London, 25 January 2010

President Barack Obama's banking proposals will have only a limited direct effect on the commodity trading activities of the major banks. But they alter the political landscape and will stiffen regulators' resolve to push ahead with position limits in energy markets. The president's proposed " Volcker Rule" would prohibit banks or bank holding companies from owning, investing in or sponsoring a hedge fund, private equity fund or proprietary trading operations unrelated to serving customers.

As I have noted elsewhere , the concept behind the reform is sensible, but the problem is how to distinguish between proprietary trades and market-making on behalf of customers.

INTERNAL HEDGE FUNDS

In some cases, banks have already broken out proprietary trading and hedge-fund activities into separate divisions or institutions. Goldman Sachs runs some of the most famous internal hedge funds, but there are plenty of others.

Reforms should be fairly easy to apply in these cases. Goldman will either have to get rid of its hedge funds (by closing them down, selling them or otherwise "externalising" them) or give up its status as a bank holding company and with it access to the discount window and associated facilities at the Federal Reserve Bank of New York.

But in many cases banks do not distinguish between proprietary trading positions and those held as part of the short-term market making book to enable them to provide liquidity for customers. All these trades are held in the same book and conducted by the same traders.

Tactical positions held for market-making purposes may be a significant source of profits. Conversely, short-term positions resulting from deal flow can be a platform around which to conduct a longer-term strategic prop trading policy. In these cases it is meaningless to try to make a distinction between proprietary and customer-related activities.

WHAT IS PROP EXACTLY?

Barclays Capital, for example, insists it does not have a standalone prop trading business but that its positions are related to customer flow. The bank, however, has given mixed messages. In a newspaper article last year Chief Executive John Varley said "proprietary trading is not a core function" of investment banking. President Bob Diamond suggested there would in future be "a premium on businesses that deploy capital on behalf of clients, rather than proprietary trading". But Chairman Marcus Agius told the Financial Times "prop trading has been demonised".

If the bank struggles to work out whether it does prop trading or not, what chance have the regulators got? Regulators will struggle to distinguish between prop trading and customer-related flow business in all asset classes (equities, bonds, currencies) but the problem will be particularly acute in commodities.

For most banks commodities are a small, if profitable, part of their overall operations. Invariably all trading is handled through a single combined book rather than broken into customer and prop elements. It is far from clear how regulators will try to draw a distinction. Moreover, since commodity markets are much smaller and less liquid than equity, bonds and currencies, the banks' liquidity-providing role is commensurately greater.

If an oil company, like Mexico's Pemex, wants to hedge a large quantity of its production, it may only be feasible if a bank is prepared to warehouse some of that risk on its balance sheet before gradually laying it off in the public markets. Would that be proprietary or customer-related? What if the bank tried to pre-position its book, and amassed a large position in the expectation PEMEX or another customer would shortly approach it? Would that be proprietary trading or customer business?

"I KNOW IT WHEN I SEE IT"

If regulators decide to press ahead, there are two options. If they adopted a rules-based approach, positions would only be classed as market-making if they were limited in duration (no overnight positions) or scope (not more than a certain percentage of the total positions held on behalf of customers). Alternatively, banks could be allowed to count any position as "market-making" but only if they could explain precisely what the rationale behind them was and how they benefited customers. If that sounds like a nightmare, it would be. Alternatively regulators could adopt the more flexible approach favoured by U.S. Supreme Court Justice

Potter Stewart, who noted in 1964 that pornography was hard to define but "I know it when I see it". Positions cease to be market-making and become proprietary when they reach such a size and scale in relation to customer business that there can be no clear relation to customer flow.

It would fit well with the "principles-based" regulation beloved of regulators in recent years. But so much discretion would create a great deal of uncertainty. It would be open to court challenges. And it would rely on regulators' (uncertain) willingness to actually enforce the rules.

In practice, regulators could enforce some separation between prop trading and customer business for most asset classes, based on a combination of rules and supervisory discretion. But the limits would probably be set so high that they have little impact, especially in commodities.

STIFFENING CFTC RESOLVE

For commodity trading businesses, the biggest impact of the Obama plan may be indirect. It will probably stiffen the Commodity Futures Trading Commission (CFTC)'s wavering resolve to impose position limits on energy markets. Chairman Gary Gensler's attempt to impose limits has so far received little support from the White House, Treasury, Congress or Britain's Financial Services Authority. Lacking meaningful political cover, the proposals have been watered down.

The Commission has proposed limits, but set so high they would not affect more than a handful of participants in crude oil and natural gas (though more players would be affected in the smaller markets for gasoline and heating oil).

Even those limits may not be imposed because the Commission remains deeply split on whether to press ahead with them. Two commissioners (Gensler and Bart Chilton) expressed strong support; one strong opposition (Jill Sommers); and two essentially reserved their final decision until later (Michael Dunn and Scott O'Malia). Democrat Dunn and Republican O'Malia's votes will be crucial. Gensler needs at least one to turn the proposed limits into actual regulations.

Dunn worried that imposing limits might be counterproductive unless the CFTC received authority to regulate OTC markets and got more support from overseas regulators. Lacking much support from the administration or Congress, the commissioner hesitated.

NEW POLITICAL ENVIRONMENT

But the Obama plan shifts the political playing field decisively. It should make congressional Democrats keener to impose regulations over the industry's objections. Note that both House Financial Services Chairman Barney Frank and Senate Banking Committee Chairman Christopher Dodd shared a platform with the president during the announcement.

It should make it much more likely the CFTC will get the OTC authority it needs. More broadly it will give the CFTC more political backing to press ahead in the face of opposition.

Internationally, the plan has drawn a chorus of approval from politicians. The changed dynamics make it marginally more likely other jurisdictions will follow the CFTC's lead on limits, or at least seek not to undermine the Commission's proposals by actively poaching business.

Finally, Democrat Dunn will be left exposed if he votes against and blocks the Commission from imposing limits. He would be one of the few Democrats in Washington not seeking to clamp down on Wall Street.

Overall, the president's proposals are unlikely to have much direct impact on commodity trading operations at the major banks, but they bring the advent of position limits in energy markets closer.

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