US red tape is a green light for Macquarie

JP Morgan Chase may have sold its commodities trading unit to the Swiss-based Mercuria for $US3.5 billion but Macquarie Group’s interest in acquiring that business highlights the opportunities being created as the post-crisis regulatory environment finally takes on a firmer shape.

Macquarie had teamed up with Blackstone Group to bid for the unit but the privately-owned Mercuria, already a major commodity trader, outbid them. Macquarie, which has long had a significant presence in energy trading, has been looking to bulk up its commodities trading activities.

JP Morgan’s exit from what was once an extremely lucrative business for the Wall Street banks -- it had grown the unit rapidly into the biggest of the Wall Street commodity trading operations amid a decade-long scramble by the US banks to position themselves in the sector -- reflects the diminished appeal of physical trading activities but, more particularly, the regulatory pressure on US banks to rein in their trading.

Commodity trading is both capital intensive and increasingly low-margin as competition has intensified, volatility has reduced and groups like Glencore, Vitol, Trafigura and Mercuria have grown rapidly.

The Basel III capital requirements by themselves would have forced a reappraisal of the merits of banks operating in physical commodities trading but for banks operating in the US there is also the Volcker Rule’s prohibitions on principal trading and recent Federal Reserve moves to limit their physical trading activities. In January the Fed issued advance notice of proposed regulatory changes to limit the risks posed by banks’ physical trading activities.

The Wall Street banks were, of course, converted from investment banks to commercial banks in 2008 during the height of the financial crisis and are therefore captured by the full net of global and US banking requirements. Interestingly, Macquarie doesn’t operate as a commercial bank in the US and therefore isn’t caught up in the US-specific banking legislation.

What the experience of JP Morgan and, indeed, others -- Morgan Stanley and Deutsche Bank, among others, have similarly exited some of their commodities trading activities -- highlights is the reality that the post-crisis regulatory reforms do force changes within international banking systems but not all the changes are the same.

The backlash against the Wall Street banks’ risk-taking and involvement in the sub-prime crisis has seen an overlay of specific US law reform and regulation beyond the global reforms flowing from the Basel Committee. The US reforms will capture most of the global banks that operate in the US, whether US-domiciled or not.

In turn that will push a lot of activity out of the regulated banking system -- in the US and elsewhere -- and into either the shadow banking system of hedge funds, private equity and private traders, plus banks like Macquarie, investment banks and non-banks that aren’t subject to the particular sets of regulation. The Canadian banks, for instance, have been moving cautiously into energy trading in the US.

The potential for regulatory arbitrage creates both opportunities and risks.

Macquarie, which also lost out when RBS’ physical metals trading business was offloaded under pressure from the European Union authorities (ironically to JP Morgan), is presumably still keen on beefing up its physical trading activities, and there are other Wall Street and US-regulated banks still operating in the sector so there might still be opportunities available where the exit of some of the major and more aggressive players with big balance sheets may reduce competitive intensity.

More broadly, however, if riskier activity is pushed out of the mainstream banking sector the core of the system might be strengthened but the risks will still be latent within less regulated and transparent organisations.

That’s an issue the regulators have been grappling with, inconclusively, since they began their response to the crisis.

Despite the efforts of regulators to bring some shadow banking activities like derivative trading out of the shadows and onto more transparent platforms, there are potential fault lines outside the core banking systems that could ultimately transmit risk and instability back into the core systems. There is no straightforward approach to quarantining banking and financial systems from that threat.