Citigroup Embraces Derivatives as Deals Soar After Crisis

Citigroup Inc. CEO Michael Corbat
Citigroup, led by Chief Executive Officer Michael Corbat, 54, expanded the business from a low base to meet the needs of customers, said Danielle Romero-Apsilos, a company spokeswoman. Photographer: Angel Navarrete/Bloomberg

Citigroup Inc. is diving deeper into derivatives.

In the past five years, the firm that took the largest U.S. bank bailout of the financial crisis increased the total amount of derivatives on its books by 69 percent, surpassing most U.S. peers and closing the gap with the market leader, JPMorgan Chase & Co. At the end of June, Citigroup had $62 trillion of open contracts, up from $37 trillion in June 2009, company filings show. JPMorgan trimmed its holdings 14 percent to $68 trillion.

Citigroup is expanding as regulators try to rein in instruments that helped fuel the 2008 credit contraction. The third-largest U.S. lender has amassed the largest stockpile of interest-rate swaps, a type of derivative that can swing in value when central banks raise rates. More than 92 percent of the bank’s derivatives don’t trade on exchanges, making it harder for regulators to spot dangers in the market.

“Risk-taking is in their DNA,” said Arthur Wilmarth, a law professor at George Washington University, who wrote a 2013 paper describing failures that led New York-based Citigroup to seek a $45 billion bailout and more than $300 billion in asset guarantees during the crisis. Even taking the winning side of a derivative carries a risk the other party can’t pay, he said. It’s “basically a speculative trading business.”

Derivatives typically require parties to make payments to each other based on the value of underlying stocks, bonds, commodities or interest rates. Airlines and farmers use the contracts to offset price swings for fuel, vegetables and meat. Bond buyers rely on them to insure against defaults, and some investors use them to speculate.

Client Demand

Regulators are demanding banks keep more capital for derivatives after credit-default swaps insuring mortgage bonds amplified losses from the U.S. housing bust. The government bailed out American International Group Inc., which sold many of the contracts, to prevent the system from collapsing.

Citigroup, led by Chief Executive Officer Michael Corbat, 54, expanded the business from a low base to meet the needs of customers, said Danielle Romero-Apsilos, a company spokeswoman.

“We have seen gradual, risk-managed increases in interest-rate derivative activity over the last five years as a result of client demand, which has brought us in line with our competitors,” she said in a statement.

Second Place

The increase in the value of Citigroup’s derivatives restores the bank to a second-place position it hasn’t held since the first quarter of 2008. Then, its portfolio was less than half the size of JPMorgan’s.

Goldman Sachs Group Inc., which increased the notional value of its positions 13 percent over the five years, was in third place with $58 trillion of contracts open at the end of June, according to company data compiled by Bloomberg. It was followed by Charlotte, North Carolina-based Bank of America Corp. with $55 trillion and Morgan Stanley with $44 trillion.

JPMorgan, Goldman Sachs, Bank of America and Morgan Stanley cut their combined derivatives positions 8 percent in the period. Spokesmen for the four firms declined to comment.

The 25 U.S. financial firms with the largest derivatives positions reduced the gross notional value of their contracts to $297 trillion at the end of March from a peak of $333 trillion in mid-2011, according to the most recent figures compiled by the Office of the Comptroller of the Currency. The earlier numbers may not include updates to the data made by banks after the regulator published its report.

Diverging Paths

Citigroup has diverged from peers elsewhere. Bloomberg News reported in June that the firm used an exemption to the Volcker Rule’s curb on proprietary trading to give a team of mortgage-bond traders the mandate of running more than $1 billion in bets for the bank. The firm also has made higher-than-market bids to buy blocks of stock from clients to win market share.

Citigroup said at the time it limits risk-taking, complies with rules and provides the best services possible for clients. Corbat, a former managing director in Salomon Brothers’ derivatives business, has said he wants to take the firm “back to its roots of being a bank.”

The bank doesn’t disclose how much it earns from derivatives. During the first half of the year, it brought in $6.85 billion from fixed-income markets, including currencies and commodities, and $1.54 billion from equities. The figures include revenue from trading derivatives as well as cash instruments such as Treasuries and corporate bonds.

Flow Trading

About 20 percent of banks’ fixed-income revenue typically comes from flow trading of derivatives linked to corporate credit, interest rates and currencies, according to industry averages compiled by London-based analytics firm Coalition Ltd. That would equate to $1.37 billion, a decline of about 16 percent from the first half of 2013, based on figures disclosed by Citigroup.

Much of the increase in the notional value of the bank’s derivatives positions has been in contracts tied to interest rates, a business overseen by Andy Morton, who led the fixed-income unit at Lehman Brothers Holdings Inc. until September 2008. He reports to Paco Ybarra, head of Citigroup’s markets unit.

Citigroup seized market share in European swaps in recent years by offering low prices to win larger deals in countries including Germany, Italy and Austria, according to a person with knowledge of the matter who asked not to be identified discussing the bank’s strategy. The lower pricing could help explain why the value of derivatives deals rose as revenue fell.

Romero-Apsilos, the Citigroup spokeswoman, declined to comment on the bank’s tactics or earnings from the business.

Gross Notional

Citigroup’s $62 trillion of derivatives is what’s known as a gross notional figure, a raw tally of all contracts without adjusting for risk-reduction efforts. The amounts don’t represent money that changed hands and are used to calculate payments between parties. Banks prefer to focus on net figures, which are much smaller, in part because they can use offsetting positions to cancel each other.

That math relies on every party paying -- something AIG couldn’t do -- and on the trades moving in opposite directions, a relationship that can break down. In 2012, offsetting trades at a JPMorgan subsidiary in the U.K. led to more than $6.2 billion in losses when they moved in the same direction.

Citigroup reported $44.5 billion of derivatives assets at the end of June after backing out netting arrangements and collateral, according to filings with the Securities and Exchange Commission. JPMorgan reported $49.1 billion.

‘Break Down’

The tendency of banks to rely on each other to net positions means one firm’s failure can cascade through the system. The danger that one party can’t hold up its end of the deal is known as counterparty risk. It means even if positions are netted, every trade adds risk unless it’s fully backed by collateral, said Marti Subrahmanyam, a finance professor at New York University’s Stern School of Business.

“Always the concern with gross numbers is that netting could break down,” Craig Pirrong, a finance professor at the University of Houston, said in an interview.

That could put the government on the hook. More than 99 percent of the notional value of Citigroup’s derivatives were at its bank subsidiary, which holds customer deposits guaranteed by the Federal Deposit Insurance Corp., according to March figures compiled by the OCC.

To prevent another bailout and reduce losses, regulators have adopted a new leverage rule that allows for less netting of derivatives. The regulation, which takes effect in 2018, has pushed most of Citigroup’s competitors to trim their positions and gives the bank, with a higher ratio of equity to total assets than its peers, more leeway to expand.

Clearing Contracts

Regulators also are pushing for more of the contracts, including interest-rate swaps, to be backed by clearinghouses, which help safeguard the financial system by holding funds to back the transactions.

Derivatives sold by banks have hurt some customers in the past, contributing to the bankruptcies of Detroit and Jefferson County, Alabama, and forcing U.S. states and cities to pay at least $5 billion to end interest-rate swaps, according to data compiled by Bloomberg.

Sovereign governments would have to pay Citigroup $14.4 billion if over-the-counter contracts were settled immediately, while corporations and other nonfinancial entities would owe $24.7 billion, according to the company’s most recent filing. The figures don’t include money owed by hedge funds and other banks or contracts where Citigroup holds a losing position.

Rising Rates

About 55 percent of Citigroup’s portfolio is interest-rate swaps, which typically involve exchanging a floating-rate payment for one that’s fixed. Less than half of the bank’s interest-rate contracts are cleared, and while those in which the firm receives a fixed payment look safe in a low-rate environment, they can lose value when rates rise.

Reduced volatility associated with Fed policies to suppress interest rates is making it harder to profit from swaps. Firms typically generate revenue through the bid-ask spread, or the gap between what they charge customers and what they pay to hedge the trades. When a client wants to enter into a swap, the bank checks what it would cost to make the opposite trade with another party to offset exposure. Armed with that information, it offers a higher swap price to the client. Prices are measured in basis points, each of which is 0.01 percentage point.

Over the past six months, the average bid-ask spread on a five-year plain-vanilla interest-rate swap was 0.9 basis point, according to data compiled by Bloomberg. That’s down from 1.3 basis points in the same period last year. Banks typically expect to make about one-third of the spread in profit, said a former Citigroup trader with knowledge of pricing practices.

In credit derivatives, which are among the riskiest swaps contracts, Citigroup ranked fourth among the five biggest banks with $2.28 trillion in notional contracts open at the end of June, less than half of JPMorgan’s $5.1 trillion.

Increases in the notional value of derivatives are worth watching at banks because of the danger that a big trading party could someday fail, said Charles Peabody, an analyst at Portales Partners LLC in New York.

“Counterparty risk is a growing issue,” Peabody said.

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