Federal Reserve Governor Daniel Tarullo told the United States Senate that the central bank planned to introduce strict new limits on bank activity in the commodities markets in early 2015 during his testimony in 2014. While these regulations still haven’t been formally introduced by the Federal Reserve, the threat of regulation led most major banking institutions to close, or significantly curtail, their commodity trading activities to avoid any issues.
In this article, we will take a look at why Wall Street banks are likely to miss out on any turnaround in the commodities markets.
Growing Concern
Senator Carl Levin accused witnesses from Goldman Sachs (GS), J.P. Morgan (JPM) and Morgan Stanley (MS) of obscuring their investments in metals or natural gas from regulators back in 2013 and 2014. Mr. Levin encouraged the Federal Reserve to aggressively keep banks from manipulating commodity markets to benefit other positions and using loopholes to avoid regulations, since their involvement in these markets could introduce systemic risks to the financial system.
The Federal Reserve subsequently expressed concerns that banks holding commodities could be buying and selling physical assets in order to benefit their other trading positions. The central bank intends to combat these tendencies by reducing the amount of allowable asset or revenue that banks derive from physical commodity markets, while increasing the capital costs for the activities and prohibiting involvements in markets that pose systemic risks.
Filling the Void
Macquarie Group Ltd., Australia’s largest investment bank, has taken the opportunity to fill the void left by many U.S. investment banks in the commodities market. Currently, the company is the third largest trader of physical gas in North America following BP plc (BP) and Royal Dutch Shell (RDS-A), while it owns electrical utilities in Seattle, Pittsburgh and other U.S. regions. It also imports Canadian oil into the U.S. through pipelines and dealt with the Republic of Congo.
These activities have gone under the radar of the Federal Reserve because its U.S. unit isn’t considered to be a bank. The Sydney-based bank doesn’t take customer deposits, doesn’t have a banking license and has no access to Fed funding. But, global commodities revenue hit $960 million in March of 2016, which is up 75% over March of 2013 when U.S. banks began to be scrutinized for their participation in the commodities markets.
The Bottom Line
Many large Wall Street banks exited their commodities trading activity following a 2014 warning shot from the Federal Reserve. After concerns arose from potential reporting loopholes and unfair advantages, Federal Reserve Governor Daniel Tarullo indicated that the central bank was intending to introduce new restrictions in early 2015. The threat of these restrictions alone led many banks to get out of the business.
Foreign banks like Macquarie Group ended up filling the gap with their U.S. offices, since they aren’t legally considered banks in the U.S. These trends are likely to continue as U.S. banks stay away from the market, leaving an enormous opportunity for financial institutions to get involved in a market that’s starting to turn around.
