Talk about being late to the party. In mid-April the U.S. Federal Reserve Board closed the comment period for its investigation into the risks posed by big banks’ participation in the commodities markets. Democratic Senators Sherrod Brown and Elizabeth Warren argued in a letter that banks “should be prohibited from owning physical assets like warehouses, pipelines and tankers” because this poses significant “safety and soundness, legal and reputational risks.”
But while the Fed has been busy digesting the market’s different perspectives, the banks themselves have been quietly pushing the regulatory discussion toward redundancy by retreating from the commodities sector. And there’s no strong sense that what lies ahead for the commodities markets will be any safer or less fraught with the potential for conflicts of interest. “It’s still not clear exactly how things are going to play out, but what is clear is that we’re witnessing a once-in-a-generation shift,” says Ehud Ronn, a professor of finance at the University of Texas at Austin.
In the past 12 months, Deutsche Bank, Royal Bank of Scotland and UBS have significantly scaled down their participation in commodities; last December, Morgan Stanley agreed to sell its oil trading unit to Rosneft, the Russian state-owned oil company; and in March, JPMorgan Chase & Co. announced the sale of its commodities unit for $3.5 billion to Mercuria Energy Group, a Geneva-based commodities trading house founded by two former Goldman Sachs Group traders. Late last month Barclays announced that it was shutting down most of its operations in those markets.
The last time there was a mass reorganization of the primary actors in the commodities sector was in the early 2000s, in the wake of the Enron Corp. scandal, when the large Houston-based merchant energy companies sold off their physical holdings and exited the trading business in droves. Banks flooded in to replace them and rode the commodities bull market into 2008 with glee; but with the market cooling and Basel III occasioning a more parsimonious deployment of bank capital, many institutions decided to get out before commodities sank any further. “The pressure didn’t come from the regulators; the pressure was on the banks to rebuild their balance sheets,” says Walter Zimmermann, Jersey City, New Jersey–based chief technical analyst at United-ICAP, the advisory arm of the world’s largest interdealer broker. “If you’re running a huge commodity book, that’s taking up a lot of capital.”
But concerns abound that the underlying problems that have traditionally beset the commodities markets are simply being pushed onto a new and less tightly regulated set of actors. The big beneficiaries are independent trading houses such as Mercuria, Louis Dreyfus Commodities Group, Trafigura Beheer and Vitol Group, many of which look set to fill the market vacuum like the banks did after 2001. In one sense, UT Austin’s Ronn contends, the rise of these smaller players is good from a market safety perspective because they won’t have recourse to the “implicit Fed subsidy” that banks can count on: “Their default would likely have far fewer marketwide repercussions,” he says. However, these institutions aren’t subject to the same density of regulatory oversight as the big banks.
Institutions with a stake in the physical and trading sides of commodity markets have always faced the challenge of skewed incentives. Enron traders manipulated the price of energy during the 2001 California electricity crisis by illegally shutting down pipelines the company owned; more recently, Goldman Sachs, one of the few banks still active in commodities, has faced accusations of hoarding aluminum to drive up prices and reap a trading gain. Nothing about commodities’ emerging breed of market makers removes that potential for conflicting interests.
Meanwhile, some analysts remain worried that market liquidity may suffer: The trading houses, with far skinnier balance sheets at their disposal, have none of the big banks’ ability to smooth the market by stepping into trades when buyers or sellers are in short supply. “You’re likely to see bid-ask spreads widen,” Ronn predicts. “It’ll make hedging far less convenient and increase the cost.”
United-ICAP’s Zimmermann counters that if “there is fear out there, it’s fear of the unknown.” What’s happening is a return to the situation that existed before the commodities bubble inflated in the mid-2000s, he adds: “The market functioned perfectly well then; it can function well again.” • •
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