Federal Reserve to Re-evaluate the Permissibility of Physical Commodities Trading: The Rationale Historically and Today

July 22, 2013

On July 19, 2013, Barbara Hagenbaugh, a spokeswoman for the Board of Governors of the Federal Reserve System (Federal Reserve) made the surprising announcement that the Federal Reserve “is reviewing the 2003 determination that certain commodity activities are complementary to financial activities and thus permissible for bank holding companies.”  The statement, upon which the Federal Reserve did not elaborate, seems to call into question the physical commodities trading activities (Physical Commodities Trading) that certain financial holding companies (FHCs), both domestic and foreign, have engaged in for the better part of the last decade.

This Client Alert describes the justifications for the original Federal Reserve conclusion that, under Section 4(k) of the Bank Holding Company Act of 1956 (BHC Act), Physical Commodities Trading is complementary to a financial activity and does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.  It then analyzes these justifications in light of the current state of the financial system and enhanced regulatory environment, which support the conclusion that the Federal Reserve’s original view of Section 4(k) continues to be a reasonable interpretation of the statute.

Section 4(k) of the Bank Holding Company Act

The Physical Commodities Trading orders are based on Section 4(k) of the BHC Act, which was added by the Gramm-Leach-Bliley Act of 1999 (GLB Act).  Prior to the GLB Act, bank holding companies (BHCs) and their nonbank subsidiaries were generally limited to engaging in banking and those activities that the Federal Reserve determined by order or regulation were “so closely related to banking as to be a proper incident thereto.”[1]  The GLB Act granted additional powers to BHCs whose subsidiary banks were well-capitalized and well-managed, and that had satisfactory ratings under the U.S. Community Reinvestment Act.  Upon electing “financial holding company” status, these companies could engage in activities that were “financial in nature or incidental to such financial activity,” and, upon filing an application and obtaining Federal Reserve approval, activities that were “complementary” to a financial activity as well.[2]

The GLB Act defined certain activities that were financial in nature — e.g., securities underwriting and dealing, insurance agency and underwriting activities, and merchant banking activities — but it did not define any complementary activities.  The GLB Act’s legislative history, moreover, was sparse on the subject of what constituted a complementary activity.

Physical Commodities Trading as Complementary to a Financial Activity

In 2003, in the first Physical Commodities Trading order, the Federal Reserve determined that it was permissible for Citigroup, Inc. to retain its subsidiary Phibro, Inc., which had been a subsidiary of Travelers Group before the Citigroup-Travelers merger.  Phibro was engaged in the activity of purchasing and selling commodities in the spot market and taking and making delivery of physical commodities to settle commodity derivatives.

The Federal Reserve determined that Section 4(k)’s complementary authority was intended “to allow the [Federal Reserve] to permit FHCs to engage in a limited basis in an activity that appears to be commercial rather than financial in nature, but that is meaningfully connected to a financial activity such that it complements the financial activity.”[3]

The Federal Reserve then noted that prior to the GLB Act, it had determined that it was a “closely related to banking” activity for BHCs to engage as a principal in a wide variety of commodity derivative activities, including forwards, options, futures, options on futures, swaps, and similar contracts (Commodity Derivatives).  These Commodity Derivatives activities were subject to certain restrictions designed to limit the “commercial” nature of the activities — for derivatives on commodities that banks could not own directly, which were most commodities other than certain precious metals, BHCs were required to make reasonable efforts to avoid physical delivery of the underlying commodities or to take physical delivery only on an instantaneous pass-through basis.[4]

In approving Citigroup’s application to retain Phibro and engage in Physical Commodities Trading, the Federal Reserve stated that Physical Commodities Trading activities “flow from the existing financial activities of FHCs,” in that they would provide FHCs with an alternative method of fulfilling their obligations under permissible Commodity Derivatives transactions.  If warranted by market conditions, an FHC would be able to use physical settlement rather than terminating, assigning, offsetting or otherwise cash-settling the contract.  The Federal Reserve further noted that the inability to settle Commodity Derivatives transactions physically placed FHCs at a competitive disadvantage, because counterparties were able to negotiate uneconomic terms for cash settlement.  Because a number of non-BHC participants in the commodity derivative markets, including diversified financial services companies, conducted Physical Commodities Trading activities in connection with their commodity derivatives business, permitting FHCs to engage in these activities would allow increased competition in those markets.[5]

Physical Commodities Trading Does Not Pose a Substantial Risk to the Safety or Soundness of Depository Institutions or the Financial System Generally

In the Citigroup order, as required by Section 4(k) of the BHC Act, the Federal Reserve also concluded that permitting the Physical Commodities Trading activities did not “pose a substantial risk to the safety or soundness of depository institutions or the financial system generally.”[6]

On this subject, not only were the Physical Commodities Trading activities not being carried out by Citigroup’s depository institutions, but, as a condition to the approval, Citigroup committed that the market value of commodities held as a result of the activities would at no time exceed 5 percent of Citigroup’s consolidated Tier 1 capital; Citigroup was required to notify its supervising Reserve Bank if the market value of commodities held by Citigroup as a result of its Physical Commodities Trading activities exceeded 4 percent of its Tier 1 capital.  In addition, Citigroup could make and take delivery only of physical commodities for which derivatives had been approved for trading on a U.S. futures exchange by the Commodity Futures Trading Commission, unless the Federal Reserve permitted otherwise — this requirement was designed to prevent Citigroup from dealing in items that lacked the fungibility and liquidity of exchange traded instruments.[7]  The Federal Reserve concluded that because through its existing Commodity Derivatives authority, Citigroup already incurred market risk associated with commodities, the Physical Commodities Trading activities “would not appear to increase significantly the organization’s potential exposure to commodity price risk.”[8]

In addition, the Federal Reserve imposed conditions on the conduct of the activities to minimize storage risk, transportation risk, and legal and environmental risks.  Citigroup would not be permitted to own, operate, or invest in facilities for the extraction, transportation, storage, or distribution of commodities, or to process, refine, or otherwise alter commodities.  Citigroup committed to use storage and transportation facilities owned and operated by third parties, and to take additional measures with respect to environmentally sensitive products, such as oil and gas.  Finally, the activities would remain subject to general securities, commodities, and energy rules and regulations.[9]

On this basis, the Federal Reserve concluded that permitting Physical Commodities Trading did not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally and could reasonably be expected to produce benefits to the public that outweighed any potential adverse effects.

Following the Citigroup approval, other domestic and foreign FHCs received approval to engage in Physical Commodities Trading activities in approvals from 2004 to 2011.[10]  Subsequent Federal Reserve orders permitting the activities for particular FHCs imposed conditions identical to those imposed on Citigroup.

The Orders’ Rationale Today

The orders’ interpretation of the term “complementary” in Section 4(k) of the BHC Act would seem to be as reasonable in 2013 as in the Citigroup order.  That order defined “complementary” as “allow[ing] the [Federal Reserve] to permit FHCs to engage in a limited basis in an activity that appears to be commercial rather than financial in nature, but that is meaningfully connected to a financial activity such that it complements the financial activity.”[11]  This interpretation of the statute — which focuses on a limited amount of activities meaningfully connected to financial activities — accords with the plain meaning of “complementary,” which is “serving to fill out or complete.”[12]  The Physical Commodities Trading activities unquestionably are meaningfully connected to Commodity Derivatives activities, as they are part of an integrated commodities business.

Moreover, the Federal Reserve reiterated its interpretation of the term “complementary” in its other orders finding activities complementary when, in 2007 and 2008, it determined that providing disease management and mail-order pharmacy services was complementary to the financial activity of underwriting and selling health insurance, and that providing energy management services to owners of power generation facilities and energy tolling were complementary to Commodity Derivatives activities.[13]  Because the Federal Reserve’s interpretation of “complementary” in the Physical Commodity Trading orders is not only reasonable, but accords with the plain meaning of the term and has been reiterated in subsequent Federal Reserve orders, it would seem an unreasonable interpretation for the Federal Reserve to adopt a narrower interpretation of the term today.

Section 4(k) imposes one other interpretive question for the Federal Reserve:  whether the Physical Commodities Trading activities “pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.”[14]  As a matter of plain meaning, therefore, the question is not whether the activities pose some risk, since all banking activities pose some risk — but rather a “substantial” risk; and not to the FHC and its nonbank subsidiaries themselves, but rather to depository institutions or the financial system generally.  For multiple reasons, the Physical Commodities Trading activities pose less risk to depository institutions and the financial system today than in 2003.

First, by definition, under Section 4(k), Physical Commodity Trading activities are carried out not in an FHC’s depository institution subsidiaries, but in nonbank subsidiaries.  Such nonbank subsidiaries are isolated from depository institution subsidiaries by Section 23A of the Federal Reserve Act, which places limits on the ability of depository institutions to support, and thus to have risk exposure to, their nonbank affiliates.  In the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank), Section 23A was strengthened by expanding the types of affiliate transactions that are subject to Section 23A’s limits and by making it more difficult for the bank regulatory agencies to grant exemptions from Section 23A.[15]  As a result, depository institutions are more “firewalled” from an FHC’s commodities activities than in 2003.

Nor is there any evidence that depository institutions generally have been subjected to substantially increased risk as a result of certain FHCs conducting Physical Commodities Activities.  Certainly many financial institutions failed during the Financial Crisis, but the principal causes were traditional bank permissible activities related to mortgage lending and loans for real estate development.  Certainly this is true for the failed FHCs that had been granted Physical Commodities Trading powers, which came under pressure because of poor mortgage lending and substantial losses on subprime assets.

There is a similar lack of evidence with respect to substantial risks to the financial system generally.  The Federal Reserve has continued to impose a limitation of 5 percent of Tier 1 capital as the maximum amount of assets that may be held pursuant to the Physical Commodities Trading authority.  Given the increase in Tier 1 capital since the Financial Crisis at the FHCs that the Federal Reserve has publicly approved for Physical Commodities Trading, even if all such assets at those FHCs became worthless and the institutions were required to deduct the full amount of those assets from their Tier 1 capital, they would all still be well above well-capitalized levels.[16]  There is no evidence that the 5 percent of Tier 1 capital limitation is insufficient to guard against a “substantial” risk to the financial system.

In addition, although commenters have isolated numerous causes of the Financial Crisis of 2008, there is no substantial evidence that Physical Commodity Trading activities played any meaningful role.  Indeed, one searches the 663 pages of the majority and dissenting reports of the National Commission on the Causes of the Financial and Economic Crisis in the United States in vain for any meaningful reference to commodities trading.  This is the case notwithstanding that the prices of certain commodities have undergone substantial volatility since 2003.  It appears, therefore, that FHCs and the Federal Reserve do have the capability to control the economic risks related to these activities.

As with amendments to Section 23A of the Federal Reserve Act, Dodd-Frank has imposed heightened requirements on the large FHCs that engage in Physical Commodities Activities.  First, with Dodd-Frank, in order to engage in complementary activities, an FHC itself, and not just its depository institution subsidiaries, must be well-capitalized and well-managed.[17]  In addition, although the rules implementing these sections of Dodd-Frank are not yet final, such FHCs are now subject to heightened capital and liquidity requirements, single counterparty credit limits, capital planning, and early remediation requirements in the event of financial distress.[18]

The principal non-financial risks related to Physical Commodities Trading activities have not changed since 2003:  they are the risks related to commodities without established markets where there may not be sufficient liquidity and price transparency, and the storage, transportation, environmental, and similar risks arising out of commodities like oil and natural gas.  The conditions that the Federal Reserve has imposed in approving the Physical Commodities Trading activities, however, directly target those risks, and there has been no evidence that such risks have translated into “substantial” risk to the financial system generally.

Finally, in approving the Physical Commodities Trading activities, the Federal Reserve found that the conduct of such activities by FHCs could reasonably be expected to produce benefits to the public that outweighed any potential adverse effects.  Such a conclusion should not be lightly reconsidered, as it is necessary to consider not only the experience with FHCs conducting the activities since 2003, but also the likely outcomes if Physical Commodities Trading becomes impermissible for FHCs.

If FHCs no longer may engage in Physical Commodities Trading, they will be required to spin off the companies conducting such activities, which will then no longer be associated with a financial institution subject to consolidated supervision.  As such, not only will the new companies not be subject to the same level of financial examination — in effect, becoming “shadow” financial institutions — but they will also not have the resources to compete with the significant non-bank players in the commodities markets.  It is not at all clear, therefore, that forcing FHCs to divest these businesses will lead to increased competition and greater safety and soundness; if anything, there may be more market concentration subject to less regulation — in the same manner that the original Glass-Steagall Act diminished competition in the investment banking business and kept securities firms like Bear Stearns and Lehman Brothers from effective consolidated supervision.


Experience with Physical Commodities Trading activities since 2003 suggests that the Federal Reserve’s original rationale for finding that the activities are permissible for FHCs is correct — Physical Commodities Trading is complementary to financial activities, and it does not pose a substantial risk to depository institutions or the financial system generally.  The Federal Reserve would therefore be required to overcome substantial evidence in order to demonstrate that its original conclusions in interpreting Section 4(k)’s complementary activities provision were mistaken, particularly since some reviewing courts have noted that consistently held interpretations adopted soon after a statute’s passage are particularly entitled to judicial deference.[19]

[1]  12 U.S.C. § 1843(c)(8).

[2]  Id. § 1843(k).

[3]  Citigroup Inc., Order Approving Notice to Engage in Activities Complementary to a Financial Activity, October 2, 2003.

[4]  Id.

[5]  Id.

[6]  Id.

[7]  Id.  In 2008, the Federal Reserve specifically approved certain commodities that did not meet this condition for a particular FHC on the ground that they were appropriately fungible and liquid.  It made clear, however, that the approval did not extend to all FHCs with Physical Commodity Trading powers.

[8]  Id.

[9]  Id.

[10]  Institutions that became BHCs in the Financial Crisis are subject to another GLB Act provision with respect to their commodities activities:  the grandfather provision contained in Section 4(o) of the BHC Act.  Section 4(o) generally restricts the amount of commodities assets that may be owned under its authority to 5 percent of the company’s total consolidated assets.  Unlike Section 4(k), Section 4(o) permits institutions that become BHCs to own “underlying physical properties” if the conditions to its grandfather are complied with.

[11] Citigroup Inc., Order Approving Notice to Engage in Activities Complementary to a Financial Activity, October 2, 2003.

[12]  Merriam-Webster’s Collegiate Dictionary.

[13]  Order Determining That Certain Activities Are Complementary to the Financial Activity of Underwriting and Selling Health Insurance, September 7, 2007; Fortis, S.A./N.V., Order Approving Notice to Engage in Activities Complementary to a Financial Activity, December 4, 2007.

[14]  12 U.S.C. § 1843(k).

[15]  Dodd-Frank, § 608.

[16]  Based on capital ratios at March 31, 2013.

[17]  Dodd-Frank, § 606.

[18]  Id. §§ 165, 166.

[19] See, e.g., National Home Equity Mortgage Association v. Office of Thrift Supervision, 373 F.3d 1355, 1360 (D.C. Cir. 2004) (citing Power Reactor Develop. Co. v. International Union of Electrical, etc., 367 U.S. 396 (1961)).

Gibson, Dunn & Crutcher’s Financial Institutions Practice Group lawyers are available to assist in addressing any questions you may have regarding these areas.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work, or the following:

Arthur Long – New York (212-351-2426, [email protected])
Chuck Muckenfuss – Washington, D.C. (202- 955-8514, [email protected])
Michael D. BoppWashington, D.C.
(202-955-8256, [email protected])
Kimble Cannon – Washington, D.C. (2028873652, [email protected])
Alex Acree – Washington, D.C. (202-887-3725, [email protected])
Colin Richard – Washington, D.C. (202-887-3732, [email protected])

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