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NEW YORK As the U.S. Federal Reserve considers new ways of reining in banks' trading in what it sees as risky physical commodity markets, Wall Street's two oldest and biggest players may ultimately gain in stature.
Thanks to a longstanding legal exemption that Fed officials say limits their regulatory capacity, Morgan Stanley (MS.N) and Goldman Sachs (GS.N) may yet emerge from the regulatory upheaval that is upending banks' commodities trading better-off than their peers, who face potentially tougher new rules.
Although Morgan Stanley is selling its large physical oil trading desk and Goldman has said it may be open to selling its metals warehousing unit, which it was alleged to have used to inflate metal costs, they show little sign of pulling back from other big physical markets such as power, natural gas and metals.
Their determination to stick with vast parts of the business may irritate rivals, such as Bank of America Corp's Merrill Lynch (BAC.N) and Citigroup Inc (C.N), who have long complained about the uneven playing field created by a 1999 banking law.
During the financial crisis more than five years ago, the two former investment banks traded their freedom from Fed oversight for the benefit of its last-resort lending.
In becoming bank holding companies, they became subject to the same regulatory scrutiny as commercial banks, barring several significant exceptions, one of which focused on commodities
Thanks to a 15-year-old legal statute, they alone enjoy special "grandfather" status in the realm of commodity trading and investment.
That allows them far more latitude than the rest of the U.S. banking industry, whose ability to trade things like crude oil cargoes and copper pallets was granted directly by the Fed over the past decade, and is now subject to revision.
Even when they have been allowed trade raw materials, the Fed explicitly barred them from acquiring physical assets such as pipelines, storage terminals and metals warehouses.
In electricity, metals and coal, Goldman and Morgan still own and operate assets that other banks would be barred from holding, such as power plants. They trade broadly in these markets, even as competitors face the possibility of new limits that could constrain the businesses.
Backed by Fed credit, the two may also be able to compete with some of the less-regulated companies that are rapidly expanding to fill a void left by Wall Street: foreign banks like Brazil's BTG Pactual that are not subject to Fed rules, and privately owned merchants traders like Castleton Commodities.
While the past few months have seen an unprecedented commodity market exodus among banks, industry insiders say the two giants may be waiting till the commodity cycle turns.
"The businesses are getting materially smaller, but these guys do see a future," said Chip Register, managing director of Sapient Global Markets, a consultancy focused on commodities trading. He noted that any eventual regulation would likely be months, if not years, away.
"They're all to some extent waiting it out."
Spokesmen from both banks declined to comment on this story.
NO NEW IDEAS
Last month, through a 19-page paper and testimony in front of the Senate banking sub-committee, the Federal Reserve broke years of silence on the issue of physical commodities, which had become a growing sources of concern for Fed officials and anxiety for bank executives since the financial crisis.
Fearing that a catastrophe, such as an oil tanker spill, could bring down a bank and imperil the financial system, the Fed sought public comment on a series of possible ways to put a cap on such risks for banks that had been allowed to grow deeper into the physical markets.
Yet, they offered few ideas as to how the Fed might address the legal protection afforded to Goldman Sachs and Morgan Stanley: a clause in the 1999 landmark law Gramm-Leach-Bliley Act that "grandfathered" any commodity trading and investment activities for investment banks who later converted to Fed authority.
Michael Gibson, the Fed's director of bank supervision and regulation, told lawmakers last month that its ability to rein in the grandfathered banks was "more limited."
"I think it's a good question why some companies should have different authority than others -- and broader authority," Gibson told lawmakers. He did not provide an answer.
The two banks may engage in these activities without "approval by or notice" to the Fed, according to the clause, which was added to the GLB law almost as an afterthought, at the last minute, according to Saule Omarova, a banking law expert at the University of North Carolina law school, who has researched the history of the clause.
"No one had a chance to notice how open-ended and ambiguous it was until it really became a practical issue with Goldman Sachs and Morgan Stanley," she said.
The question that emerged in recent years has been whether the Fed would allow the banks to hold onto assets and trades that they acquired in the 15 years since it took effect.
TEA LEAVES AND BODY LANGUAGE
Some sources who work closely with banks and the Fed point to the planned sale of TransMontaigne, the oil terminal business that Morgan Stanley bought in 2006, as evidence that the Fed may be privately emphasizing a narrow interpretation, drawing a sharp line to reject purchases made after 1997.
"In a case like this, they're not going to call someone in and say 'We don't like what you're doing,'" said one banking lawyer who declined to be named.
"They're going to call you in and talk about it, and as a private party, you can read the tea leaves or figure out from their body language."
Even so, the two may still hold advantages not available to other banks if the Fed opts to move ahead with new limits.
For instance, while Morgan Stanley sold the bulk of its physical oil trading business to Rosneft (ROSN.MM), it still owns three power plants, assets which give its several hundred power and gas traders extra insight into the power markets, and remains one of biggest banks trading in those markets. It will also still trade physical oil for clients, officials say.
It also raises the question of how the Fed will draw the line within a certain commodity trade. For example, Morgan Stanley received a U.S. power marketing license in 1995. It was not until 1999, though, two years after the cutoff date, that it built its own power plants in Nevada, Alabama and Georgia. A spokesman said the bank has no plans to sell its U.S. power plants.
In late January, Morgan Stanley said it had signed a deal to buy natural gas and electricity in the wholesale market for Britain's Spark Energy, a small retailer.
Goldman Sachs is still a major coal and natural gas trader, though it trades far less physical oil than it did in the 1990s. As of the September 1997 cut-off, it owned a condensate refinery in Rotterdam; by the time the GLB law was passed in 1999, Goldman had agreed to sell the plant to Koch Industries.
Many of Goldman's top executives are former traders from J. Aron, the commodities trading operation that Goldman bought over three decades ago, and have been resolute about remaining in commodities. Harvey Schwartz, Goldman's chief financial officer, said last month it was "too important" to its clients to exit.
All banks that remain in commodities now face a range of possible limits, such as higher capital requirements to safeguard against potential loss or liabilities from "catastrophic" events like an oil tanker accident, according to the Fed's paper in January.
Forcing banks to set aside more capital or cap commodity-related revenue could make such activities uneconomic, while sidestepping the grandfather issue, lawyers say.
Several major players, including JPMorgan Chase & Co (JPM.N) and Deutsche Bank (DBKGn.DE), have quit physical trading altogether.
"Goldman will continue to be at the top of the tree, and they are going to mop up a lot of customer business in the wake of the other banks shutting down," said Kriss Tremaine, a longtime trader and founder of a commodity trade finance fund launching later this year, who mentioned Goldman's strong research team as an added advantage.
But Goldman and Morgan are unlikely to yield more ground easily.
"They're facing somebody who's going to be very aggressive in defending their turf, and they're well-connected and able to do so," said Craig Pirrong, a finance professor at the University of Houston, who has written extensively on commodities.
(Reporting by Anna Louie Sussman; Editing by Jonathan Leff, Peter Henderson, Josephine Mason and Marguerita Choy)