My old boss in the 1990s was fond of telling us that regulation and transparency were a good thing for our business. It was slightly counter-intuitive, in that he also had a great penchant for putting together deals that resided in that grey, slightly out-of-focus area of the market where physical business and futures meet. I think I understood what he meant, though. Essentially, his point was that, certainly as far as the brokerage element of the business was concerned, where other people’s money (in the sense of client funds) was involved, life was far easier in an environment where the rules were clear and unambiguous. That cuts both ways, of course. For the client, the knowledge that his funds are protected by the framework of regulation around the broker is clearly an important part of the decision to invest (and in this context, when I say invest, I include hedge - all use of the market, in other words). For the broker, clarity of regulation is also advantageous, not least because, if the rules are clear, then it’s much simpler to explain to the client who wants a particular money transfer, for example, or a temporary fudging of margin requirements, that that is not possible. Being outlawed by public regulation is a far easier position to argue than is a pure internal rule. At least, that’s how it’s always seemed to me. So regulation is a benefit to both sides where there is a traditional broker/client relationship - where one party is holding the other’s money, in other words.
But what about that grey area which is neither conventional producer/consumer physical trade nor broker/client exchange business? It’s the fertile ground that spawned the warehouse trade in aluminium, for example; in fact, it’s the origin of the whole philosophy that metal and money are essentially the same, fully interchangeable. How should you try to regulate that? After all, it’s in the main a business where participants are largely using their own money - either their real capital, or secured borrowings. And then, beyond that, how should you regulate straightforward physical business?
Governments and regulators have decided - post-2008 - that these are legitimate concerns, and have tried to get to grips with them. I’m not going to rehash great detail about the LME warehousing issues, but for sure the particular circumstances of the aluminium market and the noise that has generated has been a significant driver of thinking. The two clear strains of thought are, first, that futures (exchange) trading needs to be tightly controlled, and secondly, that banks - specifically - should not really be involved in the physical trading of commodities. That sort of makes sense. Exchange trading is logically lumped together with the bulk of securities trading, which is after all its closest comparable. And, although we all tend to get excited about automobile production, tech developments and finished products in general when we look at trade figures, the reality is that these are all pretty much underpinned by basic commodities. So attempting to curtail potential disruption caused by the influx of excess capital seems to me to be a reasonable attempt to prevent distortion working its way through into the whole economy. I’ve long been an advocate of keeping banking and trading separate.
Changing World - New Breed
So that’s the background, and against it, we’re seeing another change in the make-up of the participants in the business. Starting in the mid to late 1990s, there was a substantial migration of LME traders to banks. The reason wasn’t difficult to see: the banks had big balance sheets - lots of money, in other words - and they were happy to take an active part in trading commodity markets. It was a two-pronged attack, with proprietary physical trading working alongside the brokerage business - naturally with Chinese walls between them, it goes without saying. That epoch saw Goldman Sachs, JP Morgan, Barclays, Deutsche, Morgan Stanley et al become the biggest players in the whole business (with, of course, the the exception of the almost uncategorizable Glencore). It didn’t last long, though, as the tsunami of global indebtedness overwhelmed the world’s attempts to create yet more synthetic products to avoid it. Under pressure from capital adequacy needs and clear prescriptive legislation, the banks are now bailing out as fast as they can. Look at JP Morgan - that metals powerhouse is now a brokerage business - undoubtedly a very good one, but the physical involvement that had been driving the business has gone. And where it’s gone is to the new breed in commodity trading - to those privately-owned entities that span the areas of physical positional trading, warehousing and prop futures business. But not - emphatically not, because of the regulatory requirements, with which they want to have as little involvement as possible - brokerage. That is left to the traditional brokers and banks. That’s a dying business, though, as I think I’ve said before, as the space is invaded more and more by the exchanges themselves and electronic traders with direct access, who don’t need brokers, on the whole.
And just to finish the story - who has emerged as the latest to head up one of this newest breed in private equity/prop trading/physical powerhouses, freeing themselves from the shackles of bank regulation? Peter Sellars, previously an extremely significant part of JP Morgan’s strength.
The Story's not over....
Regulation and financial crisis may have driven this change to the business, but it looks as if it’s one that’s here for a while. I wonder if, a little way down the line, there may grow a creeping realisation that by forcing this business out of publicly-accountable banks, the control will actually be less; I have no problem with that (not least because I don’t think the banks were the right place for commodity trading in the first place), but regulators don’t like seeing things slip away from them. How this plays out promises to be interesting.