Dear ***, Thank you very much for your eager cooperation.

I am writing to you on behalf of the community of bloggers. As you know, many of us are very interested in the details of the IFC note which Citi sold to a number of investors, including the government pension fund. Unfortunately, it is common knowledge that the corporate governance in Russia is very poor, and bloggers often serve as public watchdogs to monitor and analyze suspicious transactions, especially those, in which government institutions are involved. This IFC note got special attention from the bloggers specializing in finance, because it has performed poorly and seems to have been structured particularly unfavourably for Russian pensioners. At the same time it could allow an international dealer to reap substantial profits on their behalf. Following a detailed discussion with professionals experienced in academia, financial regulation and fighting financial crime, I decided to summarize existing comments and concerns of the bloggers. I would kindly ask you to comment on the following set of identified issues. I believe that the honest reply to these questions would help to establish the atmosphere of trust and respect to your institution. At the same time it would minimize the effect of potential reputational problems faced by Citi on this particular product. As agreed, please take into account that I intend to publish your answers on the Internet and, should it be required, will also attach them to a whistleblowing report to a regulator. For your convenience I have grouped the questions in a number of sections within the document. Once again, thank you very much for your assistance. Best regards, ***,

(A)

Suitability and potential misrepresentations

Summary: The note pays an annual coupon of 3% +max[0, performance of NES inflation index]. This year, however, it paid a coupon of 3% exactly (see this article: http://www.ifc.org/wps/wcm/connect/2f7a958041f92e4da586f5b456904773/Rubal.pdf ?MOD=AJPERES), meaning that performance of the index was either zero or negative. At the same time, inflation rate in Russia was about 6.5%. Following the coupon payment announcement in the end of November 2013, it resulted in numerous discussions about suitability of this note for the pension fund and its structure.

In my post (http://ecostudent.livejournal.com/118221.html), I explain why the index consisting of constituents listed in its documentation and having pre-defined volatility target/rebalancing strategy cant track inflation in Russia. I also illustrate why stating that this product tracks inflation is approximately equivalent to stating that you have created a low frequency strategy in liquid futures with unrealistically high Sharpe ratio. Furthermore, I am not aware of any academic research or any industrial implementation which shows that non-tradable macroeconomic indicators, such as inflation in a country without inflation-linked bond markets, can be accurately replicated through tradable financial instruments. Therefore, I come to a conclusion that it is impossible for this index to track Russian inflation, and stating the opposite means misrepresenting the actual product you sell. The real world seems to prove my conclusions. Official documents, however, do seem to state otherwise: from S&P Abbreviated Index Description, http://us.spindices.com/documents/custom/description-nes-russian-inflation-targetindex.pdf: The Index is a Russian Rouble denominated index which aims to approximate in broad terms the compounded performance of the Russian week-on-week consumer price index returns (Russian CPI)

from IFC website, http://www.ifc.org/wps/wcm/connect/08f973004d9875889709b748b49f4568/Material_ event_Index_disclosure_series_1+-2-321+11+2012_final.pdf?MOD=AJPERES ( ) , RUWCWOW. , , , . . Questions: Could you please either (i) Disprove my statement about technical impossibility to create the inflation tracking index using your methodology and comment on the issues explained in my post.

(ii)

Confirm that you have informed the client in writing that, although the index may be correlated with inflation, (a) it will have substantially smaller mean values, (b) the delay of inflation tracking will increase when volatility increases, since then the weights of the constituents become smaller due to volatility targeting, (c) you have conducted sufficient background checks to make sure that the client has enough capacity to understand this product, and sales and traders involved in selling this product are fit and proper to understand the structure of this index and its limitations, (d) you have never stated that the absolute returns of this index may be anywhere close to Russian inflation.

(iii)

Please confirm that the end buyers of these notes didnt take the claimed inflation linkage and inflation tracking aspects of this index into consideration when they made an investment decision. I think it is perfectly fine to call it futures linked index or USD derivatives linked index, but calling it inflation index is incorrect, as there is no inflation in it. Given my statement above, could you explain why the Index is called (New Economic School Index The Russian Inflation), although it is technically unable to accurately track inflation?

(iv)

(B)

Profitability

Summary: The product I am currently discussing is a fairly transparent and low risk structure. It consists of a cross-currency swap with a supranational entity and embedded index/options. The index references a basket of very liquid futures. As a result, the pricing of this transaction is very transparent. You can find my estimates of P&L at http://ecostudent.livejournal.com/118221.html. I have estimated using two methods: relying on the market parameters around the time the trade was done, and based on the Bloomberg quote for the product as a whole. The annual fee is estimated to be at around 1.5% of the nominal, or about 195 million rubles per annum. This results in a roughly 970 million rubles total fee. I think that this margin is too high for the product that is fairly simple, and where the dealer takes minimal risks and allocates minimal resources in this trade. At this link: http://ecostudent.livejournal.com/118221.html?thread=711373#t711373 Sergey Guriev states that Citi employees told him in a private conversation that the actual P&L numbers are somewhat tens or even hundreds times less than my estimates. This contradicts my estimates. Furthermore, I am reasonably confident that

even 1/10th of this number (19.5 million roubles per annum, or 97 million roubles in total) is significantly smaller than the actual revenue generated by Citi from this trade. Questions: (i) Could you please confirm that what Sergey Guriev says is true and both the P&L and the credit to sales for doing this transaction is below 19.5 million roubles per annum (if you accrue revenues on this trade over time), or 97 million roubles in total (if you recognize the whole P&L at the beginning)? In this case, could you also, please, comment on my calculations and explain what kind of error resulted in such a difference between the estimated and realized profits? If Sergeys statement is false, please confirm that both the P&L and the credit to sales for doing this transaction is below at least 1% per annum [130 million roubles per annum (if you accrue revenues on this trade over time), or 650 million roubles in total (if you recognize the whole P&L at the beginning)]? The price of this note in Bloomberg (see ALLQ) is about 88, and the bid/offer spread is very tight. I suspect that the main driver for such a discount is the P&L made by the dealer, i.e. by Citi, and thus the actual P&L made by Citi is even higher than my initial estimates. If you disagree with my conclusions, could you explain what caused such a high discount on this note, given that during this time the markets havent moved dramatically and the option prices are limited by volatility target and are not very market-dependent (see my comment here: http://ecostudent.livejournal.com/118221.html?thread=713421#t713421 )? Could you please decompose this 12% discount into the main constituents to explain what led to this discount number? Finally, I also wonder how this product passed through compliance and reputational approvals. Since the structure of the note is quite transparent, one can easily observe enormous margins embedded into the product. This results in substantial reputational risks for Citi, as the trade was done with a government pension fund.

(ii)

(iii)

(iv)

(C)

Unfavourable structure for the client.

Summary: Rebalancing of the index is structured in a way that Citi revenues are not limited from above, when constituents are rebalanced. This is an especially aggressively unfavourable structure that may result in high revenues for the dealer. From S&P Abbreviated Index Description, http://us.spindices.com/documents/custom/description-nes-russian-inflation-targetindex.pdf:

"However, certain notional costs associated with the rebalancing and replication of the Index are taken into account by deducting these notional costs from the Index Level and by reducing the unit weights of the Constituents upon the monthly rebalancing." Questions:
(i) Please, confirm that Citi doesnt make P&L on rebalancing of this index. Also confirm

that the sales people originally involved in structuring and/or selling of this note do not receive credit of sales for such rebalancings.

(D)

Intended limitation of competition

Summary: One of the possible explanations of the unfavourable index structure and high P&L is the artificial limitation of competition in the market, i.e. prohibiting other dealers to use this index and forcing government pension fund to buy this index product without sourcing other dealers quotes. Sergey Guriev stated that any dealer can use this index in its products. We have a number of reports stating that this is not true (e.g. http://barskaya.livejournal.com/605044.html) and some evidence from the documentation: The Index is proprietary and confidential to the Index Sponsor. No person may use the Index in any way or reproduce or disseminate the information contained in this communication relating to the Index without the prior written consent of the Index Sponsor. The Index is not in any way sponsored, endorsed or promoted by the issuer or sponsor, as applicable, of any of its constituents.

The index Sponsor is Citigroup Global Markets Limited. Questions (i) To both NES and Citi: Please confirm that no dealer has been rejected by NES or Citi when approached with a request to use this index in their products.

(E)

Corruption and money laundering.

Summary:

Given high profitability of this trade, the jurisdiction in which it was structured and sold, and the fact that government entities were buyers, some bloggers expressed concerns about potential corruption issues. They raised a question of the role of potential consultants/intermediaries, which could be employed to launder money from this trade.

Questions: (ii) Could you, please, confirm that the number of parties involved in this project is limited to (a) Citi and its affiliates, (b) IFC, (c) New Economic School, (d) S&P, (e) end buyers of these notes (with respect to the amount that was bought by VEB/State pension funds), and there were no brokers, intermediaries or external consulting companies involved?