Citigroup's short sale on the MTS electronic platform is believed to have netted it Eu15m, but has cost the bank far more in reputation and legal headaches. The trade is being investigated by the UK's Financial Services Authority and six other European regulators.
In a leaked internal memo to all staff this week, Tom Maheras, head of Citigroup's global capital markets, referred to the Eu11bn sale of more than 100 government bonds and futures contracts and the almost immediate repurchase of Eu4bn of them as ?an innovative transaction that sought to access the liquidity in the European government bond markets?.
But he also said: ?We did not meet our standards in this instance and, as a result, we regret having executed this transaction. Unfortunately we failed to fully consider its impact on our clients, other market participants, and our regulators.?
The peculiar and defining characteristic of Citigroup's trade seems to be that there is no consensus on how it should be regarded.
Some of the borrowers whose debt was shorted appear to have been infuriated; so were some banks that lost money when their bids on MTS were hit.
But apart from those directly affected, the market as a whole has been more baffled than outraged.
The regulators' concerns about the trade have not been clearly defined, and the market will have to wait for one of the authorities to produce a judgment before there is much clarity about the transaction's legal status. But market participants believe the FSA, at least, is likely to examine the trade with an eye on its very loosely defined rules against behaviour that distorts the market.
It seems clear, now, that Citigroup broke some kind of taboo ? but unlike many market conventions, this taboo was not one that anyone could have described or formulated before the event.
Even a fortnight after the trade, several leading bond bankers in London told EuroWeek they did not believe the transaction was culpable. ?What Citigroup did may not be entirely honourable, but they are traders,? said one. ?It is only unfair because I didn't think of it.?
Since then, however, the market has witnessed the emergence of a new boundary of etiquette ? even though it is still very ill-defined.
Shuttle diplomacy
Maheras's email this week was the first firm point in the process of defining where the boundary of acceptability lies ? an unequivocal statement that the trade had been wrong and the bank would not do it again.
The impetus for Citigroup's climbdown has come, not just from regulators, but from leading bond issuers, in particular some of the sovereign borrowers whose debt Citigroup shorted.
Citigroup's senior debt bankers spent much of August shuttling between European capitals to reassure leading bond issuers that the bank could still be trusted as an adviser, underwriter and trading partner.
Few leading borrowers were keen to discuss the episode. But the Belgian, Dutch and Portuguese governments are believed to have been particularly irked.
One market participant also said the Italian government was furious because the MTS had been an Italian invention, designed originally for trading BTPs. ?They feel their baby has been mistreated,? he said.
Not all borrowers were alarmed, however. One funding official at a leading issuer told EuroWeek any wrongdoing by Citigroup would be judged by the regulator.
?If they have flouted the rules of the market they will be fined appropriately. It is not up to us to judge,? he said. ?Citigroup is a very good bond house, they have said they will fully co-operate with the regulator and do everything to rectify the situation. That is enough for us.?
Citigroup's defence
The interest in Citigroup's discomfort shown by the mainstream press has also built up the pressure on the bank, and particularly on Spiros Skordos, head of euro government bond trading in London.
EuroWeek understands that Skordos is still at the bank, but one Citigroup insider commented: ?I am sure this saga won't end pleasantly for some people because there is a question of judgement involved here.?
Citigroup has a defence and partial explanation for its actions, which it hopes will remove the worst suspicions of other market participants.
According to one well placed source, Citigroup's party line is that it had no intention to go out and sell the market and buy it back. If a bank wanted to do that, the argument goes, it would not do so in such a transparent way.
?Apparently the Citigroup traders involved overshot what they were supposed to do. The critical decision was the buyback, which was not part of the original strategy,? the source said. ?It was all part of a hedging operation. The traders said, ?there's liquidity in the system' and actually on the morning there was Eu11bn. They didn't think they would get all of it because they thought a lot of prices would be withdrawn when the market moved.
?They decided to hit everyone's bid but did not expect all the trades to go through, estimating an acceptance rate of 75% and sale of Eu8bn of bonds. But the MTS system worked perfectly and every single order was executed so they found themselves short. They took the speedy decision to go back and buy the market. If Citi had not bought back debt to cover its short position, the transaction would have been far less controversial.?
Some bankers were sceptical that this account excused the trade. ?The big banks can take a Eu500,000 hit without too much pain but the smaller houses, which focus on trading their own government's debt, would have been hurt a lot by Citigroup's trade,? said a global head of debt capital markets at one European bank. ?Citigroup must have been aware of the effect a trade of this magnitude would have on the banking community.?
MTS questioned
Another fallout from Citigroup's actions is that some market participants are calling into question the effectiveness of the MTS trading platform.
Here again, there are conflicting views. Some bankers have criticised sovereign borrowers' imposition on primary dealers of the obligation to make markets in their bonds for five hours a day, arguing that the system exacerbated the problem.
?Citi hit all the bids, all the trades were executed and this will have triggered auto hedging and all that sort of stuff,? said one banker.
But an opposing view is that the purpose of MTS is precisely to provide genuine liquidity.
Some parties in this camp blame Citigroup for unsettling the system and threatening the liquidity of government bonds.
But a third view is that the market should be pleased the trades went ahead as they did, as they proved the system worked. For this group, the worrying step was MTS's imposition of a trading cap on August 4, which was only lifted on September 10 in response to ?market consensus?.
According to this view, one of the main lessons to be learnt is that banks were ill-prepared. ?Banks should rapidly establish some kind of failsafe to protect them from this kind of operation in the future,? said one banker.
Perhaps most serious of all for the market, however, was the response from a representative of one of the Euromarket trade bodies, who feared the episode might bring down an unwelcome burden of extra regulation on the market ? ?a combination of vague principles and new principles imposed on the market without any notice?.
The official said: ?The FSA feels strongly about it and there may be more to it than has been made publicly available,? he said. ?They think it may be more egregious than the market expects. We do not know, for example, whether Citigroup was acting on its own when conducting the trade, or whether it was acting for a client. But whether their actions were legal or illegal, until we know all the facts, it is difficult to make a judgement.?
