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The Volcker-Brown paradigm


Commodity trading houses set to slip under Volcker net

By Gregory Meyer in New York and Javier Blas in London

Published: January 28 2010 22:08 | Last updated: January 28 2010 22:08

Paul Volcker and Barack Obama
President Obama’s plan is known as the Volcker rule

Commodity trading houses are set to emerge as beneficiaries of US president Barack Obama’s clampdown on Wall Street as they escape proposed rules designed to hit banks.


Mr Obama’s plan, known as the Volcker rule, would stop banks from trading on their own accounts if the business is unrelated to customers, potentially hitting their raw materials businesses. While details are fuzzy, executives at banks and the publicity-shy merchants of oil, metals, coal and foodstuffs are bracing for a shake-up of the commodity order.

A ban on proprietary bets could present unique wrinkles in commodities, an important source of trading revenue for banks including Goldman Sachs and Morgan Stanley. Beyond trading abstract derivatives such as futures and swaps, several banks also buy and sell actual shipments of oil, gas, industrial metals and other physical assets.

While the physical trading may be helpful to bank customers, some of this trading is clearly speculative. For example, some leading Wall Street groups last year stored diesel aboard tankers to profit when fuel prices rebounded.

Unlike the banks, commodity trading companies, which include Glencore, Vitol and Trafigura, face no pending rules. The US plan could present a chance to grab market share as uncertainty looms. “Obama’s crackdown on Wall Street is largely positive to the trading houses,” a senior executive at a large Europe-based trading company told the Financial Times.

“I think it is good for us,” added a senior executive at a smaller trading house in Europe. “The banks will most likely cut back on physical business.”

Commodity trading has grown among banks seeking a piece of a business long dominated by Goldman and Morgan Stanley.

JPMorgan, after acquiring commodity businesses from Bear Stearns and UBS, is in exclusive talks to buy RBS Sempra Commodities, a joint venture part-owned by Royal Bank of Scotland, the rescued UK bank. RBS Sempra has reduced its reliance on proprietary trading and and now has more customer business, traders say, potentially giving JPMorgan a deeper book of clients.

In energy, the largest of the commodity futures markets, banks already face the prospect of a ban on “speculative” trading under rules proposed this month by the US Commodity Futures Trading Commission.

But it remains unclear how non-US banks would be touched by the rules. In recent years Europe-based banks including RBS, Société Générale, Barclays and Deutsche Bank have received US approval to trade physical commodities when it complements their derivatives businesses.

As details emerge, banks may be able to circumvent a trading ban. “I think it may spur some creative thinking,” said Matthew Kerfoot, of lawyers Dechert in New York.

Yet a decline in bank commodity business could still harm the trading houses. Banks are the main dealers of derivatives used to hedge risks in relatively specialised commodity markets, such as coal and iron ore. “We need liquidity and for that we need the banks,” said one senior executive at a trading house.

Volcker has the measure of the banks

By John Gapper

Published: January 27 2010 21:11 | Last updated: January 27 2010 21:11

Ingram Pinn illustration

Since Paul Volcker stood by Barack Obama a week ago as the US president unveiled banking reforms devised by “this tall guy”, the “Volcker rule” has provoked angst on Wall Street and in Washington.

Critics complain that it is a populist measure designed to distract attention from the Democrats’ political woes; that it is impractical; that it would put US banks at a disadvantage to European ones; that its target is wrong; and that it would let investment banks escape.

Some of these objections, particularly the last, have weight, yet the Volcker rule – that deposit-taking banks would not be able to engage in proprietary trading, or to own hedge funds or private equity firms – is the first time any government has proposed a sensible structural remedy for the problems created by bailing out banks in 2008.

For that reason, I welcome the conversion of the US president to splitting up banks rather than letting them remain too big to fail and relying on tough regulation, higher capital charges and mechanisms for winding them down if they get into trouble. For the first time, a government is directly attacking the size and complexity of over-mighty institutions. 

My colleague Martin Wolf raised a number of difficulties with the Volcker plan this week, and it does indeed, as he put it, need “more work”. But it would be a great shame if – as Wall Street hopes – it runs into the sand on Capitol Hill in the same way as healthcare reform.

There is clearly a populist element to the change in regulatory approach, which Tim Geithner, the Treasury secretary, resisted before the Democrats lost the pivotal senate election in Massachusetts.

But a law intended to elicit votes and popular support is only problematic if it is a bad law. A plan drawn up by a former chairman of the Federal Reserve and first suggested in a report from the G30 group of international banks is not a piece of political chicanery.

Nor do I see why it is impractical. Hedge funds and private equity funds are easy enough to split off from banks that have federal deposit insurance and official backing such as access to the Fed discount window. There is a case, which I discussed in an earlier column, for going further and taking asset management out altogether.

The definition of proprietary trading is trickier, given that any bank with market-making activities (which includes all the biggest ones) or Treasury operations (all of them) is positioning its balance sheet in order to make money, or at least not to lose it. But the reality is that most banks know what a proprietary trading desk is and the ones that do not find themselves suffering huge losses from rogue trading. It would be easy enough for executives and regulators to eliminate pure casino-style risk-taking.

Next is the objection that the Volcker rule is – like the Glass-Steagall Act before it – a US idea that does not fit the push for global co-ordination of regulation. France and Germany – despite their oft-expressed hostility to hedge funds and financial gambling – are never going to do anything to undermine their own universal banks.

Yet it is much better for the US to do the right thing than to wait for the European Godot. That need not be a problem for the US financial system – the Volcker rule would not curb innovation or stop hedge funds or private equity groups from making money. Curbs on large financial institutions are compatible with – indeed, can stimulate – a thriving financial sector.

A further objection to the Volcker rule is that it aims at the wrong target – that hedge funds and proprietary trading desks did not cause the crisis. This point is overstated: in fact, the crisis at Bear Stearns started with its own hedge funds, and many banks were in effect trading by holding triple-A mortgage-related derivatives.

It is also more generally misplaced. As Viral Acharya, a professor at New York University’s Stern School, argues, the crisis was caused by a “general underpricing of risk” that led many banks into taking on more trading and investment risk to boost their returns.

There is, however, one substantial objection to the Volcker rule as it has been structured by the administration. It focuses on deposit-taking banks rather than, as Mr Volcker’s G30 report last year phrased it, “systemically important financial institutions”.

This means that it would apply to, for example, JPMorgan and Bank of America, but probably not to Goldman Sachs and Morgan Stanley. These investment banks have the option of giving up their bank holding company status, shedding deposit-taking, and being able to continue combining proprietary and customer businesses.

Leaving aside the strange consequence that an attempt to curb banks could end up helping Goldman by reducing the competition, this is wrong in principle. Even if Goldman and Morgan Stanley surrendered access to the discount window and their bank status, do we really believe this deals with the problem?

Of course not, for we cannot (much as everyone would like to) erase the memory of the last time trouble struck. The Treasury was forced to bail out Goldman and intervene to prop up American International Group, the full details of which are now embarrassing Mr Geithner.

The Volcker rule is not perfect but is the best attempt yet to confront head on the legacy of that time. If it were extended to Wall Street as a whole, it would be better still.
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Identifying commodity prop trades will be hard: comment

London, 25 January 2010

President Barack Obama's banking proposals will have only a limited direct effect on the commodity trading activities of the major banks. But they alter the political landscape and will stiffen regulators' resolve to push ahead with position limits in energy markets. The president's proposed "Volcker Rule" would prohibit banks or bank holding companies from owning, investing in or sponsoring a hedge fund, private equity fund or proprietary trading operations unrelated to serving customers.

As I have noted elsewhere , the concept behind the reform is sensible, but the problem is how to distinguish between proprietary trades and market-making on behalf of customers.


In some cases, banks have already broken out proprietary trading and hedge-fund activities into separate divisions or institutions. Goldman Sachs runs some of the most famous internal hedge funds, but there are plenty of others.

Reforms should be fairly easy to apply in these cases. Goldman will either have to get rid of its hedge funds (by closing them down, selling them or otherwise "externalising" them) or give up its status as a bank holding company and with it access to the discount window and associated facilities at the Federal Reserve Bank of New York.

But in many cases banks do not distinguish between proprietary trading positions and those held as part of the short-term market making book to enable them to provide liquidity for customers. All these trades are held in the same book and conducted by the same traders.

Tactical positions held for market-making purposes may be a significant source of profits. Conversely, short-term positions resulting from deal flow can be a platform around which to conduct a longer-term strategic prop trading policy. In these cases it is meaningless to try to make a distinction between proprietary and customer-related activities.


Barclays Capital, for example, insists it does not have a standalone prop trading business but that its positions are related to customer flow. The bank, however, has given mixed messages. In a newspaper article last year Chief Executive John Varley said "proprietary trading is not a core function" of investment banking. President Bob Diamond suggested there would in future be "a premium on businesses that deploy capital on behalf of clients, rather than proprietary trading". But Chairman Marcus Agius told the Financial Times "prop trading has been demonised".

If the bank struggles to work out whether it does prop trading or not, what chance have the regulators got? Regulators will struggle to distinguish between prop trading and customer-related flow business in all asset classes (equities, bonds, currencies) but the problem will be particularly acute in commodities.

For most banks commodities are a small, if profitable, part of their overall operations. Invariably all trading is handled through a single combined book rather than broken into customer and prop elements. It is far from clear how regulators will try to draw a distinction. Moreover, since commodity markets are much smaller and less liquid than equity, bonds and currencies, the banks' liquidity-providing role is commensurately greater.

If an oil company, like Mexico's Pemex, wants to hedge a large quantity of its production, it may only be feasible if a bank is prepared to warehouse some of that risk on its balance sheet before gradually laying it off in the public markets. Would that be proprietary or customer-related? What if the bank tried to pre-position its book, and amassed a large position in the expectation PEMEX or another customer would shortly approach it? Would that be proprietary trading or customer business?


If regulators decide to press ahead, there are two options. If they adopted a rules-based approach, positions would only be classed as market-making if they were limited in duration (no overnight positions) or scope (not more than a certain percentage of the total positions held on behalf of customers). Alternatively, banks could be allowed to count any position as "market-making" but only if they could explain precisely what the rationale behind them was and how they benefited customers. If that sounds like a nightmare, it would be. Alternatively regulators could adopt the more flexible approach favoured by U.S. Supreme Court Justice

Potter Stewart, who noted in 1964 that pornography was hard to define but "I know it when I see it". Positions cease to be market-making and become proprietary when they reach such a size and scale in relation to customer business that there can be no clear relation to customer flow.

It would fit well with the "principles-based" regulation beloved of regulators in recent years. But so much discretion would create a great deal of uncertainty. It would be open to court challenges. And it would rely on regulators' (uncertain) willingness to actually enforce the rules.

In practice, regulators could enforce some separation between prop trading and customer business for most asset classes, based on a combination of rules and supervisory discretion. But the limits would probably be set so high that they have little impact, especially in commodities.


For commodity trading businesses, the biggest impact of the Obama plan may be indirect. It will probably stiffen the Commodity Futures Trading Commission (CFTC)'s wavering resolve to impose position limits on energy markets. Chairman Gary Gensler's attempt to impose limits has so far received little support from the White House, Treasury, Congress or Britain's Financial Services Authority. Lacking meaningful political cover, the proposals have been watered down.

The Commission has proposed limits, but set so high they would not affect more than a handful of participants in crude oil and natural gas (though more players would be affected in the smaller markets for gasoline and heating oil).

Even those limits may not be imposed because the Commission remains deeply split on whether to press ahead with them. Two commissioners (Gensler and Bart Chilton) expressed strong support; one strong opposition (Jill Sommers); and two essentially reserved their final decision until later (Michael Dunn and Scott O'Malia). Democrat Dunn and Republican O'Malia's votes will be crucial. Gensler needs at least one to turn the proposed limits into actual regulations.

Dunn worried that imposing limits might be counterproductive unless the CFTC received authority to regulate OTC markets and got more support from overseas regulators. Lacking much support from the administration or Congress, the commissioner hesitated.


But the Obama plan shifts the political playing field decisively. It should make congressional Democrats keener to impose regulations over the industry's objections. Note that both House Financial Services Chairman Barney Frank and Senate Banking Committee Chairman Christopher Dodd shared a platform with the president during the announcement.

It should make it much more likely the CFTC will get the OTC authority it needs. More broadly it will give the CFTC more political backing to press ahead in the face of opposition.

Internationally, the plan has drawn a chorus of approval from politicians. The changed dynamics make it marginally more likely other jurisdictions will follow the CFTC's lead on limits, or at least seek not to undermine the Commission's proposals by actively poaching business.

Finally, Democrat Dunn will be left exposed if he votes against and blocks the Commission from imposing limits. He would be one of the few Democrats in Washington not seeking to clamp down on Wall Street.

Overall, the president's proposals are unlikely to have much direct impact on commodity trading operations at the major banks, but they bring the advent of position limits in energy markets closer.

By John Kemp, Reuters columnist. The views expressed are his own.

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