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Banking Interpretations

NYSBL 96(1); 200

New York State Banking Department
Memorandum

To: Deputy Superintendent Fredsall
From: Assistant Counsel Sullivan
Date: December 22, 2008
Subject: [---] New York Branch Proposed Commodity Derivatives Activities

Issue:

Whether [---] (“Bank”) may engage through its New York Branch [“--- NY”] in the derivatives transactions that it has proposed?

Recommendation:

Yes, provided that the Bank and [---] NY meet the safety and soundness conditions discussed below.

Background:

The Bank is proposing to engage in certain derivatives transactions through [---] NY. In this regard, [---] NY would enter into commodity swaps, options, collars, barrier options and forwards/variable delivery forwards based on the following commodities:

• Freight derivatives
• Oil and oil products
• Nordic power
• Agricultural products
• Metals

The above derivatives transactions would be "customer-driven"1and be cash-settled with no physical delivery of the underlying commodity. [---] NY would endeavor to avoid any market risk with respect to all of the above derivatives transactions by matching each such transaction with an offsetting transaction with a non-affiliated counterparty.

Discussion:

Generally, under New York Banking Law, the powers (except for deposit-taking) of a New York branch of a foreign bank ("New York branch ") are coextensive with those of a New York State-chartered bank.2  Such banks have been permitted to offer commodity derivative products including swaps, forward contracts and option agreements where the underlying reference asset is a particular nonfinancial commodity, provided that certain conditions were satisfied. Such commodity derivative contracts are viewed as the functional equivalents of other traditional bank intermediation.3

The conditions4to engaging in such activity include5 :

  1. The transactions must be "customer driven." A New York branch may not engage in proprietary trading of the derivative products.6 Under the proposal, [---] NY would not engage in proprietary trading or positioning of the derivative products. Moreover. [---] NY will enter into derivative transactions only where the client has an "underlying business" reason to use the transaction for hedging purposes.7 Moreover, each client will need prior approval for commodity derivatives transactions from a designated relationship officer at [---] NY.
  2. A New York branch may not assume risk resulting from the fluctuations in the price of the underlying commodity and must hedge its exposure from its commodity derivative activity. Such hedging may be effected on a matched­book or portfolio basis. In either event, it is necessary for a New York branch to develop policies and procedures to address the various risks entailed in hedging including:
  3. a.  Liquidity Risk -i.e., Whether there is sufficient depth in the market to allow efficient hedging.
    b.  Volatility Risk -i.e., whether rapid and extreme fluctuations in price would impede hedging.
    c.  Basis Risk -i.e., whether there are different price movements between the commodity underlying
         the derivative transaction and the commodity, index or other measure used to provide the hedge.

  4. As a matter of safety and soundness, a New York branch would also have to establish policies and procedures to address:

    a.  Counterparty/Credit Risk -i.e., the risk that a counterparty to a derivatives transaction might default.
    b.  Operational Risk -i.e., the risk that the internal procedures and controls are inadequate to confirm, settle,
         book and track the derivatives transactions and exposures.

The Capital Markets Team has conducted a risk management review of the proposed commodity derivatives activities of [---] NY. The review, inter alia, addressed the risks specified above. The memorandum8 summarizing this review recommended that the proposed activities of [---] NY be approved provided that there be a supervisory follow­up visit in the second quarter of 2009.

Accordingly, it would appear that the proposed activities of [---] NY are legally permissible and that such proposed activities have been appropriately reviewed for issues of safety and soundness.

Noted: MEG

cc:    Sean MacDonald
         Antonio Marfia
         John McEnerney

__________________
  1. A customer-driven transaction is one entered into for another party's valid and independent business purpose. OCC interpretive letter No.1018 n.3.  This means that [---] NY's activities would not involve "positioning" - i.e., [---] NY would neither seek nor take market risk with respect to prices of the commodities at issue. Instead, it would engage in financial intermediation to enable its customers to hedge their risks. Letter from Deputy Superintendent and Counsel Sara A. Kelsey to Marcia Wallace dated April 25, 2003 (the "Kelsey letter".)
  2. Letter from Assistant Counsel Christine M. Tomczak to Neil A. Quartaro dated August 12, 2004; See Memorandum from Rosanne Notaro to J. P. Murphy dated June 26, 1997.
  3. Memorandum from Rosanne Notaro, note 2, supra; the Kelsey letter, note 1, supra.
  4. Because all the proposed derivative and hedging transactions will be cash settled, there is no need to address the permissibility of taking physical delivery of the underlying commodities.
  5. These conditions applicable to dealing in commodity derivatives contracts are more fully reviewed in the letter from First Deputy Superintendent David T. Halvorson to Anthony J. Horan dated November 14, 1988.
  6. Letter from Deputy Superintendent David S. Fredsall to Bruce A. Otwine dated February 22, 2006.
  7. Memorandum from Principal Risk Management Specialist Peter A. Jaskierny to Chief Risk Management Specialist Antonio Marfa dated September 10, 2008.
  8. Memorandum from Peter Jaskierny, note 7, supra.

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