By Anna Louie Sussman and Emily Stephenson
NEW YORK/WASHINGTON, Jan 13 (Reuters) - The U.S. Federal Reserve is set to take its first formal step toward limiting the role of Wall Street banks in physical commodities markets this week by issuing a notice to seek public comment on the topic, sources familiar with the matter said on Monday.
The Fed will publish an "advance notice of proposed rulemaking" on Tuesday, laying out the issues it is considering, one day before a second Senate banking committee hearing on the matter, the sources said.
The notice and Wednesday's hearing come after months of public and political outcry over the risks of allowing banks to trade physical commodities such as tankers of crude oil and pallets of copper.
At a Senate hearing in July, witnesses testified that the activities pose a risk to the financial system in the event of a catastrophic accident. Metals consumers complained that banks' ownership of physical storage assets enabled them to inflate prices for commodities such as aluminum.
In 2013, banks including JPMorgan Chase and Barclays have paid hundreds of millions of dollars in fines for manipulating energy markets.
The U.S. Federal Energy Regulatory Commission (FERC), which regulates energy markets, will be represented at Wednesday's hearing by Norman Bay, a former New Mexico district attorney who has led a series of high-profile market manipulation cases against big traders in the U.S. power and gas markets, including a record $410 million penalty agreed with JPMorgan.
The other two witnesses are the CFTC's market oversight chief, Vince McGonagle, and Michael Gibson, the Fed's director of banking supervision and regulation.
It is not clear what measures the Fed may propose. The public is expected to have 60 to 90 days to submit comment letters, which the Fed can use to formulate its rules.
A Federal Reserve spokeswoman declined to comment.
An ANPR can range from being a simple list of questions designed to elicit information to something more like a concept paper, said Hugh Conroy, Jr., a banking lawyer at Cleary Gottlieb Steen & Hamilton. In any case, Tuesday's document will provide the first glimpse into the Fed's thinking since lawmakers and the public have put the issue in the spotlight.
"Usually an ANPR would be done in a context where they're trying to get people to give them more ideas, versus a proposed rule text where they just want people to comment on what they have already put in writing," he said.
Over the past year, lawmakers have pressed the Fed to examine whether Wall Street's biggest banks, including JPMorgan Chase & Co and Goldman Sachs Group Inc, should be allowed to own assets such as metals warehouses and oil tankers, and to trade physical commodities alongside commodity derivatives.
The notice by the Fed may touch on the issue of capital surcharges for certain activities, an issue that arose in media reports but was never clarified by the Fed.
In July, the Fed said it would be reviewing the role of banks in physical commodities trading, something that it has allowed a range of banks to engage in since 2003.
Karen Shaw Petrou of Federal Financial Analytics in Washington said the notice would likely seek comment on how the risk varies by commodity, and would consider the systemic impact of various physical trading activities.
"This is hard, and the Fed is busy," Petrou said. "It is really complicated. If you want to have a simple capital rule, then you would have an across-the-board charge for certain commodities activities, but it's true that some of them are a lot riskier than others."
It is unclear whether the Fed will also address a related but distinct question: whether former investment banks Goldman and Morgan Stanley should be allowed to carry on owning commodity-related assets, such as metals warehouses and oil pipeline, due to a "grandfathering" clause in a 1999 law.
Regardless of the scope of the Fed's statements, they are certain to be scrutinized by industry executives and their lawyers, who have been frustrated by the lack of clarity over a possible crack-down that could further roil Wall Street's multibillion-dollar trading operations.
Some banks have not waited for a final word. JPMorgan is in the final stage of a months-long process to sell its entire physical commodity desk, and Morgan Stanley agreed last month to sell its physical oil trading operation to Rosneft.
"One thing I'd want to look at is their justifications for such a proposal. I think for it to be an appropriately reasoned rule-making, it should address how the charges address the risks," said a banking lawyer who declined to be named.
"I would also want to see what they said about their supervisory experience over the time they have allowed financial companies to do this."
ANPRs are a preliminary step on the rulemaking path, said Conroy, adding that even more advanced documents, like draft rules or interpretive statements, can fall by the wayside.
"Generally, even notices of proposed rulemaking and interpretive statements sometimes don't end up becoming rules, so an ANPR may not end up becoming a rule," he said.
"But it indicates they are moving towards that."