Alburquerque, March 2010

The commodity trading industry is starting to see wave after wave of proposals from various government entities calling for new regulations and reporting requirements. Some of the proposals may be viewed as market tuning exercises, such as the one put forth within the last two days which could put limits on the physical location of traders' computers relative to the trading exchanges with which they transact (as the closer you are to the exchange computers, the faster you can commit trades, particularly handy if you are a programmatic or algorithmic trader). Others, if passed as proposed, could have significant and fundamental impacts on the energy commodity markets. Perhaps the most radical of the proposed regulatory changes was the one rolled out to Congress last week by the Obama Administration and widely referred to as the "Volker Rule" (named after former Federal Reserve Chairman and now White House adviser Paul Volcker). If the proposal is adopted as written and made part of the Bank Holding Company Act, it would effectively force banks out of all commodity markets, including the energy markets.

The Volker Rule would ban banks from “purchasing or selling, or otherwise acquiring and disposing of, stocks, bonds, options, commodities, derivatives, or other financial instruments for the institution's or company's own trading book, and not on behalf of a customer, as part of market making activities, or otherwise in connection with or in facilitation of a customer relationship (including hedging activities related to the foregoing).”

Additionally, banks and banking firms would be barred from investing in, or otherwise funding or sponsoring, hedge funds and private equity funds, or other similar funds. This piece of the legislation would ban banks from acting as a managing member or general partner of a fund, controlling the management of a fund, or sharing the bank's name with a fund. While banks and banking firms could act as investment advisers to hedge funds and other private funds, these banks could not lend to private funds, nor could they provide prime brokerage services to those firms.

Clearly, and even though banks and other financial funds have played a somewhat reduced role in the energy markets since the 2008 meltdown, the impacts in the energy markets could be dramatic, as these financial institutions have stepped into the void created after the implosion of Enron, Dynegy, and the others. Now, these primary sources of liquidity in energy trading could be forced out within two years of the rule's adoption.

Ironically, the energy markets may end up being pounded by a piece of legislation that is actually intended to limit "bad behaviors" that have little or nothing to do with energy. Ultimately, the primary motivators of this legislation are the behaviors of the banks and banking firms who engaged in high risk trading related to the mortgage markets, including securitized subprime mortgages and credit default swaps.

Fortunately for the energy market, there does seem to be quite a bit of bi-partisan pushback in Congress, and the chances of the new regulations passing as written do not appear to be great. However, there is no telling how much of the proposed regulation might survive the political sausage making that will surely happen as Congress reacts to the perception of populist anger that still lingers after the Great Bank Bailout of 2008.

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