FACTBOX-Then and Now: Federal Reserve on physical commodity trading

Tuesday, 14 Jan 2014 | 4:46 PM ET

NEW YORK, Jan 14 (Reuters) - The Federal Reserve on Tuesday laid out the breadth of its review of physical commodity trading on Wall Street, showing that no aspect of the business was beyond its scrutiny.

Over the years, Goldman Sachs, Morgan Stanley, JPMorgan Chase and other banks have used a range of legal means to keep multibillion-dollar commodity franchises. These include a longstanding rule allowing banks to invest in commercial enterprises and an exemption that former investment banks carved out of legislation 15 years ago.

In a notice seeking feedback on possible new curbs, the Fed raised questions about those legal authorities. It posed two dozen questions and is accepting public comments until March 15.

The segments below describe the means by which banks have been allowed to participate and invest in physical commodity markets, and a selection of Fed comments on each:

For the full notice click: http://link.reuters.com/dym95v

For a story on the Fed's notice see:


The most basic question is whether banks should be allowed to trade in physical commodity markets -- taking title to a cargo of crude oil or a container of coffee beans, even if they do not own the oil tanker or warehouse that stores it.

In 2003, the Fed issued an order allowing commercial banks to participate more deeply in the physical marketplace, trading physical markets alongside derivatives. Historically, investment banks had no material restrictions on what they could trade.

Citigroup Inc, when it bought Travelers Group in 1998, sought Fed permission to trade in oil markets to retain a small but lucrative Westport, Connecticut-based trading firm called Phibro with a century-old history and a focus on trading physical crude oil benchmarks worldwide.

Citigroup argued that it was inhibited from trading effectively in derivative markets because counterparties knew they would not be able to take physical delivery. To play fair, it needed to be able to hold the underlying commodities.

THEN: The Fed agreed with Citi, saying that trading in real commodities would allow the banks to "transact more efficiently with customers". It said the trading must be "complimentary" to their main activities, contribute to the public good and should not pose a "substantial risk" to the bank.

It said banks must take precautions by frequently inspecting stockpiles, place age limits on the tankers they use and carry substantial pollution insurance, among other things.

And it explicitly barred them from owning or investing directly into infrastructure assets such as warehouses.

NOW: The Fed appears to be raising doubts about whether owning physical commodities that may be stored or transported by another company offers adequate protection in the event of a major catastrophe such as the Deepwater Horizon Gulf disaster.

" 1/8Despite the restrictions on owning or processing commodities 3/8 liability may attach to FHCs (Financial Holding Companies) that own physical commodities involved in catastrophic events even if the FHCs hire third parties to store and transport the commodities. For example, FHCs engaging in Complementary Commodities Activities may lease and monitor facilities and vessels that hold and transport FHCs' oil. ...Moreover, parties not liable as owners or operators under relevant federal law may be held liable under common law, including liability arising from the actions of the third parties hired to store and transport commodities."

The Fed also pointed to banks' moves to sell off physical trading operations to question the fundamental notion that physical trading was a necessary adjunct to derivatives. JPMorgan is in the final stages of selling its entire physical desk, while Morgan Stanley has sold its global physical oil trading operation to Russia's Rosneft.

"Although market developments such as these may be caused by a variety of factors, the developments may indicate that Complementary Commodities Activities are not necessary to ensure competitive equity between FHCs and competitors conducting commodities derivatives or other financial activities. Moreover, these developments...may suggest that the relationship between commodities derivatives and physical commodities markets ... may not be as close as previously claimed or expected."

"Because complementary activities should be 'meaningfully connected' to a financial activity such that it 'complements' the financial activity, the Board is reexamining whether each Complementary Commodities Activity can continue to fulfill this statutory requirement."


THEN: The Gramm-Leach-Bliley banking act of 1999 that swept aside the rules of the Glass-Steagall Act of 1933 also gave financial holding companies far more leeway to invest in non-financial corporate enterprises, so long as those investments meet certain criteria to qualify for "merchant banking" status, an issue that has played a key part for JP Morgan and possibly Goldman Sachs.

These investments come with limitations: they must not exceed a certain percentage of the banks' capital base, and are generally limited to 10 years, although the bank may ask for Fed approval to extend that deadline. The rules also prohibit the bank from participating in the day-to-day operations.

Those restrictions were meant to help shield a bank from the potential liability of a subsidiary firm, a legal provision known as "piercing the corporate veil" that generally prevents transferring liabilities to the shareholders or parent.

NOW: In a section entitled "Tail-Risks of Merchant Banking Investments", the Fed questions the degree of that veil, saying that parent companies may be found legally liable for subsidiary operations in "a variety of circumstances."

"For example, courts may pierce the corporate veil when the subsidiary corporation is not treated as an independent entity... Courts also have pierced the corporate veil where the parent dominated the finances, policies, and practices of the subsidiary so that the company is used as a mere agency or instrumentality of the parent. Veil piercing also has been used to prevent fraud or other inequitable results."

It said the board was considering a number of measures that could include: (i) more restrictive merchant banking investment holding periods; (ii) additional restrictions on the routine management of merchant banking investments; (iii) additional capital requirements on some or all merchant banking investments; and (iv) enhanced reporting to the Federal Reserve or public disclosures regarding merchant banking investments.

Separately from the merchant provision, the Fed also questioned whether the existing corporate structure - in which banks' commodity trading is generally carried out by a subsidiary firm - protected it from liability.


Of the Wall Street banks, Goldman Sachs and Morgan Stanley are special cases since they converted to Bank Holding Company status only in 2008. As BHCs, they gained access to the Fed's discount lending window, but also gave up the freedom and flexibility afforded them as unregulated investment banks - which included largely unfettered commodity trading activity.

THEN: With remarkable prescience, the banks had planned for such a day about a decade earlier in the 1999 act that allowed any bank converting to holding company status to "continue to engage in, or directly or indirectly own or control shares of a company engaged in, activities related to the trading, sale, or investment in commodities and underlying physical properties that were not permissible for bank holding companies to conduct in the United States as of September 30, 1997."

In other words, if you traded and invested in commodities before 1997, you should still be allowed to do so if the bank was engaged in "any of such activities" before then and so long as it does not exceed 5 percent of the bank's total assets.

NOW: The Fed has made no public interpretation of this clause, and offered scant insight in Tuesday's notice, making clear that it has limited latitude to intervene in the legal statute: "In contrast to complementary authority, this authority is automatic; no approval by or notice to the Board is required for a company to rely on this authority."

The Board said it was seeking comment on whether additional requirements could help ensure that certain activities under the BHC Act "do not pose undue risks to the safety and soundness of the BHC or its subsidiary depository institutions, or to financial stability."

(Reporting by Jonathan Leff; Editing by Grant McCool)

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