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From Securities Regulation Daily, January 15, 2014

Senate banking subcommittee examines ownership of commodities by bank holding companies

By Lene Powell, J.D.

The Senate Banking Subcommittee on Financial Institutions and Consumer Protection held a hearing to examine involvement by bank holding companies in commodities operations, including warehousing, storage, and delivery of commodities. The hearing was conducted by Subcommittee Chair Sherrod Brown (D-Ohio), and heard testimony from officials of the Board of Governors of the Federal Reserve System (Fed), the Federal Energy Regulatory Commission (FERC), and the CFTC.

Background. As explained in a notice of proposed rulemaking issued by the Federal Reserve Board, bank holding companies (BHCs) have over the past few years expanded their activities involving physical commodity trading. In addition, some securities firms that engaged in substantial physical commodity activities were acquired by or became BHCs. The expansion of banks into physical commodities activities has raised issues of market domination, effect on regulators’ power over banks, and increase in systemic risk.

The Subcommittee on Financial Institutions and Consumer Protection Affairs held a hearing on July 23, 2013, examining bank holding companies’ activities in physical commodities and energy markets. As reported in Securities Regulation Daily, a variety of witnesses found the significant expansion of large banking institutions into physical commodities problematic. For example, Timothy Weiner, global risk manager of commodities and metals at MillerCoors, spoke of delays of 18 months to get aluminum stored in London Metal Exchange (LME) warehouses controlled and owned by U.S. bank holding companies, as well as unnecessary overpayment and higher prices.

In August 2013, CFTC Commissioner Bart Chilton expressed concern that banks’ ownership of physical commodities would allow them to evade restrictions on proprietary trading put in place by the Volcker Rule. In a letter to Federal Reserve Board Chair Ben Bernanke, Chilton said it was “critically important” that banks’ commodity warehousing, storage, and delivery activities did not result in an end-run of the Volcker Rule or CFTC-mandated position limits, as these activities could allow banks to contend that their trading activity pertained to hedging of their physical business risks, consequently putting much of their activity out of regulatory reach.

Senator Brown’s concerns. The senator said that for years, federal banking laws drew sharp lines between banking and commerce. Then in 1999, Congress weakened these laws, and over the last decade financial institutions have expanded into new and varied lines of business. The six largest bank holding companies have 14,420 subsidiaries, and only 19 of those are traditional banks, he said.

According to Sen. Brown, the Fed’s proposal was a “timid step” and too slow in coming. There is still too much unknown about these activities and investments, he said, and regulators have yet to address concerns about aluminum, zinc, and copper markets. Although the London Metal Exchange (LME) has adopted new warehouse rules, industrial end users are unconvinced that these reforms will address the problem, as premiums and queue lengths have only grown since they were announced. The senator questioned why banks should be allowed to own commodity operations at all, when everyone but the banks agrees it is not a good idea.

Section 4o authority for specific firms. Senator Brown quizzed Michael Gibson, director of the Division of Banking Supervision and Regulation, on the limits of Sec. 4o authority, which allows specific companies to continue to engage in a broad range of physical commodity activities under specific grandfathering authority after the firms became BHCs. If a bank traded zinc in 1997, asked Sen. Brown, can it now trade aluminum? If it owned a warehouse, could it purchase an oil tanker? Senator Brown said there was the problem of “the camel’s nose under the tent,” meaning that as a result of being grandfathered for certain activities, they were allowed to do much more. Gibson replied that the permitted activities were generally those that were engaged in in 1997, but it depended on the facts and circumstances of the particular case, and this was one of the issues the Fed is reviewing. When asked whether the Fed had ever used its safety and soundness authority to curtail Sec. 4o authorities, Gibson said he did not think so, because it is a high bar.

Senator Elizabeth Warren (D-Mass.) asked, if the Glass-Steagall Act were reinstituted, would the Fed still be in a position where it has to decide that trading in zinc is okay, but trading in aluminum is not, or how much insurance an oil tanker has to buy? Gibson replied that no, the Fed would not be in that position, because those would not be permitted activities. The senator said she had to admit, that sounded pretty appealing to her.

Price impact. Senator Jeff Merkley (D-Or.) asked about the effect on consumer prices of banks’ involvement in commodity operations. The senator asked if it were good policy to allow a firm with enormous assets to control supply and demand of a product, while also trading in that product. Specifically, he asked whether banks’ control of large amounts of aluminum is equivalent to a tax on financial system, increasing the cost that end users pay, resulting in higher prices for aluminum cans. Gibson said he would not call it a tax, and what the Fed looks at it is safety and soundness, and whether banks have enough capital to back up risk. He did not know the effect on price.

Vince McGonagle, director of the CFTC Division of Market Oversight, said one factor that affects price is market concentration, or the size of position that any trader might hold. Concentration of position can lead to impact on price, he said, and the CFTC looks at that. Norman Bay, director of the FERC Office of Enforcement, added that any time there is fraud or manipulation, there is an impact on consumers, and that cost is borne by end users.

CFTC-FERC coordination. Senator Warren asked McGonagle and Bay about coordination between the CFTC and FERC on surveillance in the energy markets. She noted that the Memorandum of Understanding on information sharing recently executed by the two agencies was long overdue, having been mandated by the Dodd-Frank Act three-and-a-half years ago. Now that it was in place, the senator asked if FERC was getting everything it needed.

Bay explained that FERC receives data on physical gas and power markets through its own sources, and that data is very helpful to beef up market surveillance. However, the regulatory construct behind FERC and CFTC was fashioned years ago when there was a large physical market and very small futures market, and now the converse has now occurred; the financial market is larger than the physical. There are three components cross-product manipulation: tool, target, and benefitting position. Manipulators trade in a way that might even be uneconomic for a given trade because they want to move prices for the benefitting position, which involve financial products. If FERC had access to more data, then the agency could create more efficient and sensitive algorithms. Specifically, FERC would like access to the CFTC’s large trader report.

McGonagle said the CFTC has allowed FERC staff to visit its premises to view data from the large trader report, and are working on a protocol to protect confidentiality of data. The CFTC has worked diligently with FERC when it comes to information sharing, and surveillance is layered onto a strong cooperative enforcement relationship. Bay replied that the on-site sharing was a “step forward,” but what they would really like is a live data stream of gas and power market data from the large trader report. In response to McGonagle’s explanation that technical personnel needs to work out issues with data transfer, Sen. Warren said she would be following up on the subject to make sure that data is transferred smoothly to FERC in the future.

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