Excuse the language – a treasury source at one of the world’s biggest interest rate swap end-users is speaking his mind.
“When we need to trade, two or three banks will be there. Of those, Citi is number one because of its consistency. Others, if they don’t have an axe or a clear way of getting out, will give a ‘fuck-you’ price,” he says.
Citi’s global head of G10 rates, Andy Morton, might not have used the same words, but he appreciates the sentiment.
“It’s definitely part of our strategy. A trader at Citi is there to make prices for clients, period. It doesn’t have to be mid, it doesn’t have to be an awesome price, but any time you give a bad price you’re harming the franchise,” he says.
It is striking how simple the rates business sounds when Morton describes it. He’s a big believer in the virtues of a sound organisational structure, having the right people in the right seats, ensuring technology helps those people do their jobs, and keeping clients happy.
The bank has stuck to those beliefs in the face of a rates market that, in many ways, has become far more complex. It has done so by, for example, creating a dedicated team to compress the huge volume of swaps flow generated by its traders, so the business does not have to manage it; by rolling out a single risk system for options, exotics and flow across all offices; and – as was the case in the $55 billion acquisition of Time-Warner Cable last year – by identifying and then removing the obstacles that lie in the path of its clients.
We felt that if we cleaned out the cobwebs, got things organised, and didn’t try to do anything fancy, we’d untap the power of the franchise
Andy Morton, Citi
The result has been a steady ascent over the past eight years that now sees Citi firmly established as a top-tier rates house – a result confirmed by multiple surveys during 2016, when by one firm’s reckoning the US bank achieved the biggest year-on-year growth of any dealer in the market.
The rise of the bank’s rates franchise is enough to land Citi the derivatives house of the year award for the second year running, when taken in conjunction with the continued success of its credit and over-the-counter derivatives clearing businesses – both of which also landed Risk awards this year. It is the first time a bank has retained the overall title since JP Morgan did so in 2008 and 2009.
All of this is very much in line with the vision sketched out by Paco Ybarra – head of Citi’s $16 billion-revenue markets and securities services business – when he hired Morton in October 2008.
“The big aim was to harness the advantages Citi has as an institution,” Morton recalls. “At the time, Citi was facing a lot of external difficulties, and of course there will always be internal obstacles as well. But Paco said ‘Once you manage that, the institution has a good way of bringing in money’. Citi is generally well-regarded by clients and is one of the few real global markets players. So, we felt that if we cleaned out the cobwebs, got things organised, and didn’t try to do anything fancy, we’d untap the power of the franchise.”
Clients tell a similar story – of a business on the up – often citing the pricing consistency Morton has sought to make a defining characteristic of the business.
“They’re one of my top two. I will always include them when seeking a quote – the pricing is just always good. They don’t win every trade but they’re generally in the mix,” says a trader at one US-based hedge fund.
“Citi was not really a major player for us in the past, but we’ve seen a major step up; we now consider them to be top two,” says a source at a UK life insurer.
It’s only been in the past 18 months that we’ve had to recognise 10-year interest rate swaps on two different clearing houses are actually two different animals
Andy Morton, Citi
Others chime in: a second UK life insurer says Citi was one of its top three counterparties during 2016, having been fifth or sixth in the past; a big European asset manager praises the bank for “very consistent” pricing on large trades.
That consistency has become harder to achieve in recent years, for flow and non-linear businesses. Regulation now creates a thicket of different constraints, against which the business has to be optimised: size of book; leverage; funding and margin; liquidity buffers; and risk-based capital. Those constraints bleed into the pricing of derivatives, via a family of valuation adjustments.
The swaps market has also become structurally more complex, with some trades subject to a clearing obligation, some to an electronic trading obligation and almost all to a reporting requirement – rules that are identical in outline in many jurisdictions, but different in detail.
When combined, these changes have produced results that would have seemed odd to traders a decade ago – for example, the appearance of a margin-inspired basis in the price of a trade, depending on which clearing house is being used.
“I think the industry knew 15 years ago that a 10-year interest rate swap with a high-yield counterparty is very different to the same swap with a less risky customer – we all figured out credit valuation adjustment back then. But it’s only been in the past 18 months that we’ve had to recognise 10-year interest rate swaps on two different clearing houses are actually two different animals, and we’re still working through the fact that a bilateral swap might be different from either of those cases. Flow derivatives have absolutely become more difficult as a result,” says Morton.
As an example of the market’s hidden dangers, one of the deals in which Citi drew most effusive praise was the acquisition of Time-Warner Cable by Charter Communications. The target had a pair of chunky cross-currency swaps – maturing in 2031 and 2042 – that had been split across different dealers. Citi had not been one of the original counterparties, but stepped into the trades as a European bank sought to exit and was later appointed M&A adviser to Time-Warner Cable on the acquisition.
These things touch all the trading books, but we keep traders immune from the impacts of it, so we don’t have to get the buy-in of people who have a different focus. We make it owned by the people whose job it is to make us more capital-efficient
David Elsley, Citi
In that role, Citi decided to check out the implications of the acquisition for its clients’ swaps – and spotted an onrushing locomotive. As a way of protecting the dealers, swaps with Time-Warner Cable specified the trades would have to be collateralised – with a threshold of zero – if the customer’s credit ratings ever fell into sub-investment grade territory, says Matthew Siegel, who left roles of treasurer and co-chief financial officer (CFO) at Time-Warner Cable after the deal and is now CFO at CBS Radio. That collateral requirement would have been applied at the point Charter Communications inherited the swaps, because the company was sub-investment grade. As a high-yield borrower, Charter also has a public credit agreement, making clear to bank and non-bank lenders how it will use cash reserves; in this case, it limited the company’s ability to post collateral in derivatives transactions.
Put simply, dealers would find themselves facing an entity with the obligation to post collateral, but not the ability to do so.
Based on Charter’s public filings, the initial posting requirement was not huge – the swaps were out-of-the-money to the tune of $69 million, but they were large enough and long-dated enough to rack up much larger liabilities. The total notional size of the sterling bond issue being hedged was £1.275 billion.
Citi alerted Time-Warner to the danger and then worked with both parties to the deal, and their lawyers, to explore possible remedies – ranging from an unwind of the trades to an amendment of the credit agreement. In the end, the dealers agreed a three-year collateral-posting holiday for the new entity, giving Charter time to amend its credit terms. An altered version of the agreement was published on May 18.
“Citi was amazing,” says Siegel. “The bank pointed out that the purchaser had restrictions on what it could do in terms of collateral, and then successfully negotiated a posting holiday that was incredibly helpful to the new owner. I’m a big fan.”
The episode highlights the hidden complexities of the derivatives market, and the role dealers can play in helping customers through them: “We really have to think about all the risk a client has – not just the market risk, but all the second-order risks that come out of a transaction,” says Carolyn Weinberg (pictured), a New York-based managing director and Citi’s head of corporate solutions for North America.
On the various regulations relating to the swaps business, Morton picks out the use of derivatives notional as a new challenge. Until recently, market participants had ignored notional as a risk measure, instead focusing on indicators of market exposure – such as value-at-risk – or credit risk, such as net uncollateralised exposure.
Andy Morton is seen in the bank not just as the manager of one of biggest businesses, but also as very influential on capital and cost and as one of the biggest experts on risk in general
Introducing the raw underlying size of a derivatives book as a constraint has changed the way banks see the business, and the way they manage it.
“I don’t think many players could have honestly said they were managing with respect to the notional in their derivatives book three or four years ago. Now, everybody knows what it is – we know it by book, and we have a group of guys managing it,” says Morton. “But, like a lot of these things, once you set your mind to it and give capable people the task of managing it, it’s not overly difficult.”
Not overly difficult, perhaps, but there are still challenges to be faced and choices to be made – especially at a bank such as Citi, which is trading at scale.
The management of notional is handled within the counterparty risk group run by David Elsley. For cleared portfolios, the bank is an enthusiastic user of the services provided by clearing houses, where compression can now be achieved on a unilateral basis, thanks to the ‘de-linking’ of the two original counterparties. For non-cleared trades, such as cross-currency swaps and swaptions, Citi uses the multilateral facilities provided by third parties such as TriOptima and BGC Partners-owned Capitalab, as well as running its own bilateral exercises – a necessary complement to third-party compression runs, says Elsley, because the latter occur less frequently.
The end result is a set of overlapping exercises that whirs away in the background, while the traders get on with their jobs.
“These things touch all the trading books, but we keep traders immune from the impacts of it, so we don’t have to get the buy-in of people who have a different focus. We make it owned by the people whose job it is to make us more capital-efficient,” Elsley says.
It appears to be working. Over the past three years, Citi estimates its new trades would have produced a more-than-20% per-annum rate of growth in the notional size and leverage exposure of the bank’s derivatives book – which respectively feed into the calculation of systemic importance and the leverage ratio, and from there into capital requirements. In practice, compression has generated an annualised 12% decline.
That gives the bank the capacity to help other dealers unwind their portfolios – there have been four such engagements over the course of 2016.
“The industry has made incredible progress on simplifying and reducing portfolios over the years – from time to time, people assign portfolios back and forth to each other and of late there have been a few dealers in different regions that have decided to exit the space. We’ve done several of these and I think it’s a good thing for the market – but the size hasn’t been huge. I don’t think we’ve made more than 1% of our revenue from it,” says Morton.
Keep it simple
Another big simplifying force at the bank is the aptly named Simpliciti, the risk platform that binds together all rates businesses and offices. Many other dealers are believed to still run risk for flow and non-linear products separately, implying two different systems, at least; others are thought to have multiple systems in competition.
At Citi, the unifying system was originally used within the exotics business, and proved its worth during the chaos of 2008.
“My goal was to make it possible to do profit attribution analysis for the whole of Andrew’s business,” says Carl Scott, the bank’s global head of G10 non-linear rates trading. “I wanted him to be able to hit a button and see exactly where we made and lost money each day. That was the initial goal because we saw how useful this was for options and exotics in 2008.”
One of the reasons this decision is never taken at other banks is because different parts of the business develop a loyalty to their particular system, and no single team has the clout to pick a winner. Morton says this kind of infighting was limited at Citi, but even then it took time to complete the migration in full.
We were quite worried about Brexit, so we worked out scenarios for interest rate moves, applied those shifts in increments to all our books and looked at how our risks would change
Carl Scott, Citi
“When I arrived, we had five different instances of our old, batch system,” Morton says. “But replacing it wasn’t hard because as global head of the vol business it was relatively easy for Carl to introduce it there – and it was so superior to what we had elsewhere that it was pretty easy to push out into the linear business as well. But it was incremental; it was like remodelling an old house, where you preserve the outside and gradually replace the interior. It wasn’t until 2016 that the last remnants of the old system were finally turned off.”
Morton and Scott cite multiple benefits of the single system, which produces more than two billion risk measures a day, using more than 150,000 hours of computing power; helping with regulatory stress tests, for example, or making it easy for traders to move from one office to another. But the system had a chance to show off as the UK’s referendum on EU membership approached last year, allowing the business to analyse a huge variety of different scenarios.
Scott says: “We were quite worried about Brexit, so we worked out scenarios for interest rate moves, applied those shifts in increments to all our books and looked at how our risks would change. At the same time, we were able to adjust volatility, or rotate the curve to look at joint effects of curve and vol moves – it was very helpful to be able to do that quickly across the whole business.”
In the event, the aftermath of Brexit generated a surge in options business – contributing to a year for non-linear trading that Scott says was the best “by a long margin” since he joined in 2005.
Outsiders give Morton a lot of credit for the growth of the rates franchise, and suggest his technical skills are one of the reasons he’s been able to guide the business effectively during a period of upheaval in pricing and regulation. In the late 1980s, Citi’s rates boss co-authored the Heath-Jarrow-Morton (HJM) model for forward interest rate curves – a demonstration of quantitative skills that one analyst believes are a big plus in his current role.
“It makes Andy quite unique,” says the analyst. “He is seen in the bank not just as the manager of one of biggest businesses, but also as very influential on capital and cost and as one of the biggest experts on risk in general.”
Morton plays this down. “I guess it helps a little bit. Maybe people don’t try to snow me as much, but everybody in my seat probably has a pretty deep understanding of what’s going on in this business. You don’t have to be able to find the flaw in some stochastic volatility model – it could be as simple as grasping curve-building techniques under various collateral posting conditions, or different ways to approach CVA,” he says.
“We don’t use it here,” he says.
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