The US Senate Permanent Subcommittee on Investigations issued a report last week and conducted two days of hearings regarding large banks’ involvement with physical commodities.
In general, the report concluded that bank activities involving physical commodities were risky (exposing the banks to “catastrophic event risks”), unfairly mixed banking and commerce (because banks benefit from lowering borrowing costs), and had undue or potentially undue impact on prices. The report also concluded that through their physical commodity activities banks had access to “commercially valuable, nonpublic information that could have provided advantages in their trading activities.” In oral testimony before the Subcommittee on November 20 to 21, bank officials generally disputed these allegations (click here for a sample of media coverage regarding these hearings).
Among the recommendations by the Subcommittee, however, was one proposal that had nothing to do with bank involvement per se with physical commodities. This recommendation was for the Commodity Futures Trading Commission and the Securities and Exchange Commission to be given joint oversight of exchange-traded funds backed by physical commodities; currently, only the SEC is responsible for ETFs. Moreover, said the Subcommittee in its report, “[t]he CFTC should apply position limits to ETF organizers and promoters, and consider banning such instruments due to their potential use in commodity market corners and squeezes.”
Other recommendations by the Subcommittee pertained solely to banks. These included that federal banking regulators, mostly the Board of Governors of the Federal Reserve System, should (1) “reaffirm” the separation of banking and commerce related to physical commodity activities; (2) limit a bank’s physical commodity holdings to five percent of its so-called “Tier 1 Capital;” (3) establish minimum capital and insurance requirements to protect against potential losses; and (4) prevent unfair trading.
Separately, the Board of Governors of the Federal Reserve System announced two internal reviews to assess the completeness of their examinations of large banks. The reviews will principally aim to determine whether decision makers at the regulator have “all necessary information to make supervisory assessments and determinations” and whether they are aware of “divergent views among an examination team regarding material issues.” One review will be conducted by the Fed’s Inspector General and the other by the Fed’s Board itself.
My View: I thought trading to mitigate the risk of a physical position was hedging and that hedging was the nucleus of futures markets —not something bad. If there is a market offense, the CFTC and futures exchanges already have an ample arsenal to address any violations.