clients really can help us by compressing their portfolios and we encourage them to do that," says Mariam Rafi, head of North American OTC clearing. "We just co-sponsored a seminar with the Managed Funds Association on compression where we had a number of different providers of compression solutions come in and speak with clients."

Netting

Citi has also been calling for action on netting, which rests on legal opinions that it would be possible for a given client or jurisdiction to set off trades with a positive and negative value, or to recognise collateral in the event of a bankruptcy. Without a netting opinion, clearing can become far more costly.

"We have exercised discipline on the clients we partner with and, to that end, we have been able to ensure we can get netting by negotiating certain parts of the clearing document and obtaining opinions where we need them," says Chris Perkins, global head of OTC clearing at Citi in New York.

As an example, lawyers are reluctant to give netting opinions on trades with pension funds in the US, because many are covered by untested state bankruptcy regimes. Citi was one of the first banks to employ a legal workaround whereby individual funds can essentially opt into a regime under which netting applies, making clearing cheaper.

Where it is impossible to cut costs, or analysis has shown clients are not meeting the return target of the bank, charges have been increased. "We have raised fees, and I think we did it the right way. Clients don't want us to lose money – they want us to be profitable. At the end of the day, we are providing a service and they want to compensate us for that service, and we have to strike an effective equilibrium that allows us to scale," says Perkins.

Internally, Citi has made some significant changes in the way it manages residual interest – the requirement that a clearing member adds a portion of its own funds to the pool of client collateral. In many cases this is calculated as a simple percentage of the total.

"As volumes ramped up, we realised that wasn't sustainable because it doesn't capture the risk of volatile clients or the fact some clients are safe, meaning there is a large amount of excess in those cases," says Rafi.

Citi has moved to a more risk-sensitive model, which helps to limit total funding requirements for the business. The bank is also passing back the interest paid on clients' initial margin, which has a significant impact on the size of the balance sheet for the clearing business.

Industry practice has traditionally been to treat interest on client margin as a source of revenue for the clearer, but under US accounting rules, doing so would force a bank to place cash initial margin on its balance sheet. Routing interest directly to the client avoids this treatment, and Perkins told a Risk conference in New York last October that Citi was avoiding the consolidation of around $3 billion in cash as a result.

Clients are required to sign off on this approach, Perkins says, but this is purely to ensure transparency, there being no legal requirement for them to do so. Similarly, even though the bank says there is no requirement to obtain regulatory approval, it has involved its regulators from the start, he adds.

Citi started removing received cash from its balance sheet more than a year ago, and is thought to have been the first clearing member to do so. As word got around the industry, other banks sought to mimic the approach, but struggled to find the right technique.

Forums

Now, the bank is beginning to disseminate its interpretation through industry forums such as FIA Europe, where Kemp is a board member. "We want the competition to remain viable," he says. "We think this is an industry that requires multiple participants for it to remain successful and well balanced. I don't think we have shared any big secrets. I view this as something that could become best practice and if you speak around the Street, people are looking at variations on this theme."

Ultimately, the business is trying to beat return-on-equity (ROE) and return-on-balance-sheet hurdles, and it is held to the same 15% ROE target that is becoming typical for many investment-banking businesses. So far, although profitable, it is not hitting that target – and critics might say its chances are likely to worsen, rather than improve, once the US fully implements the Basel III rules and introduces its own version of the leverage ratio.

Perkins is determined, however: "We are committed to meeting that metric. We are focused on building a business that will be profitable on net income, return on balance sheet and return on capital."