Carbon carve-outs: CFTC shields oil bank from swap rules
A mystery bank escapes post-crisis regulations with watchdog's blessing
First, it came for the US shale producers. Now, the oilpocalypse is blitzing the fossil fuel banks that finance them.
One big energy bank saw its commodity swaps exposure to the sector blow up so fast in recent weeks that it was on the verge of being labelled a threat to financial stability. That is, until it begged regulators for mercy.
On Friday March 20, it got its wish. The Commodity Futures Trading Commission (CFTC) temporarily suspended rules that would have forced it to register as a “major swaps participant” (MSP) — effectively exempting it from strict business conduct, reporting and disclosure standards.
The CFTC offers no clue as to the identity of the mystery bank, though there is one name swirling around the Twitterverse.
First things first — what’s an MSP?
Rules under the post-financial crisis Dodd-Frank Act describe an MSP as an entity that is not a swaps dealer, but “whose outstanding swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets”. In short, any entity with a swaps portfolio large enough to be a source of systemic risk.
Such entities are supposed to register as MSPs with the CFTC if their daily average “aggregate uncollateralised outward exposure” (AUOE) exceeds $1 billion. Once branded, they are obliged to share important risk management data with counterparties and adhere to strict standards on the documentation of trading relationships.
Now, what do we know of the mystery bank that petitioned for, and received, an exemption from these measures?
The CFTC’s letter on the “no action” relief explains that the lender provides US energy firms with commodity swaps they use to hedge against falls in oil and gas prices. Crucially, the bank does not post margin or collateral to its customers on these swaps, meaning they’re fully exposed to counterparty credit risk: the danger the lender will go under and renege on payments promised under the terms of the contracts.
As oil prices tumbled, the bank’s AUOE has skyrocketed, putting it on track to trip the MSP designation threshold by quarter-end.
Put simply, the bank’s customers are sitting on over $1 billion of commodity swaps that would become worthless if it went under — and have no cash or collateral on hand with which to insure themselves.
The cash flows promised under the swaps are essential to the bank’s energy customers, which right now are selling their product at prices way below their breakeven points. Without these flows, they could also go under.
Bending the rules
Systemic risk doesn’t get more black-or-white than this. The MSP rules were made to capture those financial entities which posed such risks but had slipped through the post-crisis regulatory drag net. Now, the CFTC is saying these rules should be suspended for one bank, at the very moment its risks are peaking.
Why? The mystery bank argued it wanted to avoid “the costs and disruptions to customer relationships that would be entailed in MSP registration and compliance”, and the CFTC said temporary relief is warranted because of the “unprecedented nature” of the oil price shock.
There’s a lot to unpack here.
First of all, there are supposed to be costs to being a systemic threat — that’s the point. The mystery bank’s exposures make it a danger to the financial system and therefore bound by strictures commensurate with its status. One purpose of the MSP designation boundary is to dissuade niche participants in derivatives markets from building up too much risk. It’s incumbent on such entities to manage their exposures carefully to avoid tipping over into MSP status if they don’t think they could cope with the operational costs.
The mystery bank argues that typically its exposure never exceeds 40% of the AUOE threshold, meaning in normal circumstances it would be very unlikely to qualify as an MSP.
Sure, these are not normal circumstances — but the rules shouldn’t care, and nor should the regulator. If an entity trips the MSP threshold, it should have to adhere to the MSP playbook. That’s the cost of doing business.
And don’t regulators want tougher rules to apply to those firms that pose a systemic risk in the midst of a crisis? By allowing this bank to discount the very swaps that pose the greatest threat from its AUOE as part of the “no action” relief, the CFTC is forfeiting its ability to put it under heightened scrutiny at the moment of peak danger.
Also, the MSP requirements are hardly onerous. Business conduct standards oblige MSPs to disclose material risks, characteristics, incentives and conflicts of interest to counterparties related to their swaps, provide a daily mid-market price for their uncleared swaps and verify whether or not a counterparty is a so-called “special entity”.
Meanwhile, documentation rules centre on “trading relationship” write-ups that include agreements on how swaps should be valued and dispute resolution protocols. MSPs are also required to produce timely swap confirmations.
This is not rocket science. That the costs and hassle involved were deemed so high that the mystery bank thought relief warranted should have prompted the CFTC to show discipline, not mercy.
Worse is yet to come
Second, is the oil collapse “unprecedented”? West Texas Intermediate (WTI) crude fell 36.5% last week, its biggest percentage-point decline since January 1991. So the most dramatic collapse in a long while...but not unprecedented. World Oil says WTI futures were lower in constant dollar terms for certain contracts in 1998 and 1999. In addition, price plunges like these could become more frequent, even endemic, in future as countries shrink their carbon footprints in pursuit of the Paris Agreement objectives.
This latest intervention by the CFTC therefore invites the question: would fossil fuel lenders be able to claim similar relief in such circumstances? If the climate minsky moment takes place, and the value of fossil fuel assets plunge as they have done in recent weeks, would banks be offered similarly tailored carve-outs from key regulations?
Third, the mystery bank petitioned for relief until September 30, gambling the present price disruption would be temporary. If oil does not recover sufficiently by then, it said it “would register as an MSP or be required to make other adjustments to its business to reduce its AUOE”.
Yes, the supply shock triggered by the Saudi-Russia price war may be dampened through diplomatic channels. But demand is being killed by the worldwide coronavirus pandemic, which has placed one in five Americans in lockdown. Barring a rapid end to the public health crisis and a gargantuan stimulus to put the economy back on track, it’s hard to imagine crude prices rallying enough to substantially curtail the bank’s swaps exposures.
In which case, the CFTC is simply kicking the can down the road. What’s likely is come September 30, the bank’s exposure will still be in excess of the threshold and the regulator would have lost six months in imposing tougher swaps standards.
In short, a bank of systemic importance to the US shale industry has won temporary relief from rules designed to make it more accountable to its counterparties and regulators, partly because imposing the rules would be an inconvenience.
This is mind-boggling stuff. Buried in the “no action” letter, though, is something else that should put climate risk experts teeth on edge. At one point, the mystery bank explains that though its counterparties do not have recourse to any collateral or margin, its own exposure to the energy companies is “collateralized by the underlying loan collateral” — the firms oil reserves.
This, allegedly, reduces the credit risk of the commercial end-users to the mystery bank. But the experience of the last few weeks shows that the value of such collateral can fall precipitously, making it a poor form of insurance for counterparty credit risk.
The CFTC granting relief to an oil bank in the midst of an oil crisis is bemusing in itself. What it reveals about the substructure of fossil fuel finance, though, is terrifying. Without wholesale reform of the way oil and gas companies intersect with financial institutions, certain risk transmission channels will remain wide open, free to destabilise and destroy banks the moment the carbon bubble pops.
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