BANKS AND COMMODITIES
historic bankruptcy of Lehman Brothers, and the spotlight has shifted to commodities. Regulatory change is coming from many directions:
the Dodd-Frank Act and Volcker rule in the United States; the European Market Infrastructure Regulation (EMIR), revised Markets in Financial Instruments Directive and Market Abuse Regulation (MiFID) in the EU and the Basel III capital and liquidity rules – changes intended to reduce systemic risk and increase market transparency and integrity. Additional changes could be on the way, with the US
Federal Reserve Board releasing an advance notice of proposed rule-making in January that could impose tougher restrictions on US financial holding companies trading physical commodities. JPMorgan Chase’s announcement last July that it was looking to exit the physical commodities business heralded the beginning of the end for some of the world’s biggest commodity banking behemoths. JPM’s commodities head Blythe Masters is reported as likely staying with the bank until the commodities unit sale is completed with Swiss trading house Mercuria Energy Group who beat offers from Macquarie Group and Blackstone Group. The UK’s FCA now thinks it might have spotted some in
the commodity markets, warning in a report published at the end of last month about the impact a retreat by investment banks may have on market liquidity and transparency.
So, what’s the way forward? It seems unlikely the
regulatory to-do list will change any time soon, but it opens the door to new debate about the changes in commodities markets, and raises the very legitimate question of whether this is where we want to be.
Conclusion Traditional commodity banks are either quitting or scaling down their commodity operations and trading activities. This could be as a consequence of the excess capacity across the commodity trading sector, capital considerations (given the identification of more attractive ways of deploying capital, human skills and balance sheet resources), and reporting conditions – or most probably a mixture of all three. “As profit margins have shrunk, commodities have become a niche and non-core business for many banking giants. The returns have not been worth the complexity and level of regulatory risk involved in managing them,” explains specialist commodity market staff writer John Kemp at Reuters. It foreshadows further consolidation as new players,
... commodities have become a niche and non-core business for many banking giants. The returns
have not been worth the complexity and level of regulatory risk involved in managing them
While stressing that it believes these measures are necessary and appropriate, the FCA notes the balance in commodity market participation is changing, with banks playing less of a role and other participants – specifically, commodity trading firms – taking up some of the slack. This comes with some potential challenges. For one, these firms tend to operate outside the UK, which could pose a challenge to the FCA’s market supervision. More to the point, however, the FCA acknowledges that
regulation has actually become a driver of market change, rather than being a response to it. The new market reality could mean fewer market participants, less liquidity, less customer choice, less transparency, competitive inequality and high barriers to entry. That’s not an ideal scenario for anyone – including the FCA. A comment towards the end of the paper perhaps sums it up best: the legislation has been implemented in response to decisions taken by the Group of 20 nations in 2009, but “markets have changed since then and the risks now are less about growing markets and a rising tide of speculative activity and more about a lack of liquidity and a retreat by classes of participants”.
28 March 2014
particularly from the emerging markets of Asia and Latin America vie to enter the space. Interestingly, commodities derivatives trading jumped 23% last year, led by the US and China, even as the biggest banks pulled back amid slumping revenues, according to the latest World Federation of Exchanges report.4 Derivatives trading rose to 4 billion contracts in 2013, from 3.24 billion a year earlier, as volumes were boosted by transfers of cleared over-the-counter energy swaps to futures by the InterContinental Exchange and the “continuing sharp increase” in volume at exchanges in mainland China. Trading volumes climbed – even as investors pulled $47.2 billion out of commodities. Commodity- related assets under management shrank by about $100 billion, or about 25% of the total held at the start of 2013, according Barclays. Going forward there are clearly going to be opportunities
for the brave and the bold, and disappointments for others. Traditional commodity banks, however, are unlikely to exit the market completely. There are important synergies between dealing in financials and being able to make and take physical delivery of the underlying, including owning storage and logistics assets. One possible outcome (as suggested here) is that banks and non-bank traders launch a wave of joint ventures. Sovereign wealth funds could become involved, but the likelihood is that more joint ventures with private equity, major established physical trading houses and Asia banks will continue. •
Footnotes 1. Commodity Markets Update, Feb 2014; Financial Conduct Authority. 2 Figures provided by Coalition. 3 Keeping the faith in commodity trading, Financial Times, 27 Feb 2014. 4 World Federation of Exchanges, Mar 2014.
www.commodities-now.com
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