Capital One oil swaps waiver could haunt CFTC

Oil price collapse raises fresh questions about regulator’s justification for offering relief

When US crude oil prices fell below zero for the first time ever on April 20, the Commodity Futures Trading Commission’s regulatory regime was bound to be tested as never before. But one potential problem is largely of the agency’s own making.

On March 20, the CFTC granted an undisclosed bank, later revealed to be Capital One, a special waiver from registering under its major swap participant (MSP) regime, which kicks in if current uncollateralised swap exposures top $1 billion, or $2 billion including potential future exposure.

Capital One had entered into uncollateralised trades with oil and gas companies in Oklahoma, which were set to push its exposure past the threshold by the end of the second quarter.

The exemption was valid for six months, and followed a sharp drop in the benchmark West Texas Intermediate (WTI) price to $22 per barrel in March.

With the oil market rout and the Covid-19 recession deepening, the CFTC could see more firms facing profound consequences from swaps activity that was not part of their core business.

From an industry perspective, the pragmatism shown towards Capital One is “good news”, says Julian Hammar, partner at law firm FisherBroyles.

But some CFTC staff members are said to be rather less impressed, and former officials fear the agency could jeopardise its credibility if it is seen to be prioritising the interests of banks and select clients over keeping a lid on potential systemic risk. 

The no-action letter provoked disquiet among some agency staff, says Justin Slaughter, a partner at public policy consultancy Mercury Strategies and former aide to Sharon Bowen, a former Democrat commissioner at the CFTC.

Capital One’s swaps protect its clients from a fall in oil prices, thereby reducing the credit risk on the associated loan portfolio. But unless properly hedged, that protection will come at the expense of the bank itself.

“There was concern in some quarters at the CFTC about why this company was getting relief,” Slaughter says. “They got in over their heads to some extent with these energy swaps. Capital One is not a firm we typically hear of in our space.”

With WTI contracts for May delivery briefly dipping to almost minus $40 per barrel at one stage this week, and little reason to expect a strong recovery until the global economy has restarted, any form of exposure to the oil and gas sector will remain high risk for the foreseeable future.

 

“Granting relief is a large source of risk given the volatility and the likelihood of defaults going forward,” says another former CFTC official.

Capital One did not respond to questions in time for publication.

On April 4, a spokesperson for the bank told Reuters it would not rely on the waiver to avoid registering as an MSP. The CFTC subsequently indicated the bank had withdrawn its request for no-action relief.

Capital One may well explain its position in more detail when it holds its first-quarter earnings call after market close today (April 23).

If the bank was close to the threshold in March, the extraordinary market move this week may well have pushed it into the MSP category, unless Capital One dramatically wound down its domestic oil and gas exposures in the interim.    

However, this is unlikely to be the end of the matter. Having set a precedent with its offer of no-action relief to Capital One, the CFTC may face waiver requests from other firms with exploding commodity swap exposures, calling into question the entire MSP regime – and the regulator’s judgement.     

A directory maintained by the National Futures Association shows that, as March 31, 2020, there were no firms registered with the agency as MSPs. 

Compliance burden

Capital One’s swaps exposure, which it entered into with Oklahoma oil and gas clients to help them hedge loans made by the bank in 2018 and 2019, blew up in March as oil prices collapsed, potentially barring the firm from maintaining its counterparty position until registration as an MSP is completed.

A CFTC spokesperson implies that the six-month waiver was not necessarily intended to avoid the applicant registering at all – it could simply have been used to provide time to register: “Generally speaking, time limits take into consideration an amount of time necessary for the requesting party to come into compliance with the rule requirement at issue, whether by changing its conduct to comply with the requirement or to undertake registration with us in a capacity that is needed to continue conducting its activities.”

The CFTC was almost betting on oil prices going up; like this is a momentary blip

Former CFTC official

Ed Ivey, a lawyer at Alexander Ricks who previously worked in swap dealer compliance at Wells Fargo, says he would expect the MSP registration process – which the CFTC has delegated to the self-regulatory body, the National Futures Association – to take three to six months.

“It’s a lot to gear up; you’re investing in a real business. It’s not just products and technology build-out, it is the personnel. The NFA has new licensing exams rolling out for associated persons of MSPs and swap dealers, so you’re tying personnel to prepare for new exams,” Ivey says.

In Capital One’s case, he adds: “They’re going to have to hire the legal and compliance team to do this, redo a bunch of documents, re-onboard clients which in their market I expect are middle-market companies that require a lot more hand-holding.”

Don’t scare the horses

However, the emphasis of the no-action letter from the Division of swap dealer and intermediary oversight (DSIO) was not so much on giving Capital One extra time to register, but more on providing reasons why the firm should not be registered as an MSP at all. The two thresholds for registration as an MSP in commodity swaps are $1 billion in daily average aggregate uncollateralised outward exposure (AUOE); or $2 billion in AUOE plus daily average aggregate potential outward exposure.

The DSIO letter says that in each quarter of 2019, which it describes as a “typical” year, AUOE “never exceeded 40% of the registration threshold”. As a result, the DSIO noted, “a return of relevant commodity prices to previously trending levels would permit [the firm] to de-register as an MSP, but not before incurring the costs of compliance and disruptions to trading relationships that will occur as a consequence of registration.”

We could still have a sufficient handle on their activity that we understood the risk presented

Dan Berkovitz, CFTC

The stakes were high, CFTC commissioner Dan Berkovitz, who chairs the agency’s Energy and Environmental Markets Advisory Committee (Eemac), tells Risk.net. Oil and gas sector jobs were on the line, and there were few options for the small and medium-sized enterprises in Oklahoma to find alternative lenders if Capital One dropped their business.

“Were they going to establish a new relationship with a new bank on Wall Street in the midst of this crisis, with the markets going crazy? There could be a company at the end of this that couldn’t get any more financing that would declare bankruptcy,” Berkovitz says.

In the circumstances, given the price war between Saudi Arabia and Russia and collapse in demand from the Covid-19 economic shutdown, the DSIO was justified in trying to provide support, says Matthew Kulkin, a former head of the DSIO.

“It is an extraordinary time in the market, not just for coronavirus but energy market developments. The Commission is trying to be helpful to non-traditional market participants, particularly in the commodity space,” Kulkin says.

One source adds that the relief could also have helped the CFTC itself, because Capital One would be the first and only registered MSP. With many CFTC staff working remotely and fighting whatever fires the combined Covid and oil price crisis throws up, now is not the moment for setting up an entire supervisory regime to oversee a single entity.

Failed gamble

The counter-argument would be that now is precisely the time to be taking a closer look at non-dealers who may have flown below the radar, but are heavily exposed to the fall in oil prices. The DSIO’s reasoning that Capital One might quickly decline below the MSP threshold looks like a gamble that has already failed.

“The CFTC was almost betting on oil prices going up; like this is a momentary blip. I don’t think it’s the CFTC’s role to be judging the future of the markets. Especially with all the volatility in the oil markets, you want to ensure the counterparty is properly overseen,” says the former CFTC official.

The fact that crisis conditions caused a firm to trip the threshold is a sign of “good planning” in the rules, the former official adds – risks are rising, so it is right that more companies are facing intensified CFTC scrutiny.

Dan Berkovitz

“The thing I would be most concerned about is risk management requirements. As an MSP, they would have to produce disclosures related to their risk management programme,” says the former official.

As a regulated bank, Capital One is already subject to substantial risk management scrutiny from prudential regulators. However, the former official says: “The CFTC’s approach to risk management is much more targeted at derivatives and swaps risk, so you would want to make sure an MSP has a specific programme around managing their derivatives risk.”

“To throw that away is disconcerting,” he adds.

The CFTC spokesperson rebuffs the accusation, saying: “We are glad to regulate markets in which people may choose to speculate lawfully, but we do not speculate on our rule set.”

Berkovitz explains in more detail how the bank may have made assumptions about the direction of oil prices in applying for no-action relief, but the six-month time limit meant the CFTC did not necessarily make any assumptions in offering that relief.

“They [Capital One] saw the price dislocation as temporary and that they wouldn’t have to register. But if it continued, then they would. My impression is that it was all dependent on what the price of oil is and how long it goes on,” says Berkovitz.

No free pass

Some of the anxiety about the waiver among ex-regulators stems from the limits of the information contained in the DSIO’s no-action letter. Neither the CFTC nor the bank has disclosed anything about how the oil swaps may have been hedged (see box: Unknown risk), or what conditions were attached to the now-withdrawn waiver.

A lawyer active in the swaps space says they would have expected the CFTC to require binding assurances from Capital One that it would unwind its current energy swap positions in order to reduce its exposure, in return for granting the relief.

Berkovitz reveals to Risk.net that the conditions for the waiver were relatively stringent. The bank agreed it wouldn’t take on new business for the duration of the waiver, and that the CFTC and the Comptroller of the Currency (as prudential regulator) would together monitor Capital One’s swaps exposure and loan book.

“During that time, we would have full visibility into their [Capital One’s] exposure and they represented that they weren’t going to be increasing their exposure…We could still have a sufficient handle on their activity that we understood the risk presented. It could go up or it could go down based on oil prices, but we had bounds on it,” Berkovitz says.

The restriction on new business would be a particularly intrusive requirement, and may have influenced Capital One’s decision to withdraw its request for the relief.

What’s the point?

Even though the CFTC waiver would have allowed the regulator to keep a close eye on Capital One, it still raises questions about the purpose and future of the MSP rules, especially since the bank would be the first entity assigned to the category.

CFTC chairman Heath Tarbert added to the uncertainty with remarks he made at a meeting of the Eemac on March 24, in which he appeared to redefine the purpose of the regulation.

Tarbert said the MSP registration class is “largely intended to capture large speculative swaps traders such as hedge funds”. But in the original 2012 regulation, the designation is entity-agnostic.

“It is intended for market participants that have extreme exposure on one side of the market, regardless of who they are, whether an insurance company or a bank that is not registered as a swap dealer. This is what it’s supposed to capture, if you apply the MSP definition as stated by the CFTC in 2012,” says Ivey.

Photo: CQ-Roll Call/SIPA USA/PA Images

Heath Tarbert

The fact there are no MSPs could be interpreted as a sign that the threshold works as a deterrent, discouraging non-dealer entities from building up excessive swaps risk. But the deterrent could be undermined if market participants believe the CFTC will grant them a waiver in the event they accidentally trip the threshold.

“The absence of registrants makes it a bit of an empty vessel, and I think market participants are less concerned about potential registration,” says Kulkin.  

Moreover, part of the reason for enhanced swaps regulation post-2008 was to alert the CFTC to lower-profile participants dabbling in the market, possibly without adequate risk management, and thereby posing a risk to themselves and others.

To do justice to such an approach, the CFTC would want to be aware of firms that are flying just beneath the threshold radar and potentially taking on more risk in good times that could spiral in bad times. The Capital One waiver would have let the firm do the opposite – taking on a risk that has now grown sharply, without immediate regulatory consequences.

The solution could be to lower the original MSP threshold so that it captures firms sooner, although Kulkin is sceptical of that approach.

“It’s a risk-based regime, so lowering the threshold might capture more companies, but they may not necessarily hold a ‘substantial position’ or pose a ‘substantial counterparty exposure’ at a lower threshold.”

A variation of this approach would be a more tailored set of thresholds to reflect differences in liquidity between swaps markets. At present, only rates swaps are separated from the rest, with a higher threshold of $3 billion for AUOE, and $6 billion for AUOE plus daily average aggregate potential outward exposure.

The former CFTC official says commodity swaps should be subject to lower thresholds given the smaller volumes in the market. He adds that he harboured the same concerns about the $8 billion threshold that applies to major swap dealers across all asset classes.

“I was disappointed with one-size-fits all swap dealer thresholds. Eight billion dollars is not a lot of interest rate swaps, but it’s a lot of oil swaps, it’s really generous. You could be out there providing all the counterparty credit risk management services for the equivalent of a month of US oil supply and not come under any regulation!” says the former official.

Unknown risk

CFTC chair Tarbert told the Eemac on March 24 that the agency does not want to “undercut our banking sector if they’re trying in good faith to hedge their exposure in their positions”. But the DSIO letter does not specify whether Capital One’s oil swaps positions are hedged, or whether this calculation was part of the CFTC’s decision-making process.

Participants can net their positions for the purposes of calculating the MSP threshold, but only where they are subject to a master netting agreement.

Alexander Ricks’s Ivey says Capital One could hedge its exposure either through back-to-back positions on the swaps arranged with the Oklahoma energy borrowers, or through exchange-traded oil futures contracts to correspond with each of the swaps. But if the bank chose to hedge with futures, it will not get the same netting benefits under the MSP definition as with back-to-back swaps. In normal market conditions when the hedges were first constructed, the regulatory threshold would not have been a major consideration.

“When you’re dealing with oil, it’s less expensive to go to the futures market. It’s exchange-traded, it’s open, transparent and liquid, but you lose the benefits of netting under the MSP definition,” says Ivey. “It’s just not a perfect one-to-one match because that oil swap is going to be down to individual amounts of oil produced, whereas a futures contract is based on WTI or whatever it might be.”

Editing by Philip Alexander