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Banking Interpretations

NYBL 96(1)
NYBL 200

New York State Banking Department
Memorandum

To: Deputy Superintendent Stone
From: Assistant Counsel Sullivan
Date:

June 24, 2010

Subject: [---] - New York Branch
 

Proposed Energy Derivatives Activities

Issue

Whether the New York Branch ("New York") of [---] (the "Bank") may act as an agent for the London Branch of the Bank ("London") in conducting over-the-counter energy derivatives transactions?

Answer

Yes, provided that the Bank give the Banking Department the information specified below under the heading, Recommendation.

Background:

In a letter from its counsel in April, 2009 (the "April letter"),1  the Bank has advised the Department that it intends to commence certain derivatives trading activities through New York. All Examiner Memorandum ("AEM") 2006-10 specifies that banking organizations seek the review of the Banking Department prior to offering certain new products. Such a review addresses not only the issues of legality but also those concerning risk management and safety and soundness. This memorandum focuses solely on whether the proposed activities would be legally permissible for New York.2

The Bank is proposing that New York act as an agent for London in conducting a variety of over-the-counter energy derivatives transactions. These energy derivatives would at first consist of plain vanilla swaps and options products, but could be expanded to include additional energy derivatives. Also, as agent for London, New York would execute transactions in exchange-traded energy derivatives for hedging purposes. New York would exercise investment discretion over the derivative transactions that it would effect for London subject to position limits established by London or by the head office of the Bank.3

The oil and natural gas derivatives products involved would include NYMEX futures, NYMEX options on futures, financial swaps, financial basis swaps and financial options. New York would act only as broker or agent in these transactions. In no case would New York act as principal or trading counterparty. All transactions would be cash­settled. No transaction would involve the possession of physical commodities.

The Bank has not warranted that the proposed derivatives transactions would in all cases be "customer-driven".4  Similarly, the Bank has not represented that it would endeavor to hedge the proposed transactions to the extent necessary to insulate itself from market risk.

Discussion:

Activity of New York:

Generally, under New York Banking Law, the powers (except for deposit-taking) of a New York licensed branch of a foreign bank ("New York branch") are co-extensive with those of a New York State-chartered bank ("New York bank"). In a memorandum in August, 2008 (the "August memorandum"),5 the Banking Department determined that such a New York branch could act as agent for its bank's London office and market, structure and trade property derivatives contracts based on various property indices.

The issue is whether a New York branch that is acting only as agent must meet the same requirements that would apply if it were acting as principal. New York banks and, therefore, New York branches have been permitted to act as principal 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.

These conditions6 require, among other things, that the transactions be "customer driven." A New York branch may not engage in proprietary trading of such derivative products.7  Moreover, the branch should enter derivative transactions only where the client has an "underlying business" reason to use the transaction for hedging purposes.8  Also, a New York branch must hedge its exposure on either a matched­book or portfolio basis. In either event, the New York branch must develop policies and procedures to address the various risks entailed in hedging.

However, the August memorandum stated that a proposal of a New York branch to act as agent did not "raise the question whether [such New York branch] could engage in the proposed activities as principal." Further, the memorandum stated that the restrictions precluding the New York branch from entering into the derivatives transactions as a "proprietary" business "would not necessarily be relevant" because the principal would be the bank's London office.9

Still, the August memorandum did point out that the New York branch would meet many of the requirements applicable to a branch acting as principal. The transactions would be cash-settled and "customer driven." The foreign bank would seek to "minimize its market risk by hedging" the derivatives transactions on a "matched" or portfolio basis. The foreign bank's plan to hedge was deemed to support its contention that it was not entering a "positioning" or "proprietary" business.

Based on the foregoing, a New York branch that is acting as agent should generally meet the prudential standards that would be applicable if that branch were acting as principal. There would be some differences. A transaction conducted by New York as agent for London would have to be hedged by the Bank but not necessarily by New York either as agent or principal.10

Authority of London:

The material submitted by the Bank does not explain why (or even expressly state) that the derivatives transactions that are to be booked in London constitute a permissible activity for London.

Recommendation:

The Bank should provide sufficient information to enable the Banking Department to understand fully the nature of the agency relationship between New York and London. This information, some of which the Banking Department may have already obtained, should delineate those activities which will be conducted in the New York and those which will be conducted in London. The information should clearly document the responsibilities of each of New York and London. In this regard, Legal would suggest that the Banking Department obtain:

•         A service level agreement between New York and London setting forth the role of each location;

•         Sample transactional/customer documentation; and

•         The relevant policies and procedures applicable at each location -especially those related to risk management.

The foregoing would assist the Banking Department in assessing the extent to which:

•         It would be clear to prospective customers that New York was acting only as agent;

•         New York would be exercising discretion on behalf of London;

•         The activities would be prudently managed and conducted in a safe and sound manner both in New York and            in London; and

•         New York would be attempting to engage in activities indirectly in which it would not be permitted to engage           directly.

In general, the Bank should show that the activities that New York intends to conduct as agent for London would be permissible if New York conducted such activities as principal. In the case of any activities impermissible for New York as principal, the Bank should provide a specific justification for New York's acting as agent as well as a heightened level of assurance that New York would be insulated from the risks taken by London as principal. In any event, the Bank should show that the derivatives transactions that are to be booked in London are a permissible activity for London.

Noted: M.E.G.


  1. Letter [---] to David Fredsall, Deputy Superintendent of Banks dated April 3, 2009.
  2. The Foreign and Wholesale Banks Division and the Capital Markets Team have reviewed the proposed activities from perspective of risk management and safety and soundness.
  3. It would appear that intraday position limits would be set by both London and New York and that overall limits would be established by the head office. [---]
  4. A customer-driven transaction is one entered into for another party's valid and independent business purpose. OCC Interpretive Letter No.1018 n.3. Such a representation would mean that the Bank's activities would not involve "positioning" -i.e., the Bank 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 [---] dated April 25, 2003.
  5. Memorandum from Rosanne Notaro to Examiner Nosikovsky dated August 15, 2008.
  6. The conditions applicable to dealing in commodity derivatives contracts are more fully reviewed in the letter from First Deputy Superintendent David T. Halvorson to [---] dated November 14, 1988.
  7. Letter from Deputy Superintendent David S. Fredsall to [---] dated February 22, 2006.
  8. Memorandum from Principal Risk Management Specialist Peter A. Jaskierny to Chief Risk Management Specialist [---] dated September 10, 2008.
  9. An earlier memorandum (the "June memorandum") had expressed ambivalence with the concept of allowing a New York agency ("New York agency") to effect derivatives transactions that would be impermissible for a New York bank merely because the New York agency was acting as agent for a foreign office. Memorandum from Rosanne Notaro, dated June 26, 1997, Note 5, supra. In this regard, the powers (except for deposit-taking) of a New York agency of a foreign bank are co-extensive with those of a New York State-chartered bank. Ibid
  10. The June memorandum had considered the proposal of a New York agency of a foreign bank to engage in derivatives transactions generally as agent for other offices of the foreign bank. In fact, because the New York agency would on occasion act as principal, it had to meet the requirements applicable to a New York bank when acting as principal.

  11. Even if a New York branch could act as agent to effect derivatives transactions for a foreign office that would be impermissible for the New York branch as principal, the inquiry would not end there. If the foreign office were considered a "shell," the New York branch could only engage through such "shell" in those activities that would be permissible for a foreign branch or subsidiary of a domestic bank. 12 U.S.C. § 3105(k).

The foreign office would be considered a "shell" if it were "managed or controlled" by the New York branch -i.e., if the New York branch had "a majority of the responsibility for business decisions" of the foreign office. 12 C.F.R. § 211.24(g)(2).

Under the proposal, New York will exercise investment discretion over the derivative transactions that it effects for London. However, it is seems unlikely that London would be considered to be "managed or controlled" by New York. London will have significant responsibilities with regard to the derivative transactions. For example, intraday position limits are to be established by both London and New York, and London Risk Management will be responsible for market risk. Further, the Bank's website states that London "has leading positions in structured finance, debts and capital markets." Still, the Bank did not specifically state that London would not be "managed or controlled" by New York.

However, it would not matter if London were deemed a "shell" as long as New York met the requirements applicable to a New York bank when acting as principal. New York would only be engaging in activities permissible for a domestic bank, and therefore, permissible for its foreign branches and subsidiaries.

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