WASHINGTON – Wall Street banks have become heavily involved with physical commodities markets, increasing risks to financial stability, industry, consumers and markets, a two-year investigation by the Senate Permanent Subcommittee on Investigations has found.
The investigation’s findings, contained in a 396-page bipartisan report, add important new details to the public debate about the breakdown of the traditional barrier between commercial activities and banking. Included are previously unknown details about activities by Morgan Stanley, JPMorgan Chase and Goldman Sachs, including Goldman Sachs’ controversial management of warehouses storing most of the warranted aluminum in the United States. The new details raise new questions about whether such activities harm businesses and consumers and allow for possible manipulation of the markets.
The subcommittee will hold a two-day hearing this week to receive testimony from bank officials, experts and regulators.
“Wall Street’s massive involvement in physical commodities puts our economy, our manufacturers and the integrity of our markets at risk,” said Sen. Carl Levin, D-Mich., the subcommittee’s chairman. “It’s time to restore the separation between banking and commerce and to prevent Wall Street from using nonpublic information to profit at the expense of industry and consumers.”
“Banks have been involved in the trade and ownership of physical commodities for a number of years, but have recently increased their participation in new ways,” said Sen. John McCain, R-Ariz. “This subcommittee’s hearing is an opportunity to examine that involvement, determine whether it gives rise to excessive risk, and identify potential causes for concern that warrant further oversight by Congress and financial regulators.”
One focus for the subcommittee is the management of Detroit-area metal warehouses run by Metro Trade Services International, the largest U.S. warehouse company certified to store aluminum warranted by the London Metal Exchange for use in settling trades. Since Goldman bought Metro in 2010, Metro warehouses have accumulated up to 85 percent of the U.S. LME aluminum storage market.
Since Goldman took over the warehouses, the wait to withdraw LME-warranted metal has increased from about 40 days to more than 600 days, reducing aluminum availability and tripling the regional premium for storage and delivery costs,
The investigation revealed a number of previously unknown details about these deals: that Goldman’s warehouse company paid metal owners to engage in “merry-go-round” deals that shuttled metal from building to building without actually shipping aluminum out of Metro’s system; that the deals were approved by Metro’s board, which consisted entirely of Goldman employees; and that a Metro executive raised concerns internally about the appropriateness of such “queue management.”
Goldman didn’t just store aluminum; it was involved in massive trades of aluminum at the same time its warehouse operations were affecting aluminum availability, storage costs, and prices. After Goldman bought Metro, it accumulated massive aluminum holdings of its own, and in 2012, added about 300,000 metric tons of its own aluminum to the exit queue at its warehouses.
The Subcommittee investigation also examined other instances of Wall Street bank involvement with physical commodities. The Subcommittee report details how JPMorgan amassed physical commodity holdings equal to nearly 12 percent of its Tier 1 capital, while telling regulators its holdings were far smaller; and that at one point it owned an amount equal to more than half the aluminum used in North America in a year. The report also discloses that, until recently, Morgan Stanley controlled 55 million barrels of oil storage capacity, 100 oil tankers, and 6,000 miles of pipeline, while also working to build its own compressed natural gas facility and supply major airlines with jet fuel.
Details are also provided about Goldman’s ownership of a uranium trading company and two open pit coal mines in Colombia. When one of the mines was shut down last year due to labor unrest, Goldman’s Colombian subsidiary requested military and police assistance to end a human blockade — before paying the miners with $10,000 checks to end the protest.
The Thursday and Friday hearings will begin at 9:30 a.m. each morning. Thursday’s witnesses will include executives responsible for Goldman’s aluminum warehouse subsidiary; experts on the global aluminum market; and senior commodities officials from each of the banks.
Friday will include testimony from the Federal Reserve, which is considering new rules to rein in certain physical commodities activities by bank holding companies, and the Federal Energy Regulatory Commission, which penalized JPMorgan $410 million for manipulative bidding strategies that produced excessive electricity payments from consumers in California and the Midwest. The Subcommittee will also receive testimony from experts on financial risks from catastrophic events, and banking regulation of commodities.
The findings and recommendations from the bipartisan report are as follows:
Findings of Fact
(1) Engaging in Risky Activities. Since 2008, Goldman Sachs, JPMorgan Chase, and Morgan Stanley have engaged in many billions of dollars of risky physical commodity activities, owning or controlling, not only vast inventories of physical commodities like crude oil, jet fuel, heating oil, natural gas, copper, aluminum, and uranium, but also related businesses, including power plants, coal mines, natural gas facilities, and oil and gas pipelines.
(2) Mixing Banking and Commerce. From 2008 to 2014, Goldman, JPMorgan, and Morgan Stanley engaged in physical commodity activities that mixed banking and commerce, benefiting from lower borrowing costs and lower capital to debt ratios compared to nonbank companies.
(3) Affecting Prices. At times, some of the financial holding companies used or contemplated using physical commodity activities, such as electricity bidding strategies, merry-go-round trades, or a proposed exchange traded fund backed by physical copper, that had the effect or potential effect of manipulating or influencing commodity prices.
(4) Gaining Trading Advantages. Exercising control over vast physical commodity activities gave Goldman, JPMorgan, and Morgan Stanley access to commercially valuable, non-public information that could have provided advantages in their trading activities.
(5) Incurring New Bank Risks. Due to their physical commodity activities, Goldman, JPMorgan, and Morgan Stanley incurred multiple risks normally absent from banking, including operational, environmental, and catastrophic event risks, made worse by the transitory nature of their investments.
(6) Incurring New Systemic Risks. Due to their physical commodity activities, Goldman, JPMorgan, and Morgan Stanley incurred increased financial, operational, and catastrophic event risks, faced accusations of unfair trading advantages, conflicts of interest, and market manipulation, and intensified problems with being too big to manage or regulate, introducing new systemic risks into the U.S. financial system.
(7) Using Ineffective Size Limits. Prudential safeguards limiting the size of physical commodity activities are riddled with exclusions and applied in an uncoordinated, incoherent, and ineffective fashion, allowing JPMorgan, for example, to hold physical commodities with a market value of $17.4 billion – nearly 12% of its Tier 1 capital – while at the same time calculating the market value of its physical commodity holdings for purposes of complying with the Federal Reserve limit at just $6.6 billion.
(8) Lacking Key Information. Federal regulators and the public currently lack key information about financial holding companies’ physical commodities activities to form an accurate understanding of the nature and extent of those activities and to protect the markets.
(1) Reaffirm Separation of Banking and Commerce as it Relates to Physical Commodity Activities. Federal bank regulators should reaffirm the separation of banking from commerce, and reconsider all of the rules and practices related to physical commodity activities in light of that principle.
(2) Clarify Size Limits. The Federal Reserve should issue a clear limit on a financial holding company’s physical commodity activities; clarify how to calculate the market value of physical commodity holdings; eliminate major exclusions; and limit all physical commodity activities to no more than 5% of the financial holding company’s Tier 1 capital. The OCC should revise its 5% limit to protect banks from speculative or other risky positions, including by calculating it based on asset values on a commodity-by-commodity basis.
(3) Strengthen Disclosures. The Federal Reserve should strengthen financial holding company disclosure requirements for physical commodities and related businesses in internal and public filings to support effective regulatory oversight, public disclosure, and investor protections, including with respect to commodity-related merchant banking and grandfathered activities.
(4) Narrow Scope of Complementary Activity. The Federal Reserve should narrow the scope of “complementary” activities by requiring financial holding companies to demonstrate how a proposed physical commodity activity would be directly linked to and support the settlement of other financial transactions conducted by the company.
(5) Clarify Scope of Grandfathering Clause. The Federal Reserve should clarify the scope of the “grandfather” clause as originally intended, which was only to prevent disinvestment of physical commodity activities that were underway in September 1997, and continued to be underway at the time of a company’s conversion to a financial holding company.
(6) Narrow Scope of Merchant Banking Authority. The Federal Reserve should tighten controls over merchant banking activities involving physical commodities by shortening and equalizing the 10-year and 15-year investment time periods, clarifying the actions that qualify as “routine operation and management” of a business, and including those activities under an overall physical commodities size limit.
(7) Establish Capital and Insurance Minimums. The Federal Reserve should establish capital and insurance minimums based on market-prevailing standards to protect against potential losses from catastrophic events in physical commodity activities, and specify the catastrophic event models used by financial holding companies.
(8) Prevent Unfair Trading. Financial regulators should ensure that large traders, including financial holding companies, are legally precluded from using material non-public information gained from physical commodities activities to benefit their trading activities in the financial markets.
(9) Utilize Section 620 Study. Federal regulators should use the ongoing Section 620 study requiring regulators to identify permissible bank activities to restrict banks and their holding companies from owning or controlling physical commodities in excess of 5% of their Tier 1 capital and consider other appropriate modifications to current practice involving physical commodities.
(10) Reclassify Commodity-Backed ETFs. The Commodity Futures Trading Commission (CFTC) and Securities Exchange Commission should treat exchange traded funds (ETFs) backed by physical commodities as hybrid security-commodity instruments subject to regulation by both agencies. The CFTC should apply position limits to ETF organizers and promoters, and consider banning such instruments due to their potential use in commodity market corners or squeezes.
(11) Study Misuse of Physical Commodities to Manipulate Prices. The Office of Financial Research should study and produce recommendations on the broader issue of how to detect, prevent, and take enforcement action against all entities that use physical commodities or related businesses to manipulate commodity prices in the physical and financial markets.