History of Citibank Derivative Debacle - Case Study Example

History of Citibank Derivative Debacle

Derivative instruments have been known to hedge against fluctuation of prices in the market; however, in some cases, these instruments may result in huge losses in case of failure. There have been several derivative debacles in the global business arena; some affecting individual institutions while others affecting more than one institution. The Citibank derivative debacle is an example of one, which affected a single institution causing huge losses. Citibank was the second largest commercial bank in America when the loss was incurred, thus its derivative debacle received much publicity and called for analysis into the events that led to the scandal. The $8 million loss was announced on 19thJune, 1965 (Laurent 178). So many questions arose as a result of this announcement including how such a large bank with 177 offices in 58 countries allowed a single employee to bet on a large amount of money resulting in such huge losses. Questions as to how the loss came about given that at that time currency prices were quasi-fixed also needed to be addressed. Further, how the transaction escaped detection from the bank account department is another area to explore.

First, it is important to understand how the fixed exchange rate system of Briton Woods used to work in the 1960s when the Citibank incurred the foreign exchange loss. The prevailing exchange rate in industrialized countries between the year 1944 and 1971 was based on the dollar (Singleton and Schenk 8). At that time, gold could only be traded in dollars with $35 being the fixed price per ounce. Therefore, the US dollar could be measured in terms of gold ounces. Other currencies ensured 0.75% ceiling and floor of their currency’s par value against the dollar, thus having compared to gold through the dollar. As a result, most banks kept gold reserves as a measure of wealth. Today, this system has changed, though some currencies are still pegged to the dollar, but the dollar is no longer measured in terms of gold. The price of gold is also no longer fixed, thus is a factor subject to market forces of demand, supply, inflation and much more.

Further, different from the physical market organized for the commodity, stocks and bonds, trading rooms make up the foreign exchange market connected through a network mostly present in brokerage firms and banks. In the 60’s the connection between banks and brokerage firms was done through telephone calls. Therefore, cable companies had a special role to play in the exchange process, as they were responsible for connecting the traders through the telephone call. The connection for foreign exchange trade was specifically designed for that purpose, so that there was a direct link between banks and brokerage firms through a single call. Further, the call was well organized to allow more than one trader to listen to the transaction at the same time, thus enabling many traders to trade on the exchange.

Citibank was among the banks, which were directly involved in the trade where it mostly traded in fifty currencies with the majority of the trade being carried out between the dollar and sterling pound. The bank conducted upto 500 transactions on a daily basis with a net value of upto fifty million dollars. Foreign exchange trade was among the core businesses of Citibank as it was its leeway to other countries with other services coming in second after foreign exchange trade. Most of its profit from foreign trade primarily came from carrying out exchange on behalf of corporate customers who mostly traded in who amount of money.

As at 1965, the value of the starling pound pegged to the US dollar traded at $2.80 for £1. The international monetary fund and the central bank of interested countries were responsible for setting the par value of a currency. Determination of par value was assumed to be a public commitment, thus rarely were the par value of currencies altered. However, Briton Wood allowed some level of flexibility in the exchange rate of currencies to a certain limit. For example, the bank of England, where the pound was concerned would set a price floor for the currency at 0.75% of the par value, thus the pound could not be devalued below that point. The bank also set a price ceiling at 0.75% above the par value, thus the value of the pound would range from 0.75% below $2.80 and 0.75% above $2.80.A variation of the spot price beyond these limits would see the bank of England step in to bring back the price within the range by either buying or selling the sterling pound according to the situation in the market. Thus, the bank of England had enough sterling reserve to maintain its par value within its set limits (James 92).

Most banks and other currency traders have trading limits that govern transactions by traders to avoid adverse effects of a single transaction on the operation of the institution. A good example is setting the limit to a single foreign exchange transaction to a maximum of $10 million, while no single trader can hold a net position of above $30000 within the day. The institutions are also keen to ensure at close of business, the net position of all traders is approaching zero to avoid unexpected trade surprises at the beginning of the next trading day (Braithwaite and Peter p. 91).

With this information, how then did the Belgian trader manage to gamble such a large amount of money causing huge losses to the bank? The Belgian trader made a speculative bet on the pound to the effect that the pound would not in the next twelve to eighteen months. Resultantly, he decided to use the bet in a profitable trade where he bought the sterling pound forwards at prices as low as $2.69=£1 with expected maturities of between nine to eighteen months. Whereas the bank of England was closely monitoring the price ceiling and floors for the pound, it increased interest rates, creating a loophole for the pound’s value to go below the price floor thus the trader bought the forwards at rates lower than the price floor. Though an increase in interest rates was meant to encourage short-term inflow of capital into the country, it had adverse effects on the forward rates given that the forward rate discount kept increasing with the increase in interest (Bordo, Macdonald, and Oliver 438).The fall in the value of the pound is visible in the graph (exhibit 1) around the 1960s due to increasing interest rate to increase short investment.

However, despite facing an attractive gambling opportunity with the increase in interest rate, the Belgian trader faced one major hurdle to his speculative gamble; there was a limit as to the amount he could bet thus could not bet on millions of dollars as it is against the bank’s trading requirement. Through his purchase of one-year forward sterling pound, he created a sterling long asset position, which required a short liability position of the same value but with different maturity to neutralize the position. To achieve the required neutral position, the trader sold starling forward for a short period of thirty and sixty days; purchases of 270 and 360 days were also made by the trader thus retaining the balance required at all times. Resultantly, the trader was able to escape drawing the attention of the bank’s controller over his betting trade on the sterling pound forward (Beder and Marshall sec.8).

Further, it was more difficult to notice his long asset position with the pound given that in the beginning 30 days; the actual cash flow loss would not be easily noticed. The sterling forward of $2.77 he had sold was due for delivery at the end of October where he would get payments at $2.78 given that the sterling pound had not devalued just as he had predicted. As a result, the transaction would generate a negative cash flow of £1million which, given the large number of transactions carried out within a day in the bank, the figure would balance out eliminating any suspicion of his trading activities. Soon after delivery of the forward, the trader would then proceed immediatelyto sell another set of sterling pound short position to neutralize his long asset position as required by the regulations. With every time he liquidated his short-term asset position, he incurred losses, but within manageable limits as he had presumed even as the forward rate discount fell deeper with an increase in interest rates. His loss equated the differentiation between the forward rate and the spot rate of the sterling pound thus kept increasing with increases in interest rates.

The bet on having the losses from the short-term position being less than the benefit from the long-term asset position was the motivating factor for the trader to engage in the trade. The higher yield of long-term position motivated the trader as it was always higher than several short-term positions that is equal to the long-term position due to the risk involved in the long-term position. Therefore, irrespective of the number of times the trader floated the short term forwards the trader would still earn higher return on his long term asset position as long as the sterling pound is not devalued.

However, despite his effort, the trader did not enjoy the opportunity to reap his return on the long asset position. A simple phone call to the person in charge of Citibank’s foreign operation exposed the whole scheme. A partner in Samuel Montague British firm happened to be a friend of the head of the credit department at Citibank thus made a direct call raising concern over the expected $100 million with Citibank, which was due for maturity in a week. This amount was about ten times the limit on the contract the Belgium branch of Citibank was allowed to handle. Resultantly, the whole scheme was revealed by the controller shortly after thus bringing to an end the speculative position through liquidation of the of the long asset position. The whole debacle ended up with Citibank incurring a loss of upto 10% of its entire annual profit from all its branches worldwide combined (Jacque 39).

Although the bank was able to earn profit in that financial year, the loss was too much to go unnoticed. Further, the possible effects of the debacle on the economy cannot be ignored given the large size of the customers banking with Citibank at that time. In America, it was he first city bank in the country and one of the largest financial institutions thus huge losses incurred would impact on the economy directly with a possibility of the impact spreading over to other sectors of the economy. Although the situation was arrested on the last minute minimizing the losses to $8million, the debacle was a learning opportunity for Citibank and financial institutions to avoid such incidences in future.

First, the banking institutions should rely on narrative of daily transactions as opposed to summary of the transactions as was the case in the Citibank derivative debacle. The bank simply relied on daily transaction summary to determine the state of the bank’s operations on a daily basis but failed to go into the details of the specific transactions. As long as a balance between the debit and credit was achieved, no further details were sought. Resultantly, the trader was able to take advantage of this loophole by maintaining a large asset position and selling short term forwards to balance out. Separation of the front and back office operations of the bank is also necessary to help monitor foreign exchange trading activities on a dailybasis. Through the combined accounting system, the Belgium trader was able to maintain his position as the negative cash flow easily balanced out with other transactions of the day. Separation would have brought his transactions to light.

Moreover, monitoring of individual trader’s trading activities in foreign exchange is important to a bank. Maintaining of the aggregate position required by the bank should not be enough requirements for the transactions by a trader to be validated. It is the duty of the bank to establish a control system where individual operations of every trader who participate in trade can be monitored on a daily basis. The trading accounts of traders need to be monitored to establish the source of funding, monitor every transaction to ensure they tally with the recorded outcome and ensure such speculative transactions as those carried out by the trader in the Citibank case does not occur. If such monitoring was done in city bank, the traders long term asset position could have been discovered thus preventing the loss it caused.

Further, it is necessary to put a limit to the amount of losses that can be incurred in trading. Through the loss limit, the bank can be able to notice any abnormal transaction generating higher losses than the set limit leading to investigations. Loss limit would have brought to light the speculative trade by the Belgium trader way in advance thus arresting the situation before it got out of hand causing the huge losses.

Conclusively, Citibank derivative debacle exposed the major weaknesses in the banking sector derivative trade. A single trader was able to devise a scheme that would see him earn huge cash by maintaining a long term asset position while selling short term liabilities. The long term assetposition would raise higher return than the loss on the short term liability position of the trader. The speculative position resulted in huge losses for the bank but also exposed the loopholes in derivative trading that needed to be sealed to avoid such an occurrence again. Among the steps to improve control are monitoring daily transactions using the transaction narrative, monitoring individual traders trading activities and setting a limit to the amount of loss that can be incurred in trade.

Exibit 1: sterling pound and dollar exchange rate 1915-2015

Source: http://www.miketodd.net/encyc/dollhist.htm