The Federal Reserve issued about a dozen permits for U.S. and foreign commercial banks or financial holding companies to trade physical commodities from 2003 to 2008, granting greater license to enter the lucrative market.
It must now determine whether to bring that trend to a halt as it weighs the possibility of allowing former investment banks Morgan Stanley and Goldman Sachs to keep their physical asset investments, and whether others such as JPMorgan should be able to expand in the space.
Here is a brief history and synopsis, in the Fed's own words, of its progressively broadening policy toward the trading of commodities as diverse as crude oil cargoes, copper stocks and coffee beans.
The story begins in 2003 with Citigroup, the first bank to seek permission under the Bank Holding Company Act (BHC Act) to trade physical commodities rather than only paper derivatives.
Citigroup wanted its Phibro unit -- acquired in 1998 -- to continue dealing in physical markets. Its commodities business would go on to generate over $5 billion for the bank through 2009.
The story largely concludes, for the moment, in March 2008, when after months of debate the Fed gave its blessing to RBS, which had bought half of the Sempra Commodities trading division.
The RBS permit significantly broadened the scope of how and what banks were allowed to trade to include non-U.S.-listed commodities such as nickel, "tolling" deals with power plants and third-party refining.
All applicants must meet certain basic criteria:
* They must show the activities are "complementary" and that the bank has adequate safeguards and expertise.
* The activities must "not pose a substantial risk to the safety or soundness of depository institutions or the U.S. financial system generally".
* They must "reasonably be expected to produce benefits to the public, such as greater convenience, increased competition, or gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interests, or unsound banking practices".
* The market value of the commodities must not exceed 5 percent of the banks' consolidated Tier 1 capital.
Throughout the letters, however, the Fed has made one point consistently clear: Renting assets, chartering tankers and leasing storage tanks may be OK, but the Fed will not allow commercial banks to own the assets around which they trade.
CITIGROUP INC (October 2, 2003):
A number of considerations support a Board determination that Commodity Trading Activities are complementary to a financial activity. First, Commodity Trading Activities flow from the existing financial activities of FHCs (Financial Holding Companies).
In particular, Commodity Trading Activities would provide FHCs with an alternative method of fulfilling their obligations under otherwise BHC-permissible Commodity Derivatives. For example, if warranted by market conditions, an FHC would be able to use Commodity Trading Activity authority to take a Commodity Derivative to physical settlement rather than terminating, assigning, offsetting, or otherwise cashsettling the contract.
The Board also notes that Citigroup contends that the existing restrictions of Regulation Y place FHCs at a significant bargaining disadvantage when operating in physically settled over-the-counter ("OTC") derivatives markets.
According to Citigroup, counterparties to FHCs in these markets are aware of the regulatory impediments that inhibit FHCs from taking derivative contracts to physical settlement. As a consequence, FHCs that participate in these markets can be forced to terminate or offset their derivative contracts on uneconomic terms. In Citigroup's view, allowing FHCs to engage in Commodity Trading Activities would permit FHCs to compete in physically settled OTC derivatives markets more economically.
Moreover, authorizing Commodity Trading Activities would enhance the ability of FHCs to efficiently provide a full range of commodity-related services to their customers.
Granting FHCs increased flexibility to buy and sell commodities in the spot market and to physically settle Commodity Derivatives likely would benefit customers by enabling FHCs to transact more efficiently with customers in a wider variety of commodity markets and transaction formats.
Approving Commodity Trading Activities as a complementary activity also would enable FHCs to acquire more experience in the markets for physical commodities and thereby improve their understanding of commodity derivatives markets and the profitability of their existing BHC-permissible commodity derivatives businesses.
It is also important to note that a number of non-BHC participants in the commodity derivatives markets, including diversified financial companies, conduct Commodity Trading Activities in connection with their commodity derivatives business.
These companies can, and regularly do, buy and sell commodities in the spot market and physically settle commodity derivative contracts. Permitting FHCs to engage in Commodity Trading Activities in connection with their commodity derivatives business would, therefore, enable FHCs to offer services that are provided by a number of other financial intermediaries.
(The Fed goes on to require Phibro take precautions by frequently inspecting stockpiles, place age limits on the tankers it uses and carry substantial pollution insurance.)
UBS AG (January 27, 2004)
(UBS had purchased Enron's trading operations. Its grandfathered rights were due to expire on February 8, 2004.)
To minimize the exposure of UBS to additional risks, including storage risk, transportation risk, and legal and environmental risks, UBS may not: (i) own, operate, or invest in facilities for the extraction, transportation, storage, or distribution of commodities; or (ii) process, re?ne, or otherwise alter commodities.
In conducting its Commodity Trading Activities, UBS will be expected to use appropriate storage and transportation facilities owned and operated by third parties.
(The following were largely unvaried in form)
BARCLAYS BANK PLC (July 22, 2004)
JPMORGAN CHASE & Co (November 18, 2005)
DEUTSCHE BANK (December 19, 2005)
SOCIETE GENERALE (March 15, 2006)
WACHOVIA CORPORATION (April 13, 2006)
BANK OF AMERICA CORPORATION (April 24, 2007)
CREDIT SUISSE GROUP (March 27, 2007)
FORTIS S.A./N.V., (December 4, 2007) here
(Fortis was later carved up in 2008 during the financial crisis.)
Fortis S.A./N.V. ("Fortis"), a financial holding company ("FHC") for purposes of the Bank Holding Company Act ("BHC Act"), Fortis, N.V., Fortis Brussels S.A./N.V., and Fortis Bank S.A./N.V. (collectively, "Fortis") have requested the Board's approval under section 4 of the BHC Act1 and the Board's Regulation Y2 to provide energy management services ("Energy Management Services") to owners of power generation facilities under energy management agreements ("EMAs") as an activity that is complementary to the financial activities of engaging as principal in commodity derivatives and providing financial and investment advisory services for derivatives transactions.
In connection with its acquisition of Cinergy Marketing & Trading LP from Duke Energy Corp, Fortis received approval to engage in the United States in physical commodity trading activities, on a limited basis, as an activity that is complementary to the financial activity of engaging in commodity derivatives activities.
See Board Letter to David R. Sahr, Esq., dated September 29, 2006. In addition to its physical commodity trading activities, CME, now Fortis Energy Marketing & Trading GP (FEMT) also serves as an energy manager under EMAs with several power generators. At the time Fortis's request was approved, Fortis was informed that FEMT's activities under the EMAs would continue to be reviewed for permissibility as an FHC activity.
Fortis's Energy Management Services - Under FEMT's current EMAs, FEMT, as energy manager, assists power plant owners by providing transactional and advisory services.
The transactional services consist primarily of FEMT acting as a financial intermediary, substituting its credit and liquidity for those of the owner to facilitate the owner's purchase of fuel and sale of power. FEMT's advisory services include providing market information to assist the owner in developing and refining a risk-management plan for the plant.
ROYAL BANK OF SCOTLAND GROUP PLC (March 27, 2008)
Most of the transactions in which RBS proposes to engage as part of Physical Commodity Trading do not differ from transactions that the Board has approved. RBS proposes to engage, however, in a wider set of transactions under the Physical Commodity Trading authority and requests confirmation that these activities are within the scope of that authority.
Specifically, RBS proposes to enter into long-term power supply contracts with large commercial and industrial end-users; to engage in physical trading in commodities for which derivatives contracts have not been approved by the Commodity Futures Trading Commission ("CFTC") for trading on a U.S. exchange or specifically approved by the Board; and to enter into contracts with third parties to process, refine, or otherwise alter commodities.
Permitting RBS to engage a third party to alter a commodity would not significantly increase the risks to the institution from Physical Commodity Trading.
Under this authority, an FHC may already engage a third party to store commodities, which exposes an FHC to substantially the same types of risks as engaging a third party to alter a commodity.
Moreover, an FHC could sell a commodity to a refinery and buy back the refined commodity if both the commodity sold to and bought from the refinery were permissible commodities. Permitting an FHC to engage third parties to alter commodities also would enhance an FHC's ability to meet its customers' needs.
RBS will not use this authority to own, invest in, or operate facilities for the extraction, transportation, storage, or distribution of commodities but will only use storage and transportation facilities owned and operated by third parties. RBS will enter into service agreements only with reputable independent third-party facilities.
RBS will conform to the requirements of the BHC Act, including by divestiture if necessary, the activities of (i) owning, investing in, or operating storage facilities for commodities that it is not permitted to hold or store under the BHC Act and (ii) making and taking physical delivery of commodities that are not Approved Commodities, including metal concentrates, acquired in connection with the transactions contemplated by the Notice within two years of consummation of the transactions, or such longer period as the Federal Reserve in its discretion may grant.
After consummation of the transactions contemplated by the Notice, RBS will not expand its direct or indirect activities or investments in the activities of (i) owning, investing in, or operating storage facilities for commodities that it is not permitted to hold or store under the BHC Act and (ii) making and taking physical delivery of commodities that are not Approved Commodities, including metal concentrates.
RBS will not expand these activities or investments beyond those engaged in by the SET (Sempra Energy Trading) Companies immediately prior to the date of the consummation of the proposed transaction by directly or indirectly (i) acquiring direct control of a company engaged in any activity, or acquiring any assets or business lines of another company that engages in impermissible activities, (ii) increasing the types of investments, products, or services to be engaged in or provided by RBS, or (iii) any similar transactions that would result in an expansion of these activities.
WELLS FARGO (April 10, 2008)
No details available.
(Compiled by Jonathan Leff and David Sheppard; Editing by Dale Hudson)