NEW YORK (Reuters) - Goldman Sachs
With unprecedented political and regulatory scrutiny of the raw material trading operations, Wall Street's powerhouses are now facing the gravest threat yet to the physical commodity desks that have allowed them to trump rivals for decades.
The banks are using various strategies in order to convince the Federal Reserve that they should be allowed to retain the metal warehouses, pipelines and oil tankers that they have purchased over the past seven years, experts and companies say.
This is a breakdown of the legal arguments behind their key operations:
THE 'GRANDFATHERED' EXEMPTION
Of the Wall Street banks, Goldman Sachs and Morgan Stanley are special cases since they converted to Bank Holding Company status only in 2008. As BHCs, they gained access to the Fed's discount lending window, but also gave up the freedom and flexibility afforded them as unregulated investment banks -- which included largely unfettered commodity trading activity.
With remarkable prescience, the banks had planned for such a day about a decade earlier, when the 1999 Gramm-Leach-Bliley act modified key parts of the BHC Act, effectively ending the separation of commercial and investment banking.
Within that amendment was a clause that said any bank converting to holding company status "may continue to engage in, or directly or indirectly own or control shares of a company engaged in, activities related to the trading, sale, or investment in commodities and underlying physical properties that were not permissible for bank holding companies to conduct in the United States as of September 30, 1997."
In other words, if you traded and invested in commodities before 1997, you should still be allowed to do so if the bank was engaged in "any of such activities" before then and so long as it does not exceed 5 percent of the bank's total assets.
However the Federal Reserve has been debating how widely or narrowly to interpret this clause, which fails to specify whether trading in one specific commodity should allow broad investment across the spectrum.
This is most pertinent for Morgan Stanley, which is under pressure over its vast TransMontaigne subsidiary, which owns and operates pipelines and oil terminals across the United States.
Morgan Stanley was a large trader of physical commodities such as crude and heating oil in the 1990s, but it only purchased TransMontaigne in 2006. The question the Fed has grappled with is: If a company traded one type of a commodity before 1997, say gasoline, should it be allowed to trade ethanol, for example, or own a crude oil pipeline?
THE MERCHANT BANKING RULE
The GLB act that swept aside Glass-Steagel rules also gave financial holding companies far more leeway to invest in non-financial corporate enterprises -- so long as those investments meet certain criteria to qualify for "merchant banking" status, an issue that is key for JP Morgan and possibly Goldman Sachs.
After 1999, major U.S. commercial banks were quick to register under the new heading of "Financial Holding Companies", allowing them to compete with then-investment banks like Goldman and Morgan to make direct investments into the commercial world.
These investments come with limitations: they must not exceed a certain percentage of the banks' capital base, and are generally limited to 10 years, although the bank may ask for Fed approval to extend that deadline.
The rules also prohibit the bank from participating in the day-to-day operations of the corporation -- a restriction that could seriously diminish the value of a commodity investment for a bank, whose traders may be able to glean valuable insight on market conditions from commercial subsidiaries.
In the case of warehouse companies, the London Metal Exchange (LME) prohibits warehouse operators from also trading the metals that they store on behalf of consumers. Industry sources say there are still trading benefits if a parent firm owns both warehouses and a trading desk.
When Royal Bank of Scotland (RBS) purchased Sempra Commodities in 2008 -- including its Henry Bath warehouse operation -- the Fed ordered it to sell the warehousing unit within two years. Reconfiguring the division as a merchant holding would have been impractical, according to someone involved in the business.
RBS ultimately sold Henry Bath and most of the Sempra business to JPMorgan for $1.7 billion, a deal that closed in July 2010. JPMorgan changed the composition of the Henry Bath board last year in an effort to gain approval from the Fed to retain the business as a merchant banking operation, sources have said.
It is unclear whether that effort was successful. More recently it has floated a possible sale of Henry Bath. A JPMorgan spokesman has declined to comment on the business.
The current status of Goldman Sachs' Metro International Trade Services is unclear, though sources familiar with the business have said it was bought by the bank's commodity arm.
PERMISSION TO TRADE - GRANTED
The issue of whether banks are allowed to trade in physical commodity markets -- taking title to a cargo of crude oil or a container of coffee beans -- is separate from the question of whether they should be able to own infrastructure or assets. As of last Friday, the question of commodity trading is also in doubt as the Fed announced a "review" of a key 2003 ruling.
Historically investment banks had no material restrictions on what they could trade. While Fed-regulated commercial banks have long been allowed to trade commodity derivatives, it wasn't until a 2003 Fed order that they were allowed to participate more deeply in the physical marketplace.
When it bought Travelers Group in 1998, Citigroup sought Fed permission to trade in oil markets in order to retain a small but lucrative Westport, Connecticut-based trading firm called Phibro, a vaunted commodity merchant with a century-old history and a focus on trading physical crude oil benchmarks worldwide.
Citi argued that it was inhibited from trading effectively in derivative markets because counterparties knew that they would not be able to take physical delivery.
The Fed agreed with Citi, saying that trading in real commodities would allow the banks to "transact more efficiently with customers". It said the trading must be "complimentary" to their main activities, contribute to the public good and should not pose a "substantial risk" to the bank.
It said banks must take precautions by frequently inspecting stockpiles, place age limits on the tankers they use and carry substantial pollution insurance, among other things.
Importantly it also added the stipulation that the banks could only trade in commodities for which there was an equivalent commodity derivative contract already regulated by the Commodity Futures Trading Commission (CFTC).
That decision, which came at the start of a decade-long boom in commodity trading, opened the door to a dozen more applications from global giants like Deutsche Bank and domestic players like Wells Fargo. With many of the permits, the Fed gave greater and greater leeway in what and how they could trade.
After converting to holding companies, Goldman Sachs and Morgan Stanley faced greater limitations in which commodities they could trade. Goldman has approached the Fed several times over the past year to seek permission to trade in iron ore, but has been rebuffed since no such U.S. futures contract exists.
It is unclear whether the "grandfathering" exemption will allow the banks to trade in a greater variety of commodity markets than their peers.
(Reporting By Jonathan Leff; editing by Andrew Hay)
