Is There Life After Banks for the Commodities Sector?

February 6, 2014

What do Barclays, JP Morgan Chase, Standard Bank and Morgan Stanley have in common – aside from being large international investment banks?
– They have recently sold off all or part of their commodities businesses.

Barclays, previously one of the largest banking players in the sector, in April announced it would sell most of its commodities and energy trading operations. This came hot on the heels of JP Morgan Chase, which in March sold its physical commodities division to a private trading firm based in Switzerland. Standard Bank sold its London-based commodities division to Industrial and Commercial Bank of China in January and Morgan Stanley kicked off the trend by selling its physical oil-trading division to Russian oil giant Rosneft back in December.

So what is going on? According to Chris Burke, managing director at Brickendon, commodity trading is no longer such an attractive proposition for investment banks.

“Regulators seem to have approached this business from two stand points,” says Burke. “Firstly they have taken the view that the systemic risk of a failing financial firm being in the physical commodity business poses substantial risks to the non-financial economy, and secondly, they have decided that banks shouldn’t be involved in the whole commodity-value-change from the physical business to derivatives and hedging.”

While the first point is subjective, as a sizable failing bank will in any case impact the wider economy, Burke is quick to add that the second point ignores the increasing impact and dominance of non-banking trading houses like Glencore-Xstrata, Vitol and Trafigura who often own all or part of the whole value chain.

The move by many banking institutions out of such operations comes amid tighter regulation, prompted by the implementation of Dodd-Frank in the US and EMIR in Europe, as well as higher capital requirements in the form of Basel III. The Volker Rule, part of Dodd Frank, bans banks from the proprietary trading of securities and derivatives, including commodity derivatives.

Slender volatility has also contributed to a lack of client hedging and trading opportunities, denting the revenues of bank commodity desks and making the investment needed to remain in the market much less attractive.

According to research firm Coalition, commodity-trading revenue for the ten biggest banks fell by more than two thirds last year to $4.5 billion, from more than $14 billion in 2008. In 2012 the figure was $6 billion and $8 billion in 2011. The headcount on commodities trading desks is now almost a fifth lower than it was three years ago, Coalition said.

However, it is worth noting that in addition to the increased regulatory burden, this could also be attributed in part to collapsing volatility in the oil and gas sector following the shale revolution in the US and weak demand during the post-crisis recession, especially in Asia.

Add to that increased concerns about risk and more focus from the regulatory authorities with regard to price fixing opportunities, and banks may feel they have enough to contend with.

”What is important to note is that when volatility is low there is little need for firms to hedge” says Burke. “But when volatility returns and the hedging options are reduced and costly, then this will impact non-financial firms substantially.”

“Not being able to hedge your risk in a commodities market will cause pain outside of the financial sector and this cost remains unknown and currently seems beyond the concern of the regulators.”

In fact, this opens up a wider debate about what banks should be involved in. In the US, Democratic Senators have urged the Federal Reserve to prohibit banks from trading, warehousing and transporting oil, metals and other commodities, saying the businesses create a conflict of interest and pose a risk to the financial system that could in turn harm consumers.

Back in January, the Fed sought public comment, saying it had serious concerns about banks’ ownership of physical commodities, citing the BP oil spill in the Gulf of Mexico in 2010 and other environmental disasters, but it has so far failed to make a definitive ruling.

Federal law already restricts banks from owning non-financial businesses unless they have special exemptions.

By contrast, the National Association of Corporate Treasurers, representing companies including Boeing, Hershey and Dow Chemical, wrote a letter to the Fed saying that banks help them hedge risks in commodities and they will not easily be replaced if they are driven out of the business because of increased regulation.

Others including the Securities Industry and Financial Markets Association and the Financial Services Roundtable, agree, arguing that having banks in the commodities business helps such operations by increasing competition and improved liquidity.

So what is the impact of these banking players leaving the market, and what does it mean for the sector in the long run?

While the reduction in the number of players in the market is impacting liquidity, it is also creating opportunities. New players, such as Hong Kong Exchanges and Clearing, which used to focus on equities but bought the London Metal Exchange in 2012, is already planning to offer local futures contracts for zinc, copper and nickel (in Chinese renminbi) and for thermal coal (in dollars).

Large energy trading firms, including BP and Shell, could also see it as an opportunity to become more heavily involved in the trading side of the commodities sector. Both companies have energy trading arms that registered this year as swap dealers under the Dodd-Frank Act, a status that allows them to market their risk management services to end-users.

Moreover, major commodities players such as Glencore, Mecuria and Vitol, which have been less affected by the sweeping regulatory overhaul, look well positioned to increase their activity in the range of commodities to fill the space left by the retreating banks. The impact of this is already leading to wider spreads and more costly hedging.

The real impact of the banks’ exit from the sector will not be known until the market experiences sustained volatility.

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