Risk Awards 2016
Flow will always be a four-letter word, but it only became a dirty one in credit derivatives markets following the financial crisis. The freezing of the market for synthetic collateralised debt obligations removed one of the structural supports for flow trading, and regulators have since piled on the pressure. For single-name credit default swaps (CDSs), gross notional outstanding slid to $7.1 trillion in mid-December – it stood at $15.4 trillion in the fourth quarter of 2008 – and trading volumes have fallen an estimated 30% year-on-year.
So, it's unusual to find a bank that still likes the business. At Citi's New York office, single-name CDS trading volumes were up 15% in 2015, confounding the broader market decline. The bank has also emerged as a strong advocate of structural changes to revive the CDS market – a development that would benefit its own trading desks, clearly, but also the buy-side firms that still see the product as an efficient way to hedge or express views on credit.
"We consider single-name CDSs to be an integral part of our overall credit business," says Brian Archer, head of global credit trading at Citi in New York. "A large number of our biggest clients still want to trade the product and use it to move risk. We have the appropriate resources in place to service that demand."
Three years ago, Citi separated its cash and derivatives traders and created teams dedicated to trading CDS single names and indexes. "We felt we needed traders solely focused on derivatives in order to respond to the structural changes in the market, such as the introduction of new clearing and capital rules," says Archer.
We consider single-name CDSs to be an integral part of our overall credit business… We have the appropriate resources in place to service that demand
Brian Archer, Citi
The firm has nine traders – five in New York and four in London – focused on single names, and another team of 11 trading CDS indexes. The move has paid off in the past two years.
Citi is now seen by clients as a top-three market-maker in single-name CDSs in both North America and Europe.
It has also established itself as a top market-maker in CDS indexes, with a 25–30% share of average daily volume on Bloomberg's swap execution facility (Sef), which accounts for an estimated 85% of CDS index volumes.
At around the same time it set up specialist teams of CDS traders, Citi also created a centralised function to handle capital, counterparty and portfolio risk optimisation across its credit businesses. That team – led by Vikram Prasad, head of correlation and exotics trading at Citi in New York – seeks to collapse gross notionals and minimise counterparty and directional credit risk exposures across the business, while optimising metrics such as return on capital and margin posting as far as possible. It played a key role in allowing Citi to buy a roughly $250 billion notional portfolio of single-name CDSs from Deutsche Bank when the German dealer chose to exit the non-cleared CDS market in 2013. Further acquisitions followed last year.
The centralised team allows Citi's traders to concentrate on trading and managing client relationships. "The capital rules are a burden on the business and we have to ensure our activities are scaled appropriately," says Brian Funk, the bank's New York-based US head of single-name CDS trading. "We rely heavily on the capital and counterparty optimisation group to put us in a position to continue moving forward with the business. Those efforts are ringfenced within Vikram's group so it doesn't affect our traders directly."
"You can't have every trader obsessing over every capital measure," says Prasad. "By giving that responsibility to a dedicated team, we're using our resources in a more efficient way."
The Basel III leverage ratio – and US supplementary leverage ratio – is the binding constraint on CDS trading desks. For leverage ratio purposes, derivatives exposures are calculated by applying a conversion factor to the gross notional of a transaction. Credit derivatives are subject to punitive conversion factors – 5% for investment grade and 10% for high yield, compared with 0.5% for a five-year interest rate swap. The rules also limit netting – if the protection a bank sells is longer in maturity than the protection it buys, the full notional of the trade is added to the firm's leverage exposure.
"Gross notional can be a constraint for every part of our business, whether it's credit trading, emerging markets or structured credit. If you can't effectively manage your gross notional, your business grinds to a halt," says Prasad.
Rather than have each business within credit markets manage its gross notional separately, which would entail calling each counterparty individually to identify and collapse offsetting trades, Prasad's team handles this across all business lines.
"We speak to all the other dealers and find ways to collapse gross notional as quickly and efficiently as possible. We've done some big transactions that have created extra capacity for the business. That helps credit trading, emerging markets and structured credit, so none of those teams feel constrained from a gross notional perspective," says Prasad.
You can't have every trader obsessing over every capital measure. By giving that responsibility to a dedicated team, we're using our resources in a more efficient way
Vikram Prasad, Citi
The capital and counterparty optimisation group wiped out several hundred billion dollars of gross notional in single-name CDSs in 2015, allowing the bank to take on a significant amount of new business.
Citi's approach to the single-name CDS business is winning plaudits from clients. "They are our most active counterpart in CDSs by a wide margin," says a credit trader at a New York-based hedge fund. "They are the most constructive, they have the most competitive pricing and the most offerings, and they can get trades done at very short notice."
That is echoed by a New York-based credit trader at a large asset management firm: "Unlike other banks, they believe the single-name CDS market has a future. Their efforts to support the business have put them streets ahead of the competition."
Having put its own house in order, Citi has been championing structural changes aimed at making single-name CDSs more capital-efficient.
For instance, in 2013, Citi was the first dealer to propose abandoning quarterly roll dates for single-name CDSs and moving to a bi-annual schedule – aligning it with CDS indexes, and potentially improving fungibility and liquidity for the product.
"We felt more simplification and standardisation was the way to get more people involved in CDSs on a larger scale," says Funk. "Moving from three- to six-month rolls was one way to do that."
The International Swaps and Derivatives Association backed the proposal in July, with the change officially taking effect on December 20, 2015.
Citi was also instrumental in convincing buy-side firms to voluntarily clear their single-name CDS trades in the absence of a formal regulatory mandate. As the firm spoke with clients about ways to improve the market, "one of the ideas that came up repeatedly was voluntary clearing," says Christopher Perkins, global head of OTC derivatives clearing at the bank in New York.
Following those discussions, on December 16, a group of 24 large US buy-side firms – including asset managers like BlackRock and Pimco along with hedge funds such as AQR, BlueMountain and Citadel – pledged to begin voluntarily clearing their single-name CDSs in the absence of a regulatory mandate.
Clearing delivers a number of benefits for end-users, says Archer – it mitigates counterparty risk, allows cross-margining of single names and indexes.
CDS users were also motivated by a bigger objective, says Archer: "There is an acknowledgement by the client base that clearing is a way to reinvigorate the market. That's what really pushed them to accept it."
One step Citi has not yet taken is to price cleared and non-cleared single names differently. "It's something market participants are discussing. We will make a decision on it in due time," says Archer. "It probably makes sense as more and more participants clear. From a capital perspective, if we have a bilateral trade and the offset on our books is a cleared trade, that's really inefficient for us. So as more and more clients take up clearing, I expect we'll see differentiated pricing. We're not there yet."
Algorithmic trading has put us in a position to remain competitive as margins compress and execution times drop
Jay Mann, Citi
Citi is equally committed to its CDS index trading business. The firm went live with a new market-making algorithm in 2012 that now handles around 25% of its average daily trading volume in CDS indexes. "Algorithmic trading has put us in a position to remain competitive as margins compress and execution times drop," says Jay Mann, co-head of global index, option and tranche trading at Citi in New York. "The execution window for a CDS index trade was 35–45 seconds in 2004. Now, it's three seconds and shrinking."
The algorithm was built from the ground up by a dedicated team of quants working in conjunction with Citi's credit traders. "We tried to download our cumulative life experience of trading into these systems. It's an ongoing process – we have bi-weekly meetings where we look at each individual ticket and try to figure out how the algorithm can respond more efficiently," says Mann.
The algorithm streams prices for ticket sizes up to $10 million for high yield and $50 million for investment grade. Traders handle pricing for tickets between $10 million and $50 million for high yield and $50 million to $250 million for investment grade. Citi also quotes prices in sizes up to $100 million for high yield and $500 million for investment grade.
"It's not efficient for a manual trader to spend their time on commoditised products. Having a market-making algorithm – not an execution algorithm, but one that makes two-way markets and provides liquidity to clients in smaller size – has allowed us to increase speed of execution and reduce trader burden, so we can spend more time on block-size transactions," adds Prasad.
Clients concur. "Right now, they're the largest two-way market-maker on the screen in high yield and investment grade, and they have the tightest bid-offer for smaller size," says a trader at a large alternative asset management firm in New York.
Citi's ambitions in credit are not limited to CDSs. The firm maintained its leading position in emerging markets and structured credit last year, despite a drop in client demand as volatility spiked. The emerging markets credit trading business, led by Marc Pagano, is ranked as a top-three player in Asia and Latin America by Greenwich Associates. Its structured credit business, headed by Mickey Bhatia, maintained its position as the top arranger of collateralised loan and debt obligations, with 32 deals under its belt through the first three quarters of last year, according to SCI.
Several clients pointed to Citi's strength across derivatives, emerging markets and structured credit as a differentiating factor. "There are other dealers that are strong in one or two of those businesses, but none are as good as Citi in all three," says a credit trader at an asset management firm in New York.
Citi's Prasad insists maintaining a comprehensive credit franchise is central to the firm's strategy. "The market is cyclical in nature and products are attractive to clients at different points in the cycle. Structured products are more popular when credit spreads are tight, and when the market is volatile, flow products are more popular," he says. "But we don't just shut businesses down when they're not in vogue. We continue to support them and take a more holistic approach to serving clients."