Need for Regulation on the Conflicts in Banks’ Growing Role in Commodities

There is a clear danger in allowing major financial institutions to dominate both commodity derivatives markets and the related cash commodities. Now, the growing involvement of banks in commodities markets is finally being placed under the microscope. Next month the US Federal Reserve is expected to report on whether it will allow US banks to continue with their current involvement in the commodity markets. Its action could well prompt governments around the world to follow the lead. The unusual role of the London Metals Exchange in licensing warehouses operated by banks that are also LME members may also come under scrutiny.

Metals, energy and soft commodities are all now heavily influenced by the activities of banks: whether it is financing, physical trading, warehousing or derivatives. Most of these areas are unregulated and opaque and thus render the banks open to allegations of conflicts of interest and abuse.

The raw materials, metals and food in which they deal, can also represent key strategic assets. For years, developing nations have blamed western financial markets for the impact on food and other soft commodities which represent vital exports and staple diets.

Whether the involvement of financial institutions in soft commodity trading either raises or destabilises prices remains unproven, but it is a sensitive issue. Such trading has the potential for assisting price stability – smoothing the impact of uncertainty over harvests – but the moral issue is increasingly questioned in the developing world.

Public attitudes in developed countries have changed since the financial crisis, and politicians distrustful of banks and the financial sector have gained support. There is also increased concern over how a number of commodities are priced.

The huge escalation in bank involvement in commodities over the past five years, in part, reflects the vacuum created by the financial crisis. Liquidity has been pumped into banks rather than some of the secondary institutions and trading firms traditionally involved in commodities. In energy, the collapse of Enron resulted in banks being encouraged to fill the financing gap in US energy. All this happened with little real scrutiny, and few boundaries have been set.

The banks involved have robustly defended their activities. They point out that warehouse storage – where they house the physical commodities they own – is typically a small – less than 5% – part of global production. They argue that they play a key intermediary role, holding inventory to meet their marketmaking responsibilities, for backing derivatives, or for client needs and hedging purposes.

Banks have denied they use metals warehousing to manipulate commodity prices.

They point out that metals warehouses in London, such as those for aluminium, are operated under licensing terms set by the London Metal Exchange. However, that is not the same as the LME being an effective regulator, because some of the banks themselves have shareholdings in the exchange. London-based monitoring of warehouses around the world cannot be readily checked. There is little public accountability in the LME role, despite its global impact.

The LME has its own rules to try to keep warehouse information confidential, but it would be better for this to be regulated externally, given the potential impact of such price sensitive information on other markets, such as mining equities.

There is also little transparency on what portion of bank activity is actually proprietary, or how knowledge of all the physical activities in the commodities markets might assist their other capital markets businesses.

Last month, JP Morgan Chase agreed to pay $410m to settle issues raised by regulators about its trading strategies in US electricity markets.

The banks argue that their huge balance sheet capacity and appetite for risk puts them in a unique position to conduct supply and off-take deals. These mean that a bank can finance a refinery via the supply of crude oil, whilst committing to take future refined product back in repayment.

But new risks have been created by the rapid expansion by banks into these areas. Global food prices and the flow of oil and gas are major strategic issues for many nations. The complexity of commodities, derivative markets and private financing arrangements, means that fragmented regulation may miss the full picture.

Commodity markets are also typically less liquid at times than cash equities, and so individual orders can move prices sharply. Regulators cannot possibly examine all such moves for the underlying purpose, nor should they try and rule on whether a trade represents a hedge, proprietary or agency activity. Preventing fraud in markets such as power may involve dissecting subtle trading strategies invoked for underlying business purposes.

The regulatory emphasis should be on systemic risk, avoiding conflicts, and demanding transparency of management for any conflicts that cannot be eradicated.

But the problem is one of approach and harks back to how the US tackled bank regulation – in the minutiae.

Commodities and related markets are complex and cannot readily be probed by regulators based on an outdated model which fails to recognise the new interconnected world.

Carefully drawn boundaries on banks’ commodity involvement have become blurred in the last five years as they have bought up assets from problem institutions such as MF Global. And, the unique status of the major investment banks changed in 2008, with little time for them to put their range of activities on a par with the major regulated banks.

Undoubtedly, banks believe that their trading in physical markets is essential for their commodity derivatives operations. But, while derivatives have seen increased regulation since the financial crisis, physical trading faces little scrutiny. The banks themselves also face a new systemic risk through their involvement in transport and storage of energy and commodities. BP offers clear evidence of the dangers, with the huge cost of its Texas City Refinery disaster, but the impact on the banking system could be significant if a bank-owned facility was involved in an accident.

The huge scale of the banks in commodity activities has the potential for creating systemic risk. JP Morgan Chase now owns one of the largest natural gas traders in UK and European markets. Its plan to issue a physically-backed copper exchange-traded fund could also add to price volatility and create shortages of a key global resource.

Clearly, there is systemic risk as well as conflicts in allowing major financial institutions to dominate both commodity derivatives markets and the related underlying cash commodity markets. Involvement in transportation and storage adds to the dangers. Investors will be hoping for a clear lead from the Fed next month on how they and other regulators might introduce transparency into these complex and interconnected banking activities.

A version of this article was published as the Op-Ed in Financial News on August 13th 2013

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