OTC client clearer of the year: Citi

Risk Awards 2018: 'Activist' FCM takes aim at G-Sib change and new leverage measure

Jerome Kemp

When the Federal Reserve proposed a change to the reporting framework for US global systemically important banks (G-Sibs) in August, the implications for the clearing business were not immediately obvious. They soon sank in.

Under the new rules – which were due to take effect from December 31, 2017 – an estimated $46 trillion of client-cleared notional would have inflated the systemic risk scores of the eight banks, forcing them to stump up an additional $10 billion of capital in aggregate.

Some banks responded by trying to put the brakes on notional growth, raising client hackles.

A source at one European hedge fund says some clearers “pressed the alarm button”, in some cases seeking to impose soft clearing limits or pushing clients to cut their notional via compression. “With the end-of-year G-Sib snapshot coming up, other banks strongly encouraged us to find ways to reduce our notional, whereas Citi took a more steady line on that,” he says.

Behind the scenes, Citi was busy. Under the Fed’s proposed methodology, the complexity component of the G-Sib assessment – which rests in part on a bank’s total derivatives notional – would, for the first time, include the client leg of all cleared trades, doubling up the contribution made by the clearing business. That could tip some banks into a higher-risk bucket, which comes with a higher G-Sib capital surcharge.

Citi was one of a small group of banks that worked with the Futures Industry Association and other industry trade associations to protest the rule change – for example, collecting data from clearing houses to help make their case, and attending a meeting with the Federal Reserve in Washington, DC. On October 23, the Fed extended the comment period for the rule change, and pushed back the proposed implementation date until the end of March next year. The industry now has more time to make its case.

This behaviour is characteristic of Citi, says Jerome Kemp, the bank’s global head of futures, clearing and collateral management, who describes Citi as an “activist” futures commission merchant (FCM).

“If you look back at Citi over the past five or six years, you get a pretty consistent message from us across the board. We are the guys who spoke about defaulter-pays and why that is essential to market infrastructure. We are the guys who raised the issue of skin in the game, which is still unresolved. We are the guys who made noise about the necessity of moving from the current exposure method (CEM), to a more meaningful measure of risk relative to capital for clearing. Now we are raising our voice over what is being said over G-Sib capital. We are the FCM that is perhaps the most activist,” says Kemp.

We are the guys who spoke about defaulter-pays and why that is essential to market infrastructure

Jerome Kemp, Citi

The focus on profitability and sustainability can be seen in Citi’s own business, where the bank has been careful to keep a lid on the consumption of balance sheet and capital – in particular by developing the ‘passthrough’ approach under which interest payable on client collateral goes direct to the client. This technique allows the bank to keep client assets off its own balance sheet, mitigating the leverage ratio hit.

Having already made billions of dollars of balance sheet savings across its platform to date, Citi expects to continue that trend, helping it take on major new clients and deliver OTC clearing revenue growth of 44% year-over-year.

The argument from Citi is that running a tight ship enables it to provide a more reliable service – and clients back that up. A US asset manager says: “Citi has been very level-headed, took a proactive approach with the regulators and made things happen.”

A large Asia-Pacific banking client says: “Citi has been on the front foot with regard to the leverage ratio and trying to get clients’ monies off their balance sheet. That separates them from their competitors. Citi for us has thought leadership and relationship management sewn up – they’re just ahead of the curve.”

A large European banking client says: “Other clearing brokers have cut our lines or increased costs, basically asking us to leave because it was expensive for them. Citi never told us to pay more or stop trading. We’ve been able to rely on them.”

In addition to the G-Sib methodology, one of Citi’s other policy goals is to shift industry debate away from the scope and calibration of the supplementary leverage ratio – the 2013 rule requiring US banks to hold more capital against total exposures than their foreign peers – towards the underlying methodology. As things stand, the ratio is based on the near-30-year-old current exposure method, which FCMs are keen to ditch, but the mooted successor – the standard approach to counterparty credit risk (SA-CCR) – also has its critics.

The work that’s been done by the trade associations, and by Citi, is really shining a light on some of the capital dislocations of a notionals-based approach

Chris Perkins, Citi

As an example, in an article published by Risk in July, Citi pointed out that an FCM holding enough initial margin to offset its SA-CCR exposure number would still have to hold capital equal to 60% of that exposure; the capital hit could only be reduced significantly by holding a huge additional margin buffer.

The US Department of the Treasury is listening. In October, its second batch of advice on financial regulation referenced the Risk article, and Citi’s call for SA-CCR to fully recognise initial margin and the risk-reducing offsets between diversified but correlated products, as well as to appropriately calibrate add-on calculations, including supervisory factors.

The Fed has now reached out to the industry and requested more data on the issue, including house and client margin figures.

Citi’s global head of OTC clearing, Chris Perkins, says: “The work that’s been done by the trade associations, and by Citi, is really shining a light on some of the capital dislocations of a notionals-based approach. Many regulators are looking at the feedback.”

Citi also played a part in building the foundations that have allowed clearing houses and banks to treat variation margin as settlement of a swap trade, rather than as collateral – a seemingly minor change that can have a major effect on the size of a bank’s derivatives book – and potentially the capital impact of the leverage ratio.

The ratio sets capital as a percentage of a bank’s total exposure, with the biggest component of exposure for derivatives being their expected lifetime movements – the potential future exposure. The PFE is generated by applying a regulator-set multiplier – varying by asset class and maturity – to the derivatives notional. A footnote to this PFE grid states banks can use the settlement maturity to determine PFE, rather than the contractual maturity, under certain conditions.

Excess collateral collected by Citi provides it with excess capacity. Cash posted segregated at CCPs enhances the yield for clients, and cuts down on wire fees. Citi’s risk and capital is lower. It’s a win-win

Chris Perkins, Citi

On August 14 US regulators published long-awaited guidance, essentially clearing the way for their banks to start using the so-called settled-to-market approach. FCMs including Bank of America Merrill Lynch, Goldman Sachs and Morgan Stanley immediately adopted STM in their third-quarter results, producing enormous reductions in gross assets – a total drop of $326 billion across the three banks.

Citi also claims to have saved billions in risk-weighted assets through this approach, but outstanding issues still need to be resolved. Clearing houses in the US apply STM on a mandatory basis, while in Europe clients are being given the option of retaining the collateralised-to-market treatment. Perkins says: “In Europe, clients need to elect CTM or STM. There is more of a process to work with clients to get them to shift on the settlement approach.”

The hotter topic for STM swaps is its implications for the CEM methodology, Perkins says. CEM limits available capital savings for any given portfolio through a crude formula, part of which requires a bank to multiply the portfolio’s PFE by the ratio of its net replacement and gross replacement costs – the net-to-gross ratio – with the product multiplied by 0.6.

Applying STM dramatically reduces PFE, but Citi and others are not sure how the NGR is treated.

Perkins says: “There is debate over how to look at the NGR part of the equation and how that should be considered under settlement. Do you zero out the NGR, or is there a tail? Based on the regulatory guidance we’ve been given to implement the flawed CEM rule, the settlement provision makes it clear how you deal with the PFE part of the equation, but as you get into the NGR if the trade resets and settles daily, what should your numerator be on the NGR? Whether that NGR numerator should be zero is something a lot of firms are looking at.”

This focus has enabled the business to grow rapidly – particularly over the past year, when segregated client margin jumped 63% to more than $17 billion, according to statistics published by the Commodity Futures Trading Commission. The bank also claims the number one notional market share position on interest rate swap client clearing platforms at CME, Japan Securities Clearing Corporation and LCH.

Excess collateral collection

Citi’s growth in segregated funds includes an increase in the amount of excess collateral the bank collects. The bank claims this mitigates risk, improves returns on risk-weighted assets and reduces contingent liquidity needs. More than $3 billion of excess in that pool is held in the US and at least another $1 billion is held outside the US.

With the Federal Reserve now able to hold cleared client collateral, Citi’s clients have the option of posting their assets to the central bank, which pays a relatively generous interest rate of 125 basis points.

This arrangement – although not unique to Citi – is beneficial all round, Perkins argues, and sees the bank collecting excess collateral, and clients choosing to hold it at CCPs or the Fed.

“Excess collateral collected by Citi provides it with excess capacity. Cash posted segregated at CCPs enhances the yield for clients, and cuts down on wire fees. Citi’s risk and capital is lower. It’s a win-win,” says Perkins.