Citibank 2015 Annual Report Download - page 253

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23. DERIVATIVES ACTIVITIES
In the ordinary course of business, Citigroup enters into various types of
derivative transactions. These derivative transactions include:
• Futures and forward contracts, which are commitments to buy or
sell at a future date a financial instrument, commodity or currency at a
contracted price and may be settled in cash or through delivery.
• Swap contracts, which are commitments to settle in cash at a future date
or dates that may range from a few days to a number of years, based on
differentials between specified indices or financial instruments, as applied
to a notional principal amount.
• Option contracts, which give the purchaser, for a premium, the right,
but not the obligation, to buy or sell within a specified time a financial
instrument, commodity or currency at a contracted price that may also be
settled in cash, based on differentials between specified indices or prices.
Swaps and forwards and some option contracts are over-the-counter
(OTC) derivatives that are bilaterally negotiated with counterparties and
settled with those counterparties, except for swap contracts that are novated
and “cleared” through central counterparties (CCPs). Futures contracts
and other option contracts are standardized contracts that are traded on
an exchange with a CCP as the counterparty from the inception of the
transaction. Citigroup enters into these derivative contracts relating to
interest rate, foreign currency, commodity and other market/credit risks for
the following reasons:
• Trading Purposes: Citigroup trades derivatives as an active market
maker. Citigroup offers its customers derivatives in connection with their
risk management actions to transfer, modify or reduce their interest rate,
foreign exchange and other market/credit risks or for their own trading
purposes. Citigroup also manages its derivative risk positions through
offsetting trade activities, controls focused on price verification, and daily
reporting of positions to senior managers.
• Hedging: Citigroup uses derivatives in connection with its risk
management activities to hedge certain risks or reposition the risk profile
of the Company. For example, Citigroup issues fixed-rate long-term
debt and then enters into a receive-fixed, pay-variable-rate interest rate
swap with the same tenor and notional amount to convert the interest
payments to a net variable-rate basis. This strategy is the most common
form of an interest rate hedge, as it minimizes net interest cost in certain
yield curve environments. Derivatives are also used to manage risks
inherent in specific groups of on-balance sheet assets and liabilities,
including AFS securities and borrowings, as well as other interest-sensitive
assets and liabilities. In addition, foreign-exchange contracts are used to
hedge non-U.S.-dollar-denominated debt, foreign-currency-denominated
AFS securities and net investment exposures.
Derivatives may expose Citigroup to market, credit or liquidity risks in
excess of the amounts recorded on the Consolidated Balance Sheet. Market
risk on a derivative product is the exposure created by potential fluctuations
in interest rates, foreign-exchange rates and other factors and is a function
of the type of product, the volume of transactions, the tenor and terms of
the agreement and the underlying volatility. Credit risk is the exposure to
loss in the event of nonperformance by the other party to the transaction
where the value of any collateral held is not adequate to cover such losses.
The recognition in earnings of unrealized gains on these transactions is
subject to management’s assessment of the probability of counterparty
default. Liquidity risk is the potential exposure that arises when the size of a
derivative position may not be able to be monetized in a reasonable period of
time and at a reasonable cost in periods of high volatility and financial stress.
Derivative transactions are customarily documented under industry
standard master agreements that provide that, following an uncured
payment default or other event of default, the non-defaulting party may
promptly terminate all transactions between the parties and determine the
net amount due to be paid to, or by, the defaulting party. Events of default
include: (i) failure to make a payment on a derivatives transaction that
remains uncured following applicable notice and grace periods, (ii) breach
of agreement that remains uncured after applicable notice and grace periods,
(iii) breach of a representation, (iv) cross default, either to third-party debt
or to other derivative transactions entered into between the parties, or, in
some cases, their affiliates, (v) the occurrence of a merger or consolidation
which results in a party’s becoming a materially weaker credit, and (vi) the
cessation or repudiation of any applicable guarantee or other credit support
document. Obligations under master netting agreements are often secured
by collateral posted under an industry standard credit support annex to the
master netting agreement. An event of default may also occur under a credit
support annex if a party fails to make a collateral delivery that remains
uncured following applicable notice and grace periods.
The netting and collateral rights incorporated in the master netting
agreements are considered to be legally enforceable if a supportive legal
opinion has been obtained from counsel of recognized standing that provides
the requisite level of certainty regarding enforceability and that the exercise
of rights by the non-defaulting party to terminate and close-out transactions
on a net basis under these agreements will not be stayed or avoided under
applicable law upon an event of default including bankruptcy, insolvency or
similar proceeding.