PRESENTATION TO
Financial Institutions
Risk Management Conference
Future of Financial Innovation
Gerald A. Beeson
April 14, 2008
Future of Financial Innovation
From Vantage Point of Market Participant
There is much needed innovation within the derivatives market and many innovations of the
past decade have been shut down, perhaps permanently, in risk transfer and funding
 Derivative Markets
 Continuing problems and hazards with respect to liquidity, transparency, valuation and
counterparty credit risk
 Securitization Markets
 Continued impairment of the securitization market will hinder the transference of risk between
providers of credit and pools of available capital
 Funding Markets
 Beginning to recover after the dislocations of Q3/Q4 and the aftermath
2
Derivatives Market
Market Participant Observations
 “Risk is essential but it needs to be supported. It’s all about the plumbing.”
 Drive toward central clearinghouse (central risk pool) where derivative contracts can be
submitted, matched, cleared and settled
 Resistance to changes that yield a standardized product that creates a more efficient market
 Management of gross notional exposures and mitigation of operational risks
 Valuation concerns
 Valuation reconciliation between counterparties, particularly during periods of market stress
 Counterparty credit concerns
 Utilization of collateral posted in the ordinary course of their capital markets activities
• Conversely, counterparties have credit risk that they want to mitigate
 Movement to exchange based and cleared products eliminates this asymmetrical benefit
• Relieves potential “run on the bank” concerns seen in 2008
3
OTC Margin Dispute Trends Example
10
9
8
Scale Factor
7
6
5
4
3
2
1
0
Jul
2008
Aug
Sep
Oct
Nov
4
Dec
Jan
2009
Feb
Mar
Apr
Commitment to Innovative Solutions
5
Impaired Securitization Markets
6
Shutdown of the Securitization Market
Market Participant Case Study
 In 2001, Citadel launched a Bermuda based reinsurance business offering large scale,
collateralized risk transfers of property and catastrophe risks
 Positive performance as business grew (ex 2005); however, needed longer term risk
management and capital efficiency strategy in order to grow
 Asymmetrical return distributions in best and worst cases
 Experience in capital markets led to offering of insurance risk-linked securitization
with several benefits
• Active market demand and diversified investor base
• Fully collateralized protection
• Multi-year coverage
• Fixed pricing terms
 Placed largest bank debt indemnity deal done to date in July 2007 at $500 M
7
Alignment of Interest
 Citadel and investors’ interests remain
aligned throughout the term of the
transaction
Pro Forma Cedants Exposure
Limits Written
Cedant Retention
 Citadel must cede all policies within the
subject business lines – no potential for
adverse selection
$1,200mm/P(E) =
0.2 bps
$1,015mm/P(A) =
0.7 bps
Term Loan A
Net Losses
 At inception Citadel funds retained
100% of the first approximately
$650mm of losses each year
 Cedants covenant to retain at least 50%
of ground up losses below the
securitized layer
Term Loan B
$875mm/P(A) = 15.6 bps
Term Loan C
$710mm/P(A) = 90.4 bps
Term Loan D
$650mm/P(A) = 140.0 bps
Cedant Retention
 Losses above the securitized layers are
retained by Cedants
8
Risk Exposure
All Peril Occurrence PMLs
Analysis of the pro forma portfolio for calendar year 2007 illustrates per occurrence PMLs
Term Loan A Exhaustion
$1,200
Term Loan A Attachment
$1,050
Term Loan B Attachment
$805
$684
Term Loan C Attachment
Term Loan D Attachment
$710
$650
$596
$532
$450
$307
20
50
100
250
Return Period (yrs) Per Occurrence PML
Note: MPCI and property per risk are not included in the above analysis.
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1,000
$875
25,000
Low Probability of Loss Impact
Remodeled Key Historical Events1
Term Loan A Exhaustion
$1,200
Term Loan A Attachment
$1,050
Term Loan B Attachment
$875
Term Loan C Attachment
Term Loan D Attachment
$710
$650
$350
$239
$36
$63
$39
$28
$28
AndrewNorthridge Lothar Charley Frances Jeane
(1992) (1994) (1999) (2004) (2004) (2004)
$27
$45
Ivan Katrina Rita
(2004) (2005) (2005)
$48
Wilma
(2005)
1. 2004 and 2005 hurricanes are modeled using RMS recommended event IDs . Events prior to 2004 are based on stochastically generated storms that are representative of the historical
events. Loss figures gross of reinstatement premiums.
2. Katrina does not include marine gulf or flood.
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Projected Earnings Distribution
(Combined Gross/Net)
Projected Earnings Distribution as of 1/1/08
400
200
Earnings ($m)
Total Gross of Emerson
(200)
Key Percentile
Percentile Gross
Net
0.000%
292
271
50.000%
220
199
75.000%
144
123
90.000%
(4)
(25)
95.000%
(143)
(164)
98.000%
(297)
(287)
99.000%
(399)
(320)
99.600%
(502)
(355)
99.800%
(558)
(370)
99.900%
(610)
(382)
99.998%
(851)
(459)
Expected
169
150
Total Net of Emerson
(400)
(600)
(800)
50%
55%
60%
65%
70%
75%
80%
Cumulative Probability
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85%
90%
95%
100%
Final Analysis
Q4 2008 Considerations
 Cost of capital
 Capital structure 75% equity and 25% debt
• Debt layer was 3 year term structure at L+100 up for renewal in May 2009
 Consideration of increased capital commitment relative to returns generated from other businesses
 Securitization Market
 Effectively closed to innovative risk management transaction like Emerson Re
 Asymmetrical upside/downside relationship would return to the business
 Decision to exit the business
12
Funding Markets
View from the Eye of the Storm
13
Business Architecture
Citadel Investment Group
Asset Management
Capital Markets
Alternative Asset Management
• Multi-strategy hedge funds
• Planned single-strategy hedge funds
Market Making /
High Frequency Trading
Citadel Solutions
• Largest options specialist
• Largest retail equity
market maker
• Fund administration
business offering
premium, tailored services
to hedge funds
• Citadel accounts for
approx 30% of US
options trading volume
and over 8% of US equity
volume
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Citadel Derivatives Group LLC
A Market Leader in Equities and Options
Embracing “disruptive” technologies to improve liquidity and
transparency in the capital markets
8% of US Equity Volume
29% of US Options Volume
Sept 2008 data
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End of an Era
Disappearance of the “Shadow Banking System”
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Treasury – Liquidity Management Philosophy
Ensure the provision of adequate liquidity to meet balance sheet funding needs
through all market environments.
Active capital and balance sheet planning
• Targeting the relationship between aggregate risk limits
and capital required to support them
• Balance sheet liquidation model: a business unit /
strategy analysis of Citadel’s ability to reduce risk
positions
Liquidity Reserve
• Maintenance of a pre-funded liquidity reserve to meet
contingent cash needs of Citadel’s balance sheet
Liquidity Management
• Model Citadel’s liquidity ladders to incorporate the
following parameters
• Mark-to-Market exposure from stress events
• Expiration of committed funding facilities
• Accelerated Capital Calls
Counterpart Diversity
• Across both financing and trading counterparts
• Broad distribution of exposures to maintain operational
flexibility in a disruptive market environment
• Diverse financing arrangements across highly rated
counterparts in robust, efficient structures
• Reductions in the Balance Sheet of the Firm
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Crowded Financing Trade
Sources of
securities
Sources of
cash
Customer Supply
Mutual Funds
Securities
Lenders
Internal
Dealer Cash
Prime
Brokers
Beneficial Owners/
Bank Portfolios
Securities Lenders
Cash Reinvest
Dealer Desks
Direct
US
Commercial Banks
Hedge
Fund
Hedge
Fund
Hedge
Fund
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Hedge
Fund
Hedge
Fund
Non-US
Commercial Banks
Treasury – Centralized Execution
Centralized execution of secured funding provides substantial scalability and
efficiency. It also allows PMs to focus on portfolio construction and Treasury
specialists to focus on funding.
 Central Funding Approach
 Assets are funded centrally through Treasury.
 Close collaboration to determine the long term
funding needs of the business.
 Centralized funding through a diverse
network of sources of cash and collateral.
 Not reliant on PB model
 Direct relationships with sources of cash and
collateral
Sources of
securities
Sources of
cash
Customer Supply
Mutual Funds
Securities
Lenders
Internal
Dealer Cash
Prime
Brokers
Beneficial Owners/
Bank Portfolios
Securities Lenders
Cash Reinvest
Dealer Desks
Direct
US
Commercial Banks
Non-US
Commercial Banks
 Longer term stable commitments
 Started effort over 6 years ago
CITADEL
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Funding Dislocation
 Accelerated deleveraging on the back of the financial panic and forced liquidations by
banks, hedge funds and other investors in Q3 and Q4
 Severe dislocation in funding markets post Lehman bankruptcy driven by several factors
 Inadequate funding models among firms taking term asset risk without term liability structure
 Concerns around systemic risk in the banking system
 Lenders became unwilling or restrictive in lending
• Multiple asset classes impacted, even in fully hedged assets
• Concerns around changing regulatory frameworks
 Implementation of short sale restrictions by regulators in several markets)
• Ability to liquidate or hedge collateral in a default as primary concern
 Breakdown in the relationship between cash and derivative assets, notably in convertible and
corporate bonds
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Funding Dislocation
 Citadel focus in Q3 and Q4
 Holder of balance sheet assets in a period of unprecedented funding dislocation
 Key Focus to maintain strong liquidity and capital position through utilization of management
framework
• Reduction in size of balance sheet/risk broadly but maintain highest quality trades
• Refocus activities on skill based investment businesses
• Elimination of several balance sheet intensive businesses
 Reinsurance
 Fundamental Credit
 U.S. Power Trading
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Estimated US Non-Financial Convertible Discount
to Fair Value
January 1, 1998 to September 12, 2008
6.5
5.6
5.5
4.5
Edge (bpt) .
3.5
2.5
1.5
0.5
-0.5
-1.5
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
The US Non-Financial Convertible Discount to Fair Value time-series represent the average US non-financial convertible bond discount to fair value, weighted by amount outstanding. For this purpose, the
Merrill Lynch US Convertible Index is used to define the set of securities considered for inclusion. Convertible securities whose underlyings do not have exchange-traded options, exchangeable bonds, convertible
preferred stock, and mandatorily convertible securities are excluded. The Citadel proprietary valuation model is used to estimate fair value. Citadel’s model is calibrated using US Credit, Equity, and Option
market data from January 2003 to present. The Estimated US Non-Financial Convertible Discount to Fair Value time-series incorporates a combination of inputs designed to provide reasonable estimates of fair
value. Individuals may disagree about the design of the framework as well as the inputs and assumptions made. The framework, inputs and assumptions may not be accurate, and the inputs will change over time.
The actual discount to fair value may differ materially from the estimated fair values generated by the Citadel proprietary valuation model. Furthermore, there can be no assurance that market prices will converge
to fair value over time.
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Estimated US Non-Financial Convertible
Discount to Fair Value by Rating
January 1, 2004 to April 6, 2009
16.0
US - All Ratings
14.0
US - High Yield
12.0
US - Investment Grade
10.5
Edge (bpt) .
10.0
8.9
8.0
6.0
5.0
4.0
2.0
0.0
-2.0
Jan
2004
Apr
Jul
Oct
Jan
2005
Apr
Jul
Oct
Jan
2006
Apr
Jul
Please see the end notes for important information about this presentation.
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Oct
Jan
2007
Apr
Jul
Oct
Jan
2008
Apr
Jul
Oct
Jan
2009
Apr
Bond Basis Spreads
Historical Data
450
Representative Bond Basis
400
350
Spread to Libor .
300
250
200
150
100
50
0
May Jun
2007
Jul
Aug
Sep
Oct
Nov
Dec
Jan Feb Mar
2008
Apr May
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Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan Feb Mar
2009
Apr
Funding Dislocation – The Road “Forward”
Dysfunctional Funding Market Continues
 Recent Fed data indicates that total bank deposits were approximately $8.8 trillion versus
$3.8 trillion in the money funds with growth rates of 5% and 23%, respectively, during 2008
 Over half of money fund growth during Q4 2008
 Effect of “breaking the buck”
 Growth directed toward S/T Agency and Treasury securities as CP holdings and Repo
holdings shrunk
• Repo market down over 30% in Q4 2008; almost 50% in the 2008
• Bank CP market shutdown even with government guarantee programs in place
• Highlights that money funds currently have little use in providing liquidity to the system
 Increased importance of bank deposits in traditional mix of short term, medium term and
long term secured and unsecured lending by banks for the foreseeable future
 Will be constrained by leverage ratio/gross balance sheet concerns
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End Notes
1. The US Non-Financial Convertible Discount to Fair Value time-series represent the average US non-financial
convertible bond discount to fair value, weighted by amount outstanding. For this purpose, the Merrill Lynch US
Convertible Index is used to define the set of securities considered for inclusion. Convertibles securities whose
underlyings do not have exchange traded options, exchangeable bonds, convertible preferred stock, and mandatorily
convertible securities are excluded. The Citadel proprietary valuation model is used to estimate fair value. Citadel’s
model is calibrated using US Credit, Equity, and Option market data from January, 2003 to present.
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