Bank commodity trading and the US Fed: An unfolding relationship

Published 17 September 2014

Last week something serendipitous happened. I  went to what was ostensibly a briefing and news broke out.

The news was that the big French bank BNP Paribas, after some high-level recruitment from a decamping JP Morgan Chase, intends to try and rebuild North American physical electricity trading to go along with its existing natural gas trading operations done primarily through its offices in New York.

BNP’s decision bucks the trend set by a number of other big banks—most notably JP Morgan Chase, Deutsche Bank and Barclays Plc– who have pulled out of several areas of physical energy commodity trading due to a combination of changing market conditions and flagging revenues, but perhaps most importantly, due to mounting regulations.


Specifically, it was word that BNP intends to try and rebuild its wholesale power business, a development that would clearly break from recent trends. It’s important because it signals that some needed liquidity could be coming back to that market.

Immediately, though, there were those who asked just how will BNP make money in a relatively low margin business? They mentioned the relatively mundane matters of overhead costs in New York, as well as salaries, particularly at a time when prices are flat, and volatility and volumes are low.

Catherine Flax, a trading veteran at JP Morgan from 2005 to late 2013, is BNP’s managing director and head of commodity derivatives for the Americas.

The first thing Flax noted after announcing that the bank would try and rebuild physical power trading was that the operation would be “client-faced,” and would not be engaged in proprietary trading. That, as she noted, is a “no-no” under the Volcker Rule, which is part of the Dodd-Frank legislation that is due to go into full effect in July 2015. Without being able to trade for the benefit of one’s own trading book, traders will become far more dependent on finding top-flight clients.

For banks, trading is a strategic decision, and there is some feeling that the financial groups don’t want to cede the field to the big merchant traders, such as Vitol.

But energy producers themselves are also becoming increasingly important, as liquidity becomes the issue and some counterparties are pulling back. Markets are seen to be very lean, with less room for intermediation due to low prices. “Low prices are hurting everyone,” as one of the BNP executives said.

On several occasions, Flax referred to the US Federal Reserve Board as the entity that needed to be most closely watched. The Commodity Futures Trading Commission is also promulgating a host of new rules.

But it is the Fed that seems determined to make trading by banks more expensive, as well as increasing the amount of collateral, or margin, they lend to others to facilitate trading.

What the Fed has been engaged in is an effort at establishing a set of rules that will force banks to preserve more capital in order to be able to respond to adverse conditions that may befall a variety of types of markets in which they have traditionally been market makers. For example, the Fed is currently preparing rules that will force lending banks to increase certain capital requirements, while hedge fund borrowers will be required to post higher levels of collateral on trading activities in non-cleared instruments. The Fed says the rationale is to reduce risk.

The Fed has still not decided whether to pull the permission it gave to banks 11 years ago to trade physical commodities as a compliment to their financial trading. A year ago the Fed said it would review the “nature of risks that physical commodity activities could pose to the safety and soundness of financial holding companies and to financial stability more broadly;” “the potential conflicts of interest and other adverse effects of engagement by financial holding companies in physical commodity activities;” and, “the potential risks and benefits of imposing additional capital requirements or other restrictions on the commodity activities of financial holding companies.”

But still, it is going ahead with other regulations. On September 3 the Fed announced that it finalized what it calls “liquidity coverage ratio rules,” and adopted a final rule on its “supplementary leverage ratio.” As well, the Fed called on September 3 for comments on proposed margin requirements of non-cleared swaps.

The intent of the two rules it has adopted, the Fed says, was to “strengthen the liquidity positions of large financial institutions,” by limiting large banks from taking on excessive liquidity risk “in advance of a period of financial stress.”