Derivatives house of the year: Citi

Risk Awards 2021: digital bets and customer-centric model paid off during pandemic

Andrew Morton, Citi

When a dealer claims to be client-centric, it is making a big statement that is easy to dismiss as branding fluff.

Paco Ybarra isn’t a fluffy guy.

“We don’t say we are client-centric because we are wonderful people,” says the chief executive officer of Citi’s institutional clients group (ICG), which comprises the bank’s investment and corporate banking businesses. “We say it because the business model that works to produce predictable returns over the cycle is the client-centric model.”

That model, in essence, requires the dealer to make money by selling things for a little more money than it buys them – capturing the bid/offer spread – rather than holding onto things it hopes will gain in value. The difference between the two approaches is huge.

A dealer that wants to run the first model successfully needs lots of clients, so it always has buyers and sellers to intermediate between; it needs to price in a way that attracts and retains those clients, without taking too much risk itself; it needs state-of-the-art technology that will connect it to those clients. A dealer running the second model doesn’t need any of those things.

Last year was an opportunity to see which dealers could walk the client-centric talk.

From their kitchen-tables and improvised basement offices, Citi’s front-office teams continued to make prices for clients through the worst days of the crisis, even as some competitors pulled back from the market. They trusted the process.

Paco Ybarra, Citi

“In a situation like this, we had to stay involved and continue to provide our clients with liquidity,” says Ybarra. “This is embedded in the way we behave. This is a time when we have to show we are an important counterparty and that clients are making the right decision by staying close to us.”

Citi’s performance during the crisis left little doubt about that. Clients praised the bank for “always being there with a price” and providing liquidity they “couldn’t get anywhere else”.

The numbers back this up.

In March, the bank’s foreign exchange business processed two-and-a-half times as many client transactions as it did the month before. Executed volumes in US dollar interest rate swaps were up 47% versus February, and 21% for euro interest rate swaps. On some days, Citi’s clearing business was handling five to six times its average number of transactions.

Citi’s trading businesses posted their best results in years in the first half of 2020. Markets and securities services revenues jumped 43%, while revenues from fixed income trading were up 53%.

For the full year, revenues grew 29% across markets and securities services and 35% in fixed income, compared to 2019.  

If you look at how we performed, it highlights the transformation of Citi into being a much more client-oriented, client-focused intermediation business

Carey Lathrop, Citi

In some ways, the results defied conventional wisdom. “We should, in theory, have lost a lot of money,” says Carey Lathrop, global co-head of markets and securities services at Citi. Standard stress tests, including those run by the Federal Reserve, projected trading and counterparty losses in the billions.

He adds: “That’s the assumption, because there’s this expectation that the bank looks very much like it did in the financial crisis, when we were not intermediaries. But if you look at how we performed, it highlights the transformation of Citi into being a much more client-oriented, client-focused intermediation business.”

As the crisis unfolded, the performance of ICG’s markets business offset weakness in the corporate lending unit, which saw revenues decline 25%.

“This crisis vindicated our decision to stay in markets and have a diversified business model,” says Ybarra. “At the beginning, we had to deal with a significant increase in loan demand as customers pulled credit lines. We had a significant increase in risk and capital usage due to downgrades, and we had to take significant credit reserves. Now, there is an appreciation for the markets businesses that was probably not there, or had been forgotten, for a while. In this situation, you see the benefits of having that within your business, because it performed as a shock absorber.”   

Churning the book

The shift to a customer-driven model has seen the bank’s trading units – it is a top-three dealer in currencies and fixed income, and has a top-five franchise in equity derivatives – transformed into market-making machines that can extract profits from razor-thin spreads.

“We try to instill in traders that you buy at the bid and sell at the offer, and if you do that with enough scale and velocity, you’re going to make money,” says Andrew Morton, co-head of markets and securities services at Citi.

Traders are charged with “churning the book – making prices, and then getting out of the risk and into new risk”. 

That is a sharp break from the former model, when they were encouraged to have a market view – for instance, on where rates were going, or whether the yield curve would steepen or flatten – and held positions for weeks or longer.

We try to instill in traders that you buy at the bid and sell at the offer, and if you do that with enough scale and velocity, you’re going to make money

Andrew Morton, Citi

Trading the way Citi does now requires a different mentality. “When you’re trading infrequently, you have to be careful not to make a mistake – you have to buy low and sell high. You’re a mini-investor,” says Morton. “If you’re trading every few seconds, it’s extremely important that you have your mid right – that you know where the market is – but you don’t necessarily have to buy something because it’s going up. You buy because there are good odds that you can get out of that risk within seconds.”   

He argues this makes Citi a more attractive counterparty to clients. “It is very difficult for a client to trade with someone that is trying to make money the same way they are,” says Morton.

A dealer with a proprietary tilt may be tempted to hold onto an asset it thinks is cheap. Citi’s philosophy of churning the book meant it was not saddled with large, problematic positions when the markets turned volatile in March.

“We were positioned pretty defensively,” says Lathrop. “Not because we predicted what was about to happen, but because our franchise is very much client-driven.”

Digital storefront

Nearly a decade ago, Citi placed what may be the largest bet in the financial services industry on delivering services digitally – a crucial step in its attempts to leave the old model behind.

Launched in 2011, its Velocity platform gives clients access to many of the bank’s services over the web. 

“Velocity is a storefront,” says Ybarra. “It is where we combine everything that we offer digitally to our clients, from research and analytics to execution. It is our digital storefront.”

Alejandra Villagra

In the pandemic, clients visited Citi’s digital storefront much more frequently. Alejandra Villagra, global head of Citi Velocity, calls it a “breakthrough year”. Activity on Citi Velocity began to increase in late January and early February as more and more clients in Asia began to work from home. When the coronavirus outbreak spread to Europe and the Americas, “usage went through the roof,” says Villagra. “We absolutely had record-breaking months in March, April and May.”    

Over the course of the year, user numbers grew 9% to nearly 100,000. Many of the new users were large institutional accounts that had previously shown limited interest in the platform.

“Parts of the business Velocity doesn’t typically serve were coming to us saying, ‘I must have access to your platform’,” says Villagra.

Most of the demand was for pre-trade information – research and analytics – as markets became more volatile and unpredictable. Citi produced thousands of webcasts and podcasts with strategists, traders and outside experts – including world-renowned epidemiologists and former central bankers, which were viewed by more than 80,000 clients. Among the most popular features – perhaps because it provided a much-needed change of pace – was a series of weekly classical music concerts, performed by London’s Philharmonic Orchestra.

In all, the platform handled around half a billion data requests and clients used Velocity’s rates vol and swaps pricer to value around 16 million derivatives instruments.

Citi’s digital services earn glowing reviews from customers. “In terms of delivery of content, Citi really has been outstanding,” says a source at a UK insurer. Another client describes Velocity’s pricing and analytics tools as “the best on the Street”. 

In March, all of a sudden, clients wanted to trade on mobile and we were the only game in town

Neil Corney, Citi

Most users access Velocity via a web browser. Last year saw a big jump in mobile usage.

Citi’s mobile trading capabilities were developed by its innovation lab in Tel Aviv. Established in 2011 to develop products for markets clients, it was one of the first of its kind anywhere. The bank now has similar labs in London, New York and Singapore, but Tel Aviv remains the largest, with more than 230 employees.

To bring mobile trading to Velocity, the lab had to tackle two main problems: latency and authentication. “Trading takes place in real time, and our teams developed advanced technologies to ensure transactions can be executed in low latency with the highest level of security,” says Neil Corney, Citi’s chief country officer in Israel.

Itay Tuchman, Citi

For security, Citi’s technologists created a pattern-based authentication system, similar to the one found on Google’s Android phones. “Clients can click-to-trade, but the trade only goes through once they’ve entered the pattern. That gets around the problem.”

Citi launched mobile trading via Velocity in 2012, in sizes of up $100 million, but adoption was slow. That changed during the pandemic, when mobile volumes soared 77%.

“In March, all of a sudden, clients wanted to trade on mobile and we were the only game in town,” says Corney. “The legal and compliance teams at funds that were wary of mobile trading allowed it, because it was the only way some of them could trade, and we saw volumes absolutely surge.”

Every bank these days recognises that digital capabilities are key to both resilience and growth. But few have made the commitment to digital transformation that Citi has. “The view we take is, everything that can be done digitally has to be done digitally,” says Ybarra. “If something can be done digitally, eventually it will be done digitally, and the sooner we get to that point the better.” 

At many banks, worries about margin compression and job security have slowed the development of digital services. Citi claims to have confronted and overcome those frictions. “Early on, we set up working groups that included sales, trading, strategy, technology and we made sure the businesses themselves were driving the roadmap. We wanted them to see this as their product, their asset,” says Villagra.

Citi’s business heads, at least, are behind this digital push. “Electronic liquidity is often seen as low touch and low value,” says Brian McCappin, Citi’s global head of institutional FX sales. “At Citi, our most important clients are the largest consumers of electronic liquidity.” 

Itay Tuchman, Citi’s global head of FX, puts it in even starker terms: “Digital tools saved us and saved our clients, particularly in the most acute phases of the pandemic.”

New code

Scale is key to Citi’s model. The bank is active in every major corner of the derivatives markets, with shares ranging from 20% to 40%. Underpinning that, again, is a huge investment in technology – but this time on the bedrock of in-house systems, rather than flashy client services.

“Building that scale and the risk management systems to handle that scale is the big differentiator,” says Morton. “When you have that scale, you’re going to get a lot of calls, and you’re going to see where the market is.”

Over time, the bank has overhauled its internal systems and infrastructure to improve speed and data quality, cutting its dependence on vendors and leaning heavily on internal development.

“For the past seven or eight years, we have been focusing on eliminating third-party systems, which we found were not as easy to integrate, or as fast and advanced as we are able to develop ourselves,” says Morton.

Across the board in markets, we are moving towards using almost entirely our own code

Andrew Morton, Citi

Big, clunky vendor systems have been stripped out and replaced with lighter, homegrown applications designed to perform specific tasks, such as valuations or reporting. Booking speeds have improved dramatically, enabling more real-time risk management. In one example, it used to take 15 to 20 minutes to manually enter a new deal into a legacy rates system. Citi had more than 5,000 trades in the system, which has since been replaced with a proprietary application. 

“Across the board in markets, we are moving towards using almost entirely our own code,” says Morton.

Citi’s FX business is emblematic of this shift. Al Saeed, global head of FX electronic platforms and distribution, estimates that over 90% of clients now access the firm’s liquidity through proprietary systems versus roughly 20% a decade ago.

In 2019, the FX unit reviewed its roster of third-party vendors and systems and decided to cut ties with around two-thirds of them. That paid off when the pandemic hit. “It definitely helped, because we had to focus on fewer platforms,” says Tuchman. “One of the biggest benefits was that we had discussed platform stability with each of our vendors and asked them to address any issues before March.”

Chris Perkins, Citi

Despite reducing support for external platforms and systems, the percentage of FX trades Citi executes electronically with European clients increased from 60% to 80% last March, and has remained at that level ever since.

Investing in proprietary systems also paid off for the clearing business. The sheer weight of volumes seen during the coronavirus market rout placed huge strains on margin systems. Outages and processing backlogs at some banks resulted in missed margin payments and give-up trades being left on the books of executing brokers. Some clearers pointed the finger at systems supplied by third-party vendors.

“In futures, we did see significant weaknesses in the industry with some of the operational flows,” says Chris Perkins, global co-head of Citi’s futures, over-the-counter clearing and FX prime brokerage businesses. “Years prior, we invested in very robust proprietary infrastructure that dealt with most trade automation, give-ups and allocations. That validated our investment as we were able to navigate this issue.” 

Pandemic prep

Those core elements of Citi’s strategy – scale, client-centricity, digital transformation and investments in proprietary systems – were critical to its performance during the Covid crisis. 

But it certainly helped that the firm saw the crisis coming somewhat earlier than others and took steps to brace itself. Citi’s staff in Asia were affected by the coronavirus months before it spread globally and warned their colleagues in London and New York what to expect.

“Everyone read about it in the papers but hearing it directly from our colleagues gave us a head start,” says Morton. 

One Sunday in mid-February, Citi’s technology department asked everyone in ICG to connect to their work computers remotely. The systems worked.

“When almost everyone had to work remotely in March, we had a good sense that it would work,” says Ybarra. “We had good infrastructure and we tested it very quickly. We discovered the systems we had built had operational resilience.”  

Even for the strongest counterparties, when we see their positions are directional and could lead to liquidity pressure in a stressed environment, we work really closely with them, show them the stress, and work with them on collateralisation

Chris Perkins, Citi

By mid-March, the vast majority of Citi’s front office staff – up to 98% in some units – were working remotely.

“To have the head swap trader sitting at home with 10 screens managing risk and pricing client trades was a little bizarre,” says Morton. “But the fact that it actually all worked was quite gratifying.” 

The bank’s trading units also took evasive action. The rates volatility desk ran a series of stress tests to pinpoint possible gap risks in their swaptions books. The equity derivatives team identified a “handful” of counterparties that might struggle to meet margin calls and began contacting them about restructuring or unwinding trades. They recorded a small loss after exiting some hedges with a counterparty that eventually defaulted, lumping rival dealers with hundreds of millions in losses.   

Citi’s derivatives clearing business was in regular contact with clients through February and early March about their directional exposures. “Even for the strongest counterparties, when we see their positions are directional and could lead to liquidity pressure in a stressed environment, we work really closely with them, show them the stress, and work with them on collateralisation,” says Perkins. “Going into this, we had agreed additional collateral to offset any kind of liquidity pressure from intraday margin calls.”  

When the seriousness of the pandemic became clear, markets exploded into activity that dwarfed anything in recent memory. Citi’s North American linear rates balance sheet grew by over 40% in March as investors dumped bonds to raise cash and meet redemptions.

The firm was also among the largest providers of liquidity in credit derivatives as investors rushed to buy protection. Matt Zhang, global co-head of securitised products trading at Citi, says the bank’s scale and technology allowed it to rapidly find ways out of the risk it was accumulating. 

Carey Lathrop, Citi

“When you have a leading market share, and the market is going one way, it can be challenging to provide liquidity,” he says. “At the same time, you get access to high-quality information to manage your risk much better. You know what customers’ needs are, so you can serve them better. The real differentiator is your data. During March and April, our risk was steady, because we were constantly able to find both sides of the liquidity and proactively match them. 

“Because we have a global footprint, we can distribute risk much better,” he adds. “If we have five-year CDSs, we can distribute that in the same fashion as other market-makers, or we can distribute it in other ways – we can put them into repack notes, we can tranche them, we can sell them to customers in Asia or Europe. When you have such wide distribution, the entire game becomes a little easier.”

Citi’s market share exceeds 40% in some credit derivatives products, including bespoke tranches and CMBX indexes, which track commercial mortgage-backed securities.      

Commercial real estate was among the hardest-hit sectors during last year’s market rout. As bonds tied to retail, hotel and office buildings tanked, investors turned to CMBX for liquidity. “We were very active and provided abundant liquidity to clients through the volatility in late March and the ensuing months,” says Zhang.   

As spreads between the cash bonds and the CMBX index widened, Citi bundled its holdings into relative value basis packages and distributed the risk to clients. “When you have a dominant franchise in both CMBS and CMBX, the cash and the index product, not only can you provide liquidity in them individually, but you can also provide trading ideas on a relative value basis as a package,” says Zhang. 

The bank also traded more than $25 billion and $5 billion, respectively, of US investment grade and high-yield credit default swaps in basis packages, placing the entirety with end-clients via total return swaps and repack notes. 

A complicated month

At the peak of the crisis, hundreds of buy-side clients breached net asset value triggers – with losses exceeding the maximum decline in NAV permitted under trading and clearing agreements.

In most cases, Citi took a pragmatic view.

“If a client hits a NAV trigger, we’re well within our rights to take very severe actions,” says Perkins. “But we have very strong governance. We look at the situation with our first- and second-line partners, and in many cases, we found a way to work with the client to navigate the situation. We did that very thoughtfully and without any credit losses.”

In the FX business, risk and relationship managers were having daily conversations with clients – sometimes multiple times a day – to agree credit limits. “The key to ensuring that was a well-managed process at a time of great chaos was communication,” says McCappin. “There was an open, trusted exchange about what large trades were coming and what they needed from us. And we were able to manage our credit facilities accordingly. We were doing that live, on a daily basis, with multiple people in the room. We were talking intensely to clients. There was great trust, great dependence, great faith. And the result was that we got through it without any major hiccups.”

Citi’s clearing and FX businesses emerged from the crisis without taking any credit losses.

There was an open, trusted exchange about what large trades were coming and what they needed from us. We were talking intensely to clients. There was great trust, great dependence, great faith

Brian McCappin, Citi

The rates business also had to make some difficult calls. The bank had traded forward-settling agency mortgage-backed securities (MBSs), known as TBAs, with a trio of non-bank mortgage originators. The price of TBAs skyrocketed when the Fed started buying agency MBSs in March, and the originators were unable to meet the resulting margin calls. 

After discussing the matter with Citi’s risk department, they decided not to enforce the margin calls, which would have tipped the originators into bankruptcy. If a sufficient number of the mortgages they had already originated pulled through, the firms would be able to settle the TBAs with newly created MBSs and pay down the remaining margin.

Citi agreed to run the exposure, subject to certain conditions. By early May, the crisis had eased and MBS prices came down. The originators were able to settle expiring TBAs with bonds and the closing mortgages generated enough cashflow to pay down the remaining margin owed.

“It was a complicated month,” says Ybarra. “There were many instances where some of our clients had difficulties, and we had to make calls about whether the difficulty was temporary or something more permanent. We navigated that pretty well. We had some very small losses, almost anecdotal losses, in the context of everything that happened.” 

In some cases, clients also helped support the bank. Clearing houses hiked margins dramatically during the market rout in March, forcing Citi’s clearing business to meet large intraday top-up calls. “On the OTC side, we saw some pro-cyclical behaviour in the form of intraday margin calls,” says Perkins. Clearing members must cover these payments on behalf of clients, adding to funding strains in times of market stress. Realising this, more clients began posting intraday margin to Citi.

“We helped some clients with liquidity, and some helped us,” says Morton. “Intraday posting picked up heavily in this period compared to any previous crisis I’ve seen. And it was voluntary, but it was in everyone’s best interest.”