Citigroup stockpiles ‘weapons of mass destruction’

Citigroup has carved out an an improbable niche, given its history of receiving the most federal aid among banks in the wake of the 2008 financial crisis.
The bank, which already has the most derivatives of any of its U.S. rivals, has been buying credit-default swaps from its European rivals, which are under growing pressure to quickly cut holdings of riskier assets.
Several weeks ago, Credit Suisse said it sold a portfolio of derivatives with a gross notional value of $380 billion, which helped the Swiss bank reduce its leverage exposure by about $5 billion. On Friday, Bloomberg News reporters Jeffrey Vogeli and Donal Griffin reported that Citigroup was the winning bidder.
Citigroup also bought credit derivatives with a notional value of about $250 billion from Deutsche Bank last year and was in talks to buy more, Bloomberg reported in March.
On the face of it, Citigroup seems to be zigging while rest of the financial universe is zagging. Not only have big Swiss and German banks been looking to slash holdings of credit-default swaps, but so have some big investment firms, including the one run by billionaire Warren Buffett, who famously labeled derivatives “financial weapons of mass destruction” in 2003.
More generally, big banks globally have lowered their holdings of credit derivatives drastically in the past decade, in large part because trading the contracts became less lucrative in the face of new regulations.
Citigroup, however, apparently senses an opportunity. About three years ago, it organized a team led by Vikram Prasad to manage risk and capital requirements across its credit businesses, according to a January article in Risk.net. Part of its job is to “collapse gross notionals and minimize counterparty and directional credit risk exposures,” according to the publication.
In other words, Citigroup’s team can essentially rip up some derivatives contracts if it has both sides of the trade, which reduces the capital cost of holding the swaps on its books. It can also justify having a team devoted to scrutinizing the billions and billions of dollars of contracts for any warning flags because of the sheer size and scale of its operation.
“We don’t just shut businesses down when they’re not in vogue,” Citigroup’s Prasad said in the Risk.net article.
Citigroup has been singularly aggressive in amassing derivatives, but it’s not alone. JPMorgan and Goldman Sachs have made similar efforts to buy such contracts from rivals. And Wells Fargo and Stifel Financial have recently started trading credit derivatives in Europe.
Credit derivatives can be useful for traders. The goal is to allow investors to bet on the creditworthiness of a specific company or a group of corporations without having to buy or sell the underlying bond. Several big investment firms are looking to revive the market so they can more quickly and easily adjust their positions.
But traders can get into serious trouble if they make a bad wager, and those problems have the potential to ripple more broadly through the financial system because they’re leveraged and rely on counterparties to make good on their promises. While central clearinghouses, which require both sides of a wager to post collateral, have reduced the counterparty risk, there’s still potential for these instruments to blow up.
Citigroup seems confident in its decision to plow ahead and become a leader in a much-maligned derivatives business. It’s an incredibly bold bet that could pay off big. But there’s a risk in amassing things that can explode. Sometimes they do.

— Bloomberg

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010