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Insight: Three years on, Fed keeps BoA-Merrill waiting on commodity trade

The company logo of the Bank of America and Merrill Lynch is displayed at its office in Hong Kong March 8, 2013. REUTERS/Bobby Yip
The company logo of the Bank of America and Merrill Lynch is displayed at its office in Hong Kong March 8, 2013. REUTERS/Bobby Yip

By David Sheppard

NEW YORK (Reuters) - In May 2010, one of Wall Street's biggest banks went to the Federal Reserve with a seemingly straightforward request: permission to expand its physical commodity operations through specialized power contracts.

The regulator had already given rivals the go-ahead for such "tolling" arrangements that allowed long-term business deals with electricity plants, and now Bank of America-Merrill Lynch (BoA-ML) wanted similar treatment as it aimed at becoming a top-three bank in the natural resources supply chain.

More than three years later, BoA-ML's commodities traders are still waiting on a decision from the Federal Reserve Board of Governors, according to documents received by Reuters through a Freedom of Information Act request.

Now, as the Fed conducts a review of how deeply involved commercial banks should be in the global trade of oil, gas, grains and metals, the Board's long deliberation on BoA-ML's request may add questions about its stance on the role of Wall Street in physical commodities.

Some regulatory and legal experts say it could suggest the Fed has been examining the growth of banks in the sector for longer than previously thought.

"The Fed is very unlikely to make a decision on BoA-ML ahead of any announcement on its far wider review of the role of banks in physical commodities," said Josh Rosner, managing director at research firm Graham Fisher & Co., who testified about the issue before the Senate Banking Committee in July.

"The Fed has known for some time that it was going to have to rule on this issue eventually."

While Goldman Sachs and Morgan Stanley appear to be the banks most clearly at risk of a regulatory crack-down on the trading of oil tankers and pallets of metal, BoA-ML also has a great deal at stake, with a $500 million a year global commodity business employing more than 200 traders.

The firm's commodity arm - still known as Merrill Lynch Commodities Inc, despite the investment bank being bought by Bank of America in 2009 - retains a sizeable physical trading operation, a legacy of the former investment bank's 2004 purchase of Texas-based energy trader Entergy-Koch.

It transports coal around the world on vessels chartered by its own in-house shipping brokerage. It is the biggest physical electricity trader of any bank in North America, according to U.S. government data. The parent company also holds stakes in at least seven U.S. power plants, according to regulatory filings, while Merrill Lynch Commodities also has trading deals with two major UK electricity providers.

The Fed has come under intense public and political pressure this summer to clarify the role of Wall Street in physical commodities, amid allegations that some banks may have driven up energy and metal prices for consumers, and concerns that "too big to fail" banks may be taking on unknown risks in operating oil tankers and power plants.

It is unclear why the Fed Board has delayed a decision on the BoA-ML application. A Fed spokeswoman declined to comment. A BoA-ML spokesman declined to discuss the issue.

It is not clear what impact, if any, the prolonged uncertainty may be having on BoA-ML's efforts to expand its business and challenge its rivals. Last month the firm shut down the Houston trading desk responsible for cutting long-term deals with power plants. A person familiar with the matter said the desk's closure was not at the request of the Fed.

Although it has lost some senior staff, BoA-ML has also been one of a handful of banks recruiting for new roles in commodities this year, in contrast to reductions across much of the industry.

Thus far, BoA-ML executives have been silent on the future of its commodities business. JPMorgan Chase & Co. has put its physical arm up for sale, arguing it is more regulatory trouble than it is worth, while Goldman Sachs has publicly backed its commodity business as "core" to its operations.

Regulatory experts say the Fed is likely to announce the result of its physical commodities review in the coming weeks.

WHAT THEY WANTED

BoA-ML's request in 2010 was hardly going to change the energy landscape.

The bank was seeking confirmation that the newly-merged firm retained earlier authorizations to operate in physical markets, and requested that the Fed allow it to enter long-term trading and operational arrangements with power plants known as 'energy-tolling agreements', as well as grant it the right to trade certain physical metals such as aluminum alloy.

In 2008, the Fed had approved such tolling deals for Scotland-based RBS as part of its joint venture with U.S. merchant trader Sempra Commodities. The approval was the most expansive the Fed had granted since it first allowed commercial banks to trade physical commodities in 2003; it included a range of activities that other banks would seek to match.

When JPMorgan bought RBS Sempra two years later, the Fed allowed the bank to carry on such energy-tolling agreements, letters between the Fed and the bank show. That $1.7 billion deal, and the purchase of Bear Stearns during the crisis, including a large energy trading unit, helped transform JPMorgan into Wall Street's largest commodity trader.

Why the Fed approved energy-tolling for JPMorgan in 2010 but not BoA-ML -- which had submitted its application a month earlier -- is not clear. It also approved energy-tolling for Germany-based Deutsche Bank in January 2010.

Regulatory and legal experts said it is possible the Fed wanted to see more information on BoA-ML's internal controls before granting the expansion into energy-tolling, or had concerns about capital levels at the newly-merged bank.

Additionally, some of the experts suggested the Fed board may have been concerned about the pace of expansion by banks into physical commodity trading so soon after the financial crisis.

One former BoA-ML commodities employee, who asked not to be named, said the bank held a briefing for traders in London where they were informed that the bank retained the right to trade in physical commodities, despite the lack of official word from the Fed.

The Fed's silence since it announced its "review" in July has added to uncertainty for Wall Street's traders. Last month, a deadline to rule on Goldman Sachs and Morgan Stanley's continued ownership of trading assets like metal warehouses and oil storage tanks passed without word from the Fed.

Those banks are counting on a "grandfather" clause from a 1999 banking law to allow them greater freedom in physical commodities than their rivals due to their decades-long history of operating in those markets. Although Merrill Lynch was also a former investment bank, the clause does not apply to BoA-ML.

BUSINESS ROLLS ON

BoA-ML is still involved a large number of physical commodity operations that may be covered by the Fed's wider review, part of a business that has generated some $2 billion in trading revenue over the past four years, according to Securities Exchange Commission (SEC) filings. The bank does not provide any data on profits, but commodities accounted for about 5 percent of Merrill's overall trading revenue last year.

London-based industry analytics firm Coalition said BoA-ML's commodity business was just outside the top six on Wall Street in the first half of this year.

After buying Entergy-Koch for almost $1 billion in 2004, Merrill Lynch leapt into the big leagues in the U.S. power market, and has maintained that position. It was the top-ranked U.S. power dealer in 2012, according to Energy Risk magazine's annual survey.

In the United States, BoA-ML is the largest bank in physical U.S. electricity trading. A review of the bank's sales, revealed in filings with FERC, showed it made over $11 billion in total sales between 2009 and the third quarter of last year, and has been growing that business.

Between June and August 2012 alone, its physical electricity sales in the United States totaled almost $1.4 billion, more than double its nearest Wall Street rival in the market.

Merrill Lynch Commodities Inc also leases around 16 billion cubic feet of natural gas storage in the United States, according to regulatory filings. While that has fallen from 23.5 billion cubic feet in 2010, it is still 40 percent more than Goldman Sachs, and second only to JPMorgan on Wall Street.

It is seen as one of the three biggest banks trading in the global coal market, and has a subsidiary called Solimar Shipping Ltd that charters vessels on behalf of its commodity arm, according to BoA-ML's application to the Fed and filings with the UK's Company House. The company is mainly involved in shipping coal, former BoA-ML traders say.

Solimar, which doesn't own any vessels itself, had turnover of $11.6 million in 2012, Companies House filings show, down from $29.8 million in 2010.

BoA-ML also retains at least seven non-controlling stakes in electricity generating units in the United States stretching from Nevada to New York, including wind farms, with a total capacity of more than 6,600 mega watts, according to an August filing with the Federal Energy Regulatory Commission. That's enough to power almost 6 million homes.

A person familiar with the matter said the commodity arm no longer holds any physical assets itself.

While BoA-ML has long been a powerhouse in gas and power markets, it has had less success in oil markets, where rivals have thrived.

In 2010, the bank sold its share of the 1.2-million-barrel Battle River oil storage terminal in Alberta, a legacy of Merrill Lynch's investment banking days. Commercial banks are not allowed to own physical infrastructure under Fed regulations. Its co-head of oil trading Thomas Andersen left this year.

The bank has hired ex-Barclays oil chief George Cultraro, who is set to start at the firm in early 2014, in an effort to expand its oil business. The bank has also hired two former Morgan Stanley oil traders in the last six months.

BRITISH POWER

While the bank didn't get approval from the Fed in 2010 to expand into energy tolling, BoA-ML was still able to ink two new deals involving the supply of coal and gas to power plants in the United Kingdom that year.

The two deals in the United Kingdom were known as ‘energy management arrangements' (EMAs) rather than tolling deals, and were set-up by the bank's desk in London and Houston, according to former BoA-ML traders.

EMAs were also first approved by the Fed for commercial banks in 2008, when Benelux bank Fortis was looking to expand its energy operations in North America.

Energy-tolling and EMAs differ in that the former gives the traders a degree of operational control of a plant, while the latter limits them to providing fuel and selling electricity into the market - with no authority to decide when the plant runs.

JPMorgan and Deutsche Bank, the two banks that were granted permission to enter energy tolling deals by the Fed in 2010, have both since been fined by U.S. regulators for their trading activity in U.S. power markets. JPMorgan announced in July it was exiting physical commodities trading, just days prior to agreeing a $410 million settlement with FERC.

(Reporting by David Sheppard in New York and London; additional reporting by Scott DiSavino and Jeanine Prezioso in New York and Dmitry Zhaddinkov in London; Editing by Jonathan Leff and Alden Bentley)

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