The pre-eminent investment bank in the international capital markets is now facing a criminal inquiry in Germany, where its traders are alleged to have manipulated the Bund futures market on the Eurex exchange to prepare the ground for the Eu12bn bond shorting trade on August 2.
The crisis is more serious than simply an instance of rogue trading, because the memo suggests a strategy, not just to exploit markets for immediate gain, but to alter the way markets work, for the commercial advantage of the firm.
The memo concludes: ?Overall, these trades may help to reduce the markets reliance on the Bund future and turn the European Government bond market into one that more closely resembles the US government bond market.?
The consequences for Citigroup may be painful, but the episode is also likely to lead to a rethinking of the way liquidity is ensured for European government bonds.
Some traders privately admit that the Citigroup memo was right to draw attention to the way the EuroMTS government bond trading system forces dealers to provide liquidity for a wide range of issues. They argue that this can open the market up to disruption, such as that practised by Citigroup last year.
On August 2, the bank sold Eu12bn of bonds in two minutes before buying back Eu4bn at lower prices shortly after. The move outraged competitors but netted the bank a swift profit of Eu17m.
According to press reports, the leaked memo appears to have been sent on July 20 by Simon Wivell, one of Citigroup's European government bond traders, to a colleague in the same group, Daniel Leadbetter.
It appears to confirm that Citigroup's trading strategy last August involved not just selling a large quantity of government bonds in a very short time and then buying some back, but also pushing up the Bund future in advance.
Bafin, the German securities regulator, had already been investigating this alleged market manipulation, and referred the matter to criminal investigators last week.
This week Tom Maheras, Citigroup's CEO of global capital markets, and William Mills, CEO of the bank's corporate and investment banking group in Europe, the Middle East and Africa, put out a statement distancing the bank from the traders who had written the email.
?We regret these comments, which do not represent the views of the supervisors who approved the trade, nor of management,? they said.
The CEOs said Citigroup was cooperating with all enquiries and had given the UK's Financial Services Authority and other regulators ?all internal communications on the trade? in September.
Crucially, Maheras and Mills still insist that Citigroup's traders did not intend to sell more than the cash position of Eu8bn of bonds that they held, but underestimated how many bids they would hit on EuroMTS and sold Eu12bn by mistake.
Yet the memo outlined a plan to profit from liquidity differences between Bund futures and cash bonds traded on EuroMTS.
?When there is a liquidity imbalance... we drive up the Bund future then hit out all the cash [bids] on MTS,? said the memo, the contents of which have been confirmed to EuroWeek. ?The only dealers who will be able to replicate these trades are those with very good access to MTS (primary dealers in most Euro zone markets). The ones, which will suffer, are the smaller primary dealers. So over time, this may help to kill of some of the smaller dealers.?
Bankers outside Citigroup greeted the chief executives' defence with scepticism.
?Although it may not be illegal, it is certainly unethical, because it undermines what many peripheral sovereigns are trying to do and makes a mockery of the MTS market,? said the head of supranational, sovereign and agency origination at one European bank this week. ?Everyone is anxious to maintain the perceived liquidity of these bonds and to make it look efficient. It has been a long process and people have spent a lot of money and effort on MTS.?
The head of rates trading at another bank said: ?If they [Citigroup] had these orders and sold them into MTS then it is a fair trade and no one could say otherwise. But if they were ramping the market only to spike it back down again, then frankly I think they should be banned from the market and banned from business with issuers.
?It is possible they made a mistake, but we were all calling [on August 2] to ask if they had made a mistake and we would have helped them out. We were all left long. But then they used exactly the same mechanism to buy it back.?
?That morning we sat and watched the futures market go up and thought ?it's the holidays, trading is thin, what is going on?'? said the head of rates trading at a European bank this week.
At 10.28am, the bankers found out as Citigroup hit bids all over the MTS market.
?Between 10.28.59 and 10.29.01 we executed over Eu600m in securities,? said a senior government dealer, ?and there are 10 other banks like us.?
In a memo to staff last summer, Maheras referred to the trade as ?an innovative transaction that sought to access the liquidity of the European government bond markets?. But he said that the trade had not met Citigroup's standards and was regrettable.
Citigroup would not comment on reports that six traders named this week as having been involved in the trade had been suspended.
The UK's FSA prohibits ?behaviour likely to give a false or misleading impression as to the supply or demand, price or value of an investment?.
The managers that approved the trade would have been well aware of the penalties for market manipulation, and should have had on hand adequate documentation to show that the motivation for the trades was legitimate.
The FSA's enforcement division is conducting a formal investigation into the trade.
Many of the large European bond dealers would like to be free of what they see as the shackles of the MTS market.
They complain that MTS's chief executive Gianluca Garbi has persuaded government issuers to insist that their primary dealers and bookrunners provide market making commitments that leave the dealers exposed to events like those of last August.
MTS's participants are all banks and dealers, not investors. Those who use it say they quote different prices for clients, so investors do not necessarily benefit from the liquidity. MTS counters that its system makes the whole market trade tighter, reducing costs for all.
For the big trading floors, with the wherewithal and systems in place to price and trade large numbers of securities, MTS offers little upside. Instead, it forces dealers to disclose the rough price they are quoting for a security to other dealers, and exposes them to potentially large risks.
Since Citigroup's trades, MTS has introduced a system of ?linking?. Dealers can, for instance, link five products, and if they are hit on one they do not have to make a price on the other four.
But regulators may also now ask whether the MTS system exposes banks to too much risk. Many of the larger primary dealers in Europe would welcome a curbing of MTS's power, but they may also end up having to carry more capital in case their bids are hit.
?There is not a manager in the government bond business that has not wondered whether to put capital aside against the risk from the liquidity mirage that MTS obliges us to create,? said a senior government bond trader in London. ?This obligatory market making is extremely dangerous. The fact that Citi was able to sell over Eu12bn in two minutes gives you an idea of the liquidity that we, the Street, provide. The futures market is a good indication of risk appetite and there is a liquidity imbalance between it and the MTS market.?
In the US Treasury market, there is huge liquidity for recently issued or on-the-run bonds, which trade in very large blocks. However, after a while those bonds are traded less and less, before fading from view as they are soaked up by buy and hold accounts.
?Why should a 30 year issue issued 29 years ago have the same liquidity as a bond issued one year ago?? asked one trader this week. ?It is not a healthy exercise, nor is it using our capital in a sensible way.?
