* Bank revenues in commodities trading halve
* Some consider spin off amid new capital, trading rules
* Return on equity fall sharply compared to heydays
By Dmitry Zhdannikov
LONDON, Nov 5 Stick, twist or fold? Like card
players, the top five banks in global commodities trade have
reached the point where they must decide to hold strategy,
adapt, or give up and get out.
The boom in resource markets that started 10 years ago
attracted many big banks to trade oil, metals and agriculture,
but the 2008 financial crisis forced a painful retreat and
tighter regulation now means some banks may throw in the towel.
Decisions rest on whether the banks believe their business
models can be changed to keep them sufficiently profitable under
the rising oversight of regulators, after four years when their
revenue from commodities was halved.
"The total wallet back at the peak was about $14 billion for
the banking sector in commodities trading. I'd imagine this year
it'll be about $7 billion. There were 10-14 banks when it was at
$14 billion, now there are really five relevant ones," said
David Silbert, who leads commodities trading at Deutsche Bank
Deutsche, together with Barclays and J.P. Morgan
, broke into the commodities arena in the last decade
with acquisitions or aggressive growth to challenge established
veterans Goldman Sachs and Morgan Stanley.
J.P. Morgan's entry charge to the club was the $1.7 billion
it paid to buy trading house Sempra and its infrastructure to
store and ship oil and metals.
Today, the five banks control 70 percent of the commodities
trading pot with the rest split between mid-sized players such
as Credit Suisse and Bank of America/Merrill Lynch
, the latter having fallen out of the top division since
the financial crisis.
The halving of revenue is largely due to a regulatory
crackdown on proprietary trading, when deals are done by banks
for themselves rather than on behalf of clients. Regulators say
banks should focus on serving the clients and helping the
economy with credit.
Also taking a toll is the reduction of risk appetite for
capital intensive businesses such as commodities because of
stricter capital rules.
As a result, commodities business at banks is increasingly
dominated by hedging of producers and consumers from sharp
volatility, as well as sales of commodity-related indices to
The proportion of physical trading is shrinking - especially
dealing for the bank's own books - which irks regulators. That
is estimated to constitute one fifth of total flows today as
opposed to four fifths five years ago, say traders.
A further drop would be hard for banks to swallow. They say
they need the scale and depth in the fray of daily business to
know markets and serve clients properly.
"In today's volatile markets, knowledge and understanding of
both the financial flows and the physical market fundamentals
are vital," Credit Suisse says about its commodities team.
Understanding physical markets without trading them is close
to impossible, said Silbert, a U.S. gas trader in the 1990s, who
joined Deutsche from Merrill Lynch in 2007.
"In commodities you don't have a client business if you
can't allocate risk capital. As soon as we stop taking a point
of view and stop participating in the market in that way, then
we restrict the ability to help our clients," he said.
Banks argue they benefit commodities markets by improving
transparency and helping producers and consumers to lower risk.
"In the 1980s, banks were barely present in commodities
markets activities and it was a pretty shadowy place dominated
by physical merchants and cartels," says Henrik Wareborn, head
of commodities trading at Natixis, who also worked for Goldman
Sachs and BP.
"To a large extent those markets were opened up and
transformed thanks to the entry of regulated European universal
banks and U.S. investment banks," said Wareborn, who built a
sizeable commodities desk at Lehman Brothers before the bank
collapsed in 2008.
Critics accuse banks of adding to speculative froth in
markets and regulators say they want to fix this.
Under the Basel 2.5 banking regulations, requirements to set
aside capital for trading nearly tripled this year.
In the United States, in addition to the limits on
proprietary trading - the Volcker rule - banks face the
Dodd-Frank regulation, which limits positions they can take in
The U.S. Federal Reserve is also locked in a battle with
banks over whether to allow them to continue holding physical
assets. If the banks lose that verdict they could be forced to
sell assets such as oil storage and metals warehouses. Bankers
bridle at the thought.
"The desire to vilify commodities markets activities at big
banks is misplaced. With rare exceptions, commodities markets
have worked impeccably in the past decade," adds Wareborn.
The banks won a small battle when a U.S. judge ruled last
month to send the position limits rule back to the Commodity
Futures Exchange Commission (CFTC) two weeks before it was to
take effect, saying the regulator had to prove it was necessary.
The rule, already partly applied by the exchanges, would
have drastically cut the trade of derivatives.
Sources at one large bank said it was forced to cut sales of
commodities-linked indices after exceeding proposed limits on
positions in the grains market.
In Europe, however, regulators are pressing ahead with
position limits rules. Leading players say that Europe could end
up with tougher regulations than the United States, potentially
opening up a regulation arbitrage.
"The U.S. banks are coming to Europe to take bigger market
share. They are better capitalised and actually less regulated
than the European banks are likely to be," one said.
In Europe, regulations cannot be overthrown by a court
ruling as in the United States. Much will also depend on the
outcome of the U.S. presidential election and whether CFTC's
current chairman Gary Gensler is replaced with a figure who
might push for less regulations, bankers say.
Regulation will squeeze banks' commodity trading units along
with other capital market businesses, according to McKinsey &
Company, which predicts return on equity (ROE) in commodity
units shrinking to 8 percent from 20 percent.
"Some of the worst-hit businesses with ROEs below the cost
of capital may have to be disposed of, especially at banks with
weak franchises," McKinsey said.
Insiders say the current ROE in commodities is about 12-16
percent, still far better than overall average banking returns.
Over the past year, banks have lost an army of commodities
traders to better-paying merchants and hedge funds, with even
heavyweights like Goldman losing out.
Banks argue that today their risk levels come nowhere near
those of trading houses.
"Our commodities business is not about betting on commodity
prices... Our business is a client-driven business where we
execute on behalf of clients to achieve their financial and risk
management objectives," J.P. Morgan's commodities chief Blythe
Masters told CNBC earlier this year.
The arguments are falling on deaf ears at the regulators
following the Libor interest rate manipulation and other
scandals which have rocked the banking industry.
Some of the banks' activities, such as storing metals in
warehouses, have also generated criticism.
"No one can afford growing because of regulations... We have
to reinvent ourselves," said a senior executive.
One noticeable change this year is discussion among U.S.
banks on how to transform desks.
Morgan Stanley set the ball rolling by considering selling
parts of its commodities business to Qatar or allowing the
unit's current management to buy it out, possibly together with
a private equity firm.
Selling the capital-intensive business would raise funds
while allowing the divested unit to maintain ownership of
physical assets and resume proprietary trading.
Goldman, which traditionally had large proprietary trading,
had also discussed a spinoff, the Wall Street Journal reported.
Goldman said it never seriously considered the move.
J.P. Morgan said it is not considering any spin out for its
commodities unit. The bank is better capitalised than its peers.
Regulations aside, the egos of the main players will play a
role in a business dominated by big personalities such as
Goldman's chief Lloyd Blankfein. "I find it hard to believe that
Blankfein can say goodbye that easily to his baby," said a
former Goldman trader.
Blankfein started his career as a precious metals salesman
for Goldman's commodities arm J. Aron and was co-head of
commodities in the 1990s. "Trading is in Goldman's blood," said
the head of a major trading house.
Today, Goldman's top commodities job is held by Isabel
Ealet, a former trader at French oil major Total who
is also global co-head of securities.
J.P. Morgan's Masters, who helped to develop credit-default
swaps in the 1990s and built its commodities business from
scratch in just five years, will also soon be running regulatory
affairs for JPM's investment banking, according to an internal
memo seen by Reuters.
Like Ealet, Morgan Stanley's commodities boss Colin Bryce is
an oil trading veteran, in his case from the long defunct
Britoil. It was the commodities team at Morgan Stanley which
suggested to management the spin off, sources said.
The bank would need to reduce its stake to below 25 percent
in the unit in order to avoid Dodd-Frank oversight, sources
said, something Morgan's leadership may hesitate to do since the
unit has made such good revenue for many years.
At Deutsche, Silbert says he plans to expand revenue and
market share after several years of speedy growth. The strategy,
though, is a challenge amid a sharp retreat to co re activities
as Deutsche slashes jobs and costs
The swift rise of Barclays up the ranks in commodities was
dealt two severe blows with losses in metals markets last year
and the recent departure of its commodities boss Roger Jones for
trading house Mercuria after a decade in charge.
The bank decided against replacing him in the same role and
asked its foreign exchange boss Mike Bagguley to look after the
However, Barclays says its commodities business remains
strong. It surprised the market earlier this year with a
landmark supply deal with an oil refiner, the first in Europe
The head of a major trading house said he feels much less
pressured from banks these days than several years ago. "I don't
see Goldman or Morgan leaving the trading space. With European
banks, I'm not so sure," he says.