Traders or Commodity Finance Banks part XXIII: Did Capital One run into a Commodity Pre-Pay Wall ?

In our last post we touted a too-big too fail return in the commodity-sector (a name nobody dare to pronounced. Today prices are down but market volatility is up (VaR is up, prices are down). Capital one, a FDIC-insured bank is allowed to skip a $1B margin call related to energy exposure of an undisclosed nature.

Zero hedge suggested that the CFTC (Fed by extension) was quietly bailing out Capital One.

`As part of that business, Capital One enters into commodity swaps with its commercial oil and gas clients to help them mitigate the risk of energy price swings and the related borrowing risks. Typically, those trades do not bring Capital One’s swaps exposure anywhere close to the CFTC’s registration threshold, according to the CFTC’s Friday notice“.

But the 50% plunge in crude oil prices caused by the coronavirus and a flood of supply by top producers has seen its exposure on those swaps balloon, putting it on course to hit the threshold by the end of this month, the CFTC said.

As Reuters details, the threshold kicks in if a bank has $1 billion in daily average aggregate commodity swap exposure that is not secured by collateral, such as cash margin. Which, it appears, was the case with CapitalOne.

Why was Capital one spec’ing long crude anyway” asked a trader ?

He noted that they cannot really call it a “hedge“ as they are directly hurt by falling prices…

-Capital One is not registered as a swap dealer, nor is a major swap participant with the CFTC. -How in the course of normal lending can they be long the equivalent of 50,000 Nymex contracts.

“The cumulative exposure facing Capital One would be many billions, and could potentially render the bank insolvent”.

The Virginia-based lender with less than a 1.5% exposure to the U.S energy and 3-sig worst case scenario prints a $1B loss or (is it more a $2B). These inputs can be left for further scrutiny.

  • Moreover raising the risk ceiling instead of triggering a margin call shows that FED-BIS enacted rules (VaR, minimum capital requirements) are malleable.
  • In other words, the people in charge of stability are avoiding the institution realizing its loss and they are now MTM (at a loss) somewhere on the balance-sheet.
  • Meanwhile, NYMEX Traders are frisked; initial margins are now at 50%…
  • Minimum 1/4 of the liquidity has evaporated. Volatility is bigger, this is not too good for hedgers but some of it might just be self-inflicted we muse.

The Capital One pseudo-bailout remains the greatest mystery since the loss of the merchant card processing with Costco wholesale. Joke aside, nobody really knows what is exactly their exposure to energy, only that they raised a white flag, “we surrender“.

What’s in the left tail, and why the the CFTC won’t let the CME liquidating the long positions (self-liquidate this risk) ?

We muse that behind Capital One’s $1B m-t-m (soon to become loss) exposure there is a structured deal that was not recognized fully as a commodity exposure by the bank regulators. It was only uncovered in the recent times, when the energy prices drastically dropped. Risks can often be the biggest movers in these energy sell-offs.

Traders or Commodity Finance Banks (2016) explains the role of the commodity prepays, simplifies their mechanics and linking them to market risk.

Traders using prepays to offshore producers, lack a credit rating have utilized the commodity pre-financing to open their document letter of credits collateralized by the oil. A lot of these deals have squandered: with inadequate cash sufficient to preserve the prepaid transaction’s cash flows, the physical flows were brought to a halt.

By contrast in the U.S, the commodity pre-financing facilities are asset-based. The pre-pay would be linking the financial institutions with a credit rating to utilities purchasing natural gas with a gas supply agreements tied to a swap line.

In these gas supply agreements, the physicality is very minimum except for one thing; the take-or-pay(s) feature in the contracts. Take or pay is a type of provision in a purchase contract that guarantees the seller a minimum portion of the agreed on payment if the buyer does not follow through with actually buying the full commodity.

Pipelines cannot be easily stop so the deltas between the contract prices (and tied to the loans) require a cash settlement. Utilities are rate-based, and cannot pass their loss to their customers (fuel cost adjustments).

Likely that’s how Capital One would be long (namely on the Henry Hub) through the exposure of a debt laden utility ( both forced to hedge long NYMEX in any times), but rejecting gas (forced by capacity planning).

It suggests this interpretation on what those Commodity pre-pays are: margin calls funding of a long.

Capital One, doesn’t have to be necessarily trading to lose; simply their gross nominal swap exposure can increase by the mere fact that they agreed to fund margin calls (it is part of the commodity pre-pays; the name of bank, as a guarantor, enables the utility to fund it’s gas purchases).

The CFTC knowing that the bank that these funding agreements cannot be easily unwind so meanwhile prefer waiting for the bank returning markets returning to a normal state below the bank $1B limit.

Jacques S.

Special Advisor to the Merchants, Producers and Banks in the Commodity Trade Financing.

Navigating the commodities markets with Freight and Spreads © 2020

13 thoughts on “Traders or Commodity Finance Banks part XXIII: Did Capital One run into a Commodity Pre-Pay Wall ?

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  12. You do not know what you are talking about. First, Capital One did not get to “skip” a $1BB margin call. The move in oil prices simply created a negative MTM on its swaps with borrowing customers of >$1 billion. Capital One’s swap customers (i.e., borrowers) agreed from Day 1 to take unsecured swap exposure to Capital One. Capital One is standing in between their borrowing customers and the big swap dealers that Capital One hedges with.

    CFTC rules require that certain (non-swap dealer) entities that generate too much unsecured swap exposure must register as an MSP (i.e., major swap participant). Capital One ran afoul (or risked doing so) and so it sought an extension of the period in which it must reduce risk or register as an MSP. Capital One could also avoid MSP registration by novating its customer facing hedges to another registered swap dealer or by agreeing to provide collateral to its swap counterparties (i.e., borrowers) under a credit support arrangement. Doing the latter would not hurt Capital One because the big swap dealers that it hedged with have already provided Capital One with cash or Treasuries equal to the MTM.

    I deal with CFTC regulation and swap dealer and MSP registration issues every day.


    • Dear James,

      Part 1 is 5/5, it summarizes the exposure of a “Long”.
      “Capital One could avoid MSP registration by novating or register as an MSP” That alone is a fallacy: With the CVA, sorry there is no such thing in this world as can’t lose agreements. When it comes to swap valuation, the devil is in the detail because the slightest miscalculation may well mean several millions dollars lost due to the notional being often very big. The financialization obscures the real economic conditions of business decisions, it leads to a risk-miscalculation by the bank, economic losses.
      M-T-M game-risk is only transferred in the balance-sheet permuted not eliminated…
      Jacques S.


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