[Senate Hearing 113-375]
[From the U.S. Government Publishing Office]


                                                        S. Hrg. 113-375
 

    REGULATING FINANCIAL HOLDING COMPANIES AND PHYSICAL COMMODITIES

=======================================================================

                                HEARING

                               before the

                            SUBCOMMITTEE ON
             FINANCIAL INSTITUTIONS AND CONSUMER PROTECTION

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                    ONE HUNDRED THIRTEENTH CONGRESS

                             SECOND SESSION

                                   ON

 EXAMINING NONFINANCIAL ACTIVITIES CURRENTLY BEING PERMITTED UNDER THE
BANK HOLDING COMPANY ACT AND THE ECONOMIC IMPACT OF SUCH ACTIVITIES ON
  THE PHYSICAL COMMODITY AND ENERGY MARKETS AS WELL AS THE SAFETY AND
               SOUNDNESS OF THE NATION'S BANKING SYSTEM.

                               __________

                            JANUARY 15, 2014
                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban
                                Affairs
                 Available at: http: //www.fdsys.gov/

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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  TIM JOHNSON, South Dakota, Chairman

JACK REED, Rhode Island              MIKE CRAPO, Idaho
CHARLES E. SCHUMER, New York         RICHARD C. SHELBY, Alabama
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
SHERROD BROWN, Ohio                  DAVID VITTER, Louisiana
JON TESTER, Montana                  MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia             PATRICK J. TOOMEY, Pennsylvania
JEFF MERKLEY, Oregon                 MARK KIRK, Illinois
KAY HAGAN, North Carolina            JERRY MORAN, Kansas
JOE MANCHIN III, West Virginia       TOM COBURN, Oklahoma
ELIZABETH WARREN, Massachusetts      DEAN HELLER, Nevada
HEIDI HEITKAMP, North Dakota

                       Charles Yi, Staff Director

                Gregg Richard, Republican Staff Director

                       Dawn Ratliff, Chief Clerk

                       Taylor Reed, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                 ______

     Subcommittee on Financial Institutions and Consumer Protection

                     SHERROD BROWN, Ohio, Chairman

       PATRICK J. TOOMEY, Pennsylvania, Ranking Republican Member

JACK REED, Rhode Island              RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York         DAVID VITTER, Louisiana
ROBERT MENENDEZ, New Jersey          MIKE JOHANNS, Nebraska
JON TESTER, Montana                  JERRY MORAN, Kansas
JEFF MERKLEY, Oregon                 DEAN HELLER, Nevada
KAY HAGAN, North Carolina            BOB CORKER, Tennessee
ELIZABETH WARREN, Massachusetts

               Graham Steele, Subcommittee Staff Director

       Tonnie Wybensinger, Republican Subcommittee Staff Director

                                  (ii)


                            C O N T E N T S

                              ----------

                      WEDNESDAY, JANUARY 15, 2014

                                                                   Page

Opening statement of Chairman Brown..............................     1

Opening statements, comments, or prepared statements of:
    Senator Reed.................................................     3

                               WITNESSES

Norman C. Bay, Director, Office of Enforcement, Federal Energy
  Regulatory Commission..........................................     3
    Prepared statement...........................................    26
    Responses to written questions of:
        Chairman Brown...........................................    38
Vincent McGonagle, Director, Division of Market Oversight,
  Commodity Futures Trading Commission...........................     5
    Prepared statement...........................................    31
    Responses to written questions of:
        Chairman Brown...........................................    41
        Senator Toomey...........................................    47
Michael S. Gibson, Director, Division of Banking Supervision and
  Regulation, Board of Governors of the Federal Reserve System...     6
    Prepared statement...........................................    33
    Responses to written questions of:
        Chairman Brown...........................................    48

              Additional Material Supplied for the Record

Letter from the Commodity Futures Trading Commission submitted by
  Chairman Brown.................................................    63
Statement submitted by the North American Die Casting Association    66

                                 (iii)

 
    REGULATING FINANCIAL HOLDING COMPANIES AND PHYSICAL COMMODITIES

                              ----------


                      WEDNESDAY, JANUARY 15, 2014

                                       U.S. Senate,
Subcommittee on Financial Institutions and Consumer
                                        Protection,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Subcommittee met at 2:02 p.m., in room SD-538, Dirksen
Senate Office Building, Hon. Sherrod Brown, Chairman of the
Subcommittee, presiding.

          OPENING STATEMENT OF CHAIRMAN SHERROD BROWN

    Chairman Brown. The Subcommittee will come to order. Thank
you to the witnesses, thank you to Senator Reed for joining us.
I will make a brief opening statement, then Senator Reed, and a
couple other Senators are going to be joining us. Ranking
Member Toomey could not make it but was helpful, and I thank
him and his staff for working with us on this important
hearing.
    For years, U.S. banking laws drew sharp lines between
banking and commerce, and Congress and regulators and the
institutions respected that separation. In 1999, things
changed. Congress weakened these laws, and over the last decade
regulators have been interpreting and implementing this law,
financial institutions have expanded into new and varied lines
of business.
    As I have said many times, the sixth largest U.S. bank
holding companies have 14,420 subsidiaries. The sixth largest
U.S. bank holding companies have more than 14,000 subsidiaries;
19 of them are traditional banks. Today we will learn more
about the rules for all of these nonbanking activities like
trading commodities, owning physical assets, how these rules
are applied.
    The Fed's proposal yesterday was a timid step. It was too
slow in coming. There is still too much that we do not know
about these activities and investments. We have still yet to
see U.S. regulators address concerns about the aluminum, zinc,
and copper markets.
    Although the London Metal Exchange, the LME, has adopted
new warehouse rules, industrial end users are unconvinced that
these reforms will address the problem as premiums and queue
lengths have only grown since they were announced.
    We are also here to seek answers to some fundamental
questions. Let me go through those briefly.
    First, what is the appropriate role for banks in the
commodities markets?
    If their commodities activities provide benefits to
customers, do those benefits outweigh the risks and the costs
of market manipulation and other harmful practices?
    Regulators in Europe and the U.S. have either investigated,
or settled with, institutions for manipulating rates in the
LIBOR, silver, gold, electricity, and oil markets.
    On Monday, it was reported that the FBI suspects that
traders at one U.S. bank earned between $50 and $100 million
through market manipulation by ``front-running'' interest rate
derivatives orders by Fannie and Freddie.
    Today it was reported that the world's largest foreign
exchange dealer has suspended several traders suspected of
manipulating currency prices. That is one of at least 13
traders at four banks that have been suspended for activities
that took place through a group known as ``The Cartel'' and
``The Bandits' Club.''
    Tim Weiner from MillerCoors testified before this
Subcommittee in July that actions by banks in the aluminum
market have cost that company tens of millions of dollars in
excess premiums over the last several years and cost aluminum
users a total of $3 billion last year alone.
    Second question: Why are banks allowed to own physical
assets?
    Most experts that have met with my office agree there is no
clear benefit to the economy from banks owning assets like
warehouses and tankers and pipelines and coal mines.
    Even analyst Dick Bove, author of the book ``Guardians of
Prosperity: Why America Needs Big Banks'', has said that
``banks went a little bit too far with the Fed's authorization
to get into the commercial side of [the] commodities
business[.]''
    If everyone but the banks agree, then why are regulators
allowing them to do it? This Subcommittee believes that the
problems of ``too big to fail'' are still with us.
    Last year, Chairman Bernanke said ``too big to fail'' is
``not solved and gone. It is still here.''
    Perhaps most importantly, the market believes that ``too
big to fail'' is still with us.
    Finally, what are the risks to our financial system, and
entire economy when ``too big to fail'' banks engage in
commercial activities?
    The Fed's proposal cites the Deepwater Horizon spill; an
explosion of a PG&E pipeline; an explosion at a natural gas
plant in Middletown, Connecticut; the tsunami and subsequent
meltdown at the Fukushima Daiichi nuclear power plant; the
derailment of a crude oil cargo train in Quebec; and older
disasters like Three-Mile Island and Exxon Valdez.
    This morning, the Wall Street Journal reported that crude
oil railroad shipments have dramatically increased and that
cities like Albany and Chicago and Denver and New Orleans may
be unprepared to deal with an accident involving this explosive
substance.
    Morgan Stanley's CEO reportedly told employees that an oil
tanker spill at one of its shipping units is ``a risk we just
can't take.'' And it is a risk that taxpayers cannot afford to
take.
    The ultimate question is who pays for mistakes or
manipulation that occurs at financial institutions. The answer
should be these institutions, their executives, their
employees. It should not be customers or taxpayers, but too
often that has been the case. It is time for a change.
    Thank you again to the witnesses. Senator Reed.

                 STATEMENT OF SENATOR JACK REED

    Senator Reed. Well, thank you very much, Mr. Chairman, for
holding this hearing. It is an extraordinarily important issue,
and one aspect that you have alluded to is the energy field.
And I can tell you that high energy costs are hurting my
constituents. Many of them are struggling just to pay the
bills. And according to the U.S. Energy Information
Administration, the average wholesale price for natural gas at
the New England Trading Point increased 75 percent in 2013
compared to 2012, while the rest of the country saw a 30-
percent increase. And EIA's most recent monthly data shows that
electricity prices in Rhode Island are nearly 45 percent more
than the national average for residential users, 35 percent
more for commercial users, and 77 percent more for industrial
users. So this is a tremendous burden, and this is one of the
things that is inhibiting our growth. Consequently, we have a
9-percent unemployment rate.
    So there are many factors involved--infrastructure
challenges, pipelines, distribution systems--but I am certainly
concerned about the potential for manipulation in the financial
markets and the physical natural gas and electric markets. That
is why I am looking forward to this hearing.
    We already know from the experience in California that it
is possible to manipulate energy markets, and we have to be
incredibly watchful, and that is why the coincidence of owning
physical assets and then participating in trading and other
activities has to raise these questions, and I am delighted
that the Chairman has seen fit to have this second hearing.
    Thank you, Mr. Chairman.
    Chairman Brown. Thank you, Senator Reed.
    Let me introduce the panel. Mr. Norman Bay is the Director
of the Office of Enforcement at the Federal Energy Regulatory
Commission. Welcome. Thank you for your service, Mr. Bay.
    Vince McGonagle is the Director of the Division of Market
Oversight at the CFTC, Commodity Futures Trading Commission.
Thank you for your service to our country.
    Mr. Michael Gibson is the Director of the Division of
Banking Supervision and Regulation for the Board of Governors
at the Federal Reserve System. Thank you also, Mr. Gibson, for
your service to our country.
    Mr. Bay, if you would begin.

 STATEMENT OF NORMAN C. BAY, DIRECTOR, OFFICE OF ENFORCEMENT,
              FEDERAL ENERGY REGULATORY COMMISSION

    Mr. Bay. Chairman Brown and Members of the Subcommittee,
thank you for inviting me to testify today. My name is Norman
Bay. I am the Director of the Office of Enforcement at the
Federal Energy Regulatory Commission. I appear before you today
as a staff witness, and the views I present are not necessarily
those of the Commission or of any individual Commissioner. I
have also submitted prepared testimony that responds to the
Subcommittee's questions, and so in my remarks today, I will
provide a brief overview of the work of the Office of
Enforcement.
    In a sense, my office is a legacy of the Western power
crisis from 2000 to 2001, and you have alluded to that crisis,
Senator Reed. During the crisis Enron and other entities
manipulated energy markets in California and the West and
ripped off consumers. At the time FERC did not have a general
antimanipulation authority, and its penalty authority was
limited to $10,000 a day. Thus, a manipulator could manipulate
the market every day for a year and face a penalty of $3.65
million, which was hardly even a rounding error for an Enron.
    In the Energy Policy Act of 2005, Congress fixed the
weakness in FERC's regulatory authority. Congress gave FERC a
broad antimanipulation authority based on Rule 10(b)(5) in the
Securities and Exchange Act of 1934. Congress also provided a
penalty authority of up to $1 million per day per violation.
These tools have been critical to FERC's efforts to protect
consumers from market manipulation in the wholesale natural gas
and power markets.
    After receiving its antimanipulation authority, FERC has
also built up its enforcement capabilities. By way of
comparison, during the Western power crisis, there were 20
staff in the Office of General Counsel who did enforcement
work. We now have around 200 staff in a stand-alone office, the
Office of Enforcement. We have staff with expertise in the
markets who are economists, accountants, and auditors; former
traders analysts with highly quantitative skill sets, including
mathematics, engineering, statistics, and physics. We also have
lawyers who are former prosecutors or who have extensive
litigation experience in private practice with some of the
finest law firms in the country.
    Our staff is organized into four divisions: the Division of
Investigations; the Division of Audits and Accounting; the
Division of Energy Market Oversight, which focuses on energy
market fundamentals, including important trends and
developments; and the Division of Analytics and Surveillance,
which provides technical support on investigations and which
creates and runs automated screens to detect potential market
manipulation. These screens are critical to our oversight of
the energy markets because, otherwise, there is simply too much
data, given the many trading hubs and markets and products, for
an analyst to be able to examine that data on a manual basis.
    Since receiving its EPAct authority in 2005, FERC has
collected about $873 million in civil penalties and
disgorgement. One of the top priorities of the office is fraud
and market manipulation. Some of our most significant
enforcement actions to date include actions against
Constellation, which settled for $245 million in 2012 for
manipulating the electricity markets in New York; JPMorgan,
which settled for $410 million in 2013 for manipulating the
electricity markets in California and the Midwest; and Barclays
in which the Commission issues a penalty assessment in July of
2013 of $453 million. Barclays has challenged that assessment,
and we are currently litigating the matter in Federal district
court in the Eastern District of California.
    In summary, the antimanipulation authority Congress
provided FERC in 2005 has been critical in our efforts to
police the energy markets and to detect and to deter and punish
market manipulation. You should know that we are committed to
doing our best to protect consumers and to further the public
interest. Indeed--and I often say this--I am honored and
humbled to be working with the many dedicated, talented, and
hard-working staff at FERC, particularly in the Office of
Enforcement.
    In conclusion, I wish to thank the Subcommittee for this
opportunity to testify today, and I look forward to answering
any questions you might have.
    Chairman Brown. Thank you, Mr. Bay.
    Mr. McGonagle, welcome.

 STATEMENT OF VINCENT MCGONAGLE, DIRECTOR, DIVISION OF MARKET
        OVERSIGHT, COMMODITY FUTURES TRADING COMMISSION

    Mr. McGonagle. Good afternoon, Chairman Brown and Members
of the Subcommittee. Thank you for the opportunity to appear
here today. I am Vince McGonagle, and I am the Director of the
Division of Market Oversight for the Commodity Futures Trading
Commission, CFTC.
    The Commodity Exchange Act serves the public interest by
permitting derivatives markets, both futures and swaps, to be
used to manage and assume price risks, discover prices, or
disseminate pricing information. Under the CEA and its mission
statement, the CFTC is charged with fostering transparent,
open, competitive, and financially sound markets. At the same
time, CFTC protects the public and market participants from
fraud, manipulation, abusive practices, and systemic risk
related to derivatives, while working to ensure the protection
of customer funds.
    To fulfill these roles, the Commission oversees designated
contract markets, swap execution facilities, derivatives
clearing organizations, swap data repositories, swap dealers,
futures commission merchants, commodity pool operators, and
other intermediaries.
    The CEA has for many years required that futures
transaction, subject to certain exemptions, be conducted on or
subject to the rules of a board of trade on a designated
contract market. With the passage of the Dodd-Frank Wall Street
Reform and Consumer Protection Act, DCMs were also permitted to
list swap contracts, and various new substantive DCM
requirements were established. In addition, the Dodd-Frank Act
established an entirely new regulatory scheme for swaps trading
and a new category of exchange for swap execution facilities
dedicated exclusively to the trading of swaps.
    Under the CEA and the Commission's contract and rule review
regulations, the terms and conditions of all products are
submitted to the Commission before implementation. In listing a
new contract, DCMs and SEFs are legally obligated to meet
certain core principles. One of the most significant core
principles prohibits the listing of contracts readily
susceptible to manipulation.
    Under this core principle, a DCM or swap execution facility
that lists a physical delivery contract must ensure that the
contract is designed to avoid any impediments to the delivery
of the commodity.
    The Commission's responsibilities under the Commodity
Exchange Act also include mandates to deter fraud and
manipulation of commodities in interstate commerce. Under that
authority, the CFTC brings enforcement cases for manipulative
activity in both cash and derivatives markets. Notably, the
Dodd-Frank Act enhanced the Commission's enforcement authority
over manipulative and deceptive actions and expanded that
authority to the swaps markets.
    The Dodd-Frank Act also established a registration regime
for foreign boards of trade who seek to offer U.S. customers
direct access to their electronic trading system. An applicants
for registration must demonstrate, among other things, that it
is subject to comprehensive supervision and regulation by the
appropriate governmental authorities in its home country, and
that its regulator's oversight of the platform is comparable to
the supervision and regulation to which Commission-designated
contract markets are subject.
    As part of our cooperative enforcement program, the CFTC
routinely provides assistance to and coordinates with other
domestic financial regulators. In addition, the Commission
recognizes that commodity markets are, of course, international
in nature and, accordingly, regularly consults with other
countries' regulators.
    Thank you for the opportunity to appear before the
Subcommittee. I will be pleased to respond to any questions.
    Chairman Brown. Thank you very much, Mr. McGonagle.
    Mr. Gibson, please.

 STATEMENT OF MICHAEL S. GIBSON, DIRECTOR, DIVISION OF BANKING
 SUPERVISION AND REGULATION, BOARD OF GOVERNORS OF THE FEDERAL
                         RESERVE SYSTEM

    Mr. Gibson. Chairman Brown and other Members of the
Subcommittee, thank you for the opportunity to testify at
today's hearing. Today I will discuss the history of bank and
bank holding company engagement in physical commodity
activities, the Federal Reserve's approach to supervising
financial institutions engaged in physical commodity
activities, and our policy review of commodity activities and
investments of bank holding companies.
    Prior to the Gramm-Leach-Bliley Act in 1999, bank holding
companies were authorized to engage in only a limited set of
commodity activities that were considered to be closely related
to banking. Under the GLB Act, Congress created the financial
holding company framework, which allowed certain bank holding
companies to engage in expanded activities under three
different provisions.
    The first provision, referred to as ``Section 4(k)
authority,'' authorizes a financial holding company to engage
in an activity that the Board finds to be complementary to a
financial activity, but only if the activities do not pose a
substantial risk to the firm's safety and soundness or the
financial system and the benefits to the public outweigh
possible adverse effects.
    Second, the GLB Act's merchant banking authority permits a
financial holding company to invest in companies that are
engaged in activities not otherwise permitted for financial
holding companies.
    In a third provision of the GLB Act, referred to as
``Section 4(o) authority,'' Congress grandfathered certain
commodity activities that are not permissible for bank holding
companies if the company was engaged in those activities as of
September 1997. No approval or notice is required for a company
to rely on this authority for its commodity activities. In
contrast to the firms that rely on the Board's authorizations
under 4(k) authority, the 4(o) grandfathered firms are also
able to engage in the transportation, storage, extraction, and
refining of commodities. Only two financial holding companies
currently qualify for these grandfathered rights--Goldman Sachs
and Morgan Stanley.
    The Federal Reserve is the consolidated supervisor of bank
holding companies and financial holding companies. As a
supervisor of financial holding companies that engage in
commodity activities, the Federal Reserve aims to ensure that
firms manage the risks of those activities, have strong
capital, and have adequate controls over their commodity
activities.
    The scale and complexity of commodity activities of
financial holding companies expanded in 2008 as a number of
securities firms with significant commodity activities either
became bank holding companies or were acquired by bank holding
companies. As a result, the Federal Reserve expanded the scope
of its examination and review of physical commodity activities.
However, the Federal Reserve has no direct role in overseeing
the commodity markets generally. The CFTC regulates commodity
futures and option markets and over-the-counter commodity
derivative markets. Other agencies, such as FERC, also regulate
segments of the physical commodity market.
    The Federal Reserve has been conducting a detailed policy
review of the commodity activities and investments of financial
holding companies. The scope of our review covers all of the
4(k), merchant banking, and 4(o) authorities I listed earlier.
Yesterday the Board issued an Advance Notice of Proposed
Rulemaking, or ANPR, to seek public comment on a range of
issues related to the commodity activities of financial holding
companies.
    In particular, the ANPR discusses the unique tail risks of
commodity activities exemplified by the recent Deepwater
Horizon oil spill and many other incidents that you mentioned,
Senator Brown, in your opening remarks. The ANPR discusses the
additional contagion risks that commodity activities may pose
to systemically important financial institutions, the Board's
concern that current safeguards and safety and soundness
considerations may not be adequate to address those risks,
recent evidence that commodity activities may not be as
complementary to banking as was previously believed, and what
further prudential restrictions or limits on commodity
activities are warranted to mitigate these risks.
    I look forward to answering any questions you may have.
    Chairman Brown. Thank you, Mr. Gibson. Thank you to all of
you.
    Mr. Gibson, the Fed, as you have pointed out, sought public
comment yesterday to help inform its consideration of physical
commodity activities conducted by these financial holding
companies. It is encouraging to see the Fed rethinking the
issue. These exemptions have existed since 1999. The first
complementary order was 2003. Some of the disasters cited by
your ANPR we just talked about--for example, the Exxon Valdez--
are not recent events. So the questions are: Why now? Why did
it take so long? Aside from the vote on the ANPR, have there
been any other Board-level discussions or deliberations or
meetings about physical commodities?
    Mr. Gibson. I think that the staff and the supervision
staff have been working on the issue of banks' and financial
holding companies' physical commodity activities since 2008
when, as I mentioned, we got a lot more authority over
securities firms that either became bank holding companies or
were acquired by bank holding companies, and that dramatically
expanded the scope of commodities activities. We started doing
more in-depth review at that point, and following on from that,
which raised a number of concerns, and is discussed in the
ANPR, really the question of whether certain risks such as the
unique tail risks that certain commodities pose, along with the
expanded activities, as well as the lesson from the financial
crisis that contagion risks of systemically important financial
institutions can pose a risk to financial stability, those were
some of the factors that made us take another look at the risks
and have led to the process up to issuing the ANPR.
    We have had a number of meetings over the years that have
worked on this issue and led up to the ANPR, not open Board
meetings, but staff-level meetings.
    Chairman Brown. I still am a bit incredulous about the
speed at which this was done. Professor Omarova, who came to
this Subcommittee in July, stated that there is ``no meaningful
public disclosure of banking organizations' assets and
activities related to physical commodities and energy.'' A
fundamental difficulty with this type of inquiry seems to be
opacity, a lack of knowledge about the size and scope of
commodities held by banks and other traders. None of us knows
the quantities and the extent of this.
    Commissioner Bart Chilton--Mr. McGonagle is one of his
bosses--sent me a letter that I got today saying that he has
been trying for months to obtain useful ownership information
from the Fed about physical commodities--now, this is another
regulatory agency--but got not response.
    Tell me, if you would, how much aluminum does Goldman Sachs
hold?
    Mr. Gibson. I do not know off the top of my head exactly
the answer to your question.
    Chairman Brown. Does the Fed know?
    Mr. Gibson. What we do require banks to disclose on their
quarterly financial reports, that are public regulatory
reports, they do disclose the amount on their balance sheet of
physical commodities that they hold, and that is a required
public disclosure.
    Chairman Brown. So the answer is yes, the Fed knows. But
does the Fed release that to anybody?
    Mr. Gibson. That is available publicly. You can download it
from our Web site.
    Chairman Brown. So why would----
    Mr. Gibson. But that is an aggregate number, all
commodities. It does not break it out by individual
commodities.
    Chairman Brown. So how can we comment on this ANPR? I mean,
it just seems to me the process is stacked in favor of the
banks, that the information is not forthcoming. The Fed has
moved extraordinarily slowly on this. Another regulator of
equal stature, as far as I am concerned, cannot get
information. How are we going to begin to exercise effective
oversight when this information is simply not forthcoming?
    Mr. Gibson. In addition to the aggregate numbers that banks
disclose in their public regulatory reports, as public
companies, they file SEC quarterly and annual reports that
disclose and discuss all their material risks. If a bank
holding company has a material exposure to commodities, the
commodities business, they are required to discuss those risks
in their public SEC disclosures. So this is another public
source of information.
    Chairman Brown. So after this hearing, will the Federal
Reserve be more--understanding some of this information is not
delineated and broken down in the detail that I think other
regulators and this Subcommittee and others that want to
oversee this can understand and can get access to, but can you
promise us that the Fed will be more forthcoming with this
information in more detail, and if you do not have all the
information, you will ask questions of these financial
institutions?
    Mr. Gibson. What we have done in the ANPR is asked a series
of questions which we hope elicits some of the information that
you are talking about. We have our own information that we get
from the supervisory side, but we also are interested in the
public comment, comments from the industry and others, to help
us inform the discussions as we go forward.
    Chairman Brown. I am not sure, though, that the public
comment can be as helpful and as incisive in its questions and
as illuminating as it could be if they--because they do not
have access to enough of this information. So I implore you to
make more of this available in a form that other regulators,
like Bart Chilton and congressional oversight and all can see
it.
    Let me ask you something else. Morgan Stanley currently has
133 legal entities it holds under, you mentioned, the 4(o),
including TransMontaigne, a wholly owned subsidiary that
stores, refines, transports gas, gasoline fuels, crude oil, and
other liquid products. Section 4(o) says that institutions that
were not banks before Gramm-Leach-Bliley passage ``may continue
to engage in''--this was the Morgan Stanley, Goldman Sachs,
obviously, as you know, it turned out to be that--``may
continue to engage in or, directly or indirectly, own or
control shares of a company engaged in activities related to
the trading, sale, or investment in commodities and underlying
physical properties'' if they were engaging in ``any such
activities prior to 1997.'' You know all this.
    A 2012 article by staff of the New York Fed, you know, the
regional Federal Reserve Bank responsible for the largest U.S.
banks, said, ``The legal scope of the 4(o) grandfathered
exemption is widely seen as ambiguous. It is unclear to what
extent it allows firms to purchase new hard assets relating to
an existing commodities business or to expand into new
commodities markets.''
    This is staff from the largest--from the regional Federal
Reserve Bank responsible for the largest U.S. banks. They say
the law is ambiguous, 15 years since the law's passage, more
than 5 years after institutions have become eligible to use
this provision.
    Can you to this Subcommittee clear up this ambiguity by
explaining the meaning of ``any such activities''? And can a
financial holding company that was not a bank holding company,
meaning these two, and was trading a single commodity like
silver prior to 1997 begin trading other commodities like zinc
or electric generation or a whole host of other things? Would
you answer those two questions?
    Mr. Gibson. What is clear is that the authority that
Congress granted under Section 4(o) which is currently being
used by Goldman Sachs and Morgan Stanley as the authority to do
a wide range of commodity businesses is very broad. It allows
them to own the storage, transportation, refining, and
extraction of physical commodities. And in contrast, the orders
that the Board has granted under Section 4(k) authority are
more limited, impose tighter limits, do not allow ownership of
storage, transportation, extraction, and refining. So that is
an important difference that we have taken into account in our
review, and we describe this in the ANPR, the fact that--as we
ask questions in the ANPR and look ahead to what the next step
will be, there are different legal avenues we have to take more
restrictive actions against activities that are done under the
Section 4(o) authority compared with the Section 4(k)
authority.
    That is an important issue that we are trying to address in
the ANPR, solicit comment on, and decide on the way forward.
    I am not a lawyer, so I cannot give you the legal
interpretation of what exactly it means. I certainly expect we
will get some public comment on that. You are right to focus in
on the fact that there is an interpretation issue there, and it
is one of the things that is an issue for our review.
    Chairman Brown. You are not a lawyer, and neither am I, and
a number of us up here I think are not. But you are enforcing
the law, so that is pretty important.
    Are there limits, and what are they, on 4(o)? In other
words, if a company--prior to 1997, one of these firms traded
zinc, can they trade aluminum? If they did not own a warehouse,
can they own assets like warehouses and pipelines and tankers
under this provision? What are the limits of 4(o)?
    Mr. Gibson. There is a limit under Section 4(o) that states
that the aggregate amount of physical commodity assets can be
no more than 5 percent of a firm's total assets. But that is a
very wide limit, and compared with the Section 4(k) authorities
that the Board has granted, the Board has imposed a much
tighter limit of 5 percent of Tier 1 capital. Since the capital
is much smaller than the assets, the 4(k) limits are, in
effect, much tighter than the 4(o) limits. So that is a big
difference.
    In terms of what is the legal interpretation of the text in
Section 4(o) about activities that were engaged in in 1997,
that is one of the issues that we are looking at in our review,
and we have asked for public comment on that.
    Chairman Brown. Thank you, Mr. Gibson, for your patience. I
get the percentages, the 5 percent, but in terms of activities,
so specifically if they traded in zinc prior to 1997, can they
now trade in aluminum? If they had no warehouse, can they own a
warehouse or own a pipeline or purchase and own an oil tanker?
    Mr. Gibson. You are not asking for a general answer, but
starting with generally, they are restricted to activities that
they were doing prior to Gramm-Leach-Bliley.
    Chairman Brown. And zinc means zinc, zinc does not also
mean aluminum?
    Mr. Gibson. It is going to depend on the facts and
circumstances of the particular case, so beyond saying that
that is one of the things we are considering in our review, I
think that is where we are at.
    Chairman Brown. It really does seem like--and I hate
cliches, but I am going to use one--the camel's nose under the
tent here. They qualify because they did some of this prior to
1997, but they are getting to do a whole lot more.
    But let me close with one other question, and then I will
turn it to--then we will do another round if Senators really
want to after Senators Reed and Merkley and Warren go. Section
5 authorizes the Fed to force a bank holding company to divest
a nonbank subsidiary that ``constitutes a serious risk to the
financial safety, soundness, or stability of any of its bank
subsidiaries.'' The primary role of all of us is the safety and
soundness and stability of our financial system. My editorial
comment, of course.
    As I said in my opening statement, James Gorman--I did not
say his name, but he reportedly told Morgan Stanley employees
that an oil tanker spill in one of its shipping units is ``a
risk we just cannot take.'' So my question is: Can the Fed use
its general safety and soundness authority to curtail some of
these 4(o) activities? Could it use Section 5 authority to
force these financial holding companies to divest themselves of
subsidiaries that expose it to undue risk--a huge oil spill, a
tank explosion? Whether they are grandfathered or not, do you
have the authority to force their sale of these activities,
ceasing of these activities and sale of these commodities?
    Mr. Gibson. We certainly have the authority under general
safety and soundness considerations to impose restrictions,
impose capital requirements, impose risk management
requirements, and other requirements on those activities and
any activities. And we also have, as you mentioned, authority
under Section 5 to require a financial holding company to
terminate certain activities if the activity constitutes a
serious risk to financial safety, soundness, or stability and a
number of other conditions. So we have both of those.
    Chairman Brown. Have they ever been used?
    Mr. Gibson. Section 5? I do not think so.
    Chairman Brown. OK. It just seems that----
    Mr. Gibson. Again, I am not a lawyer, but my understanding
is it is a high bar to use that authority.
    Chairman Brown. Well, it is a high bar except when the CEO
of one of these two says it is ``a risk we cannot take.'' When
you think of the cost of any institution, you know, if it is
owned by an oil company, it is an oil tanker, and there is a
terrible problem, that is tragic for everybody involved. But it
does not have the potential damage to our economy. These do
because these are financial--these are bank holding companies
or financial holding companies. And, I mean, you understand
risk. And that the Fed in this many years has never acted on
the authority it has suggests to me that something is not right
in our regulatory system.
    Mr. Gibson. And the concern you mentioned is the same
concern we have, that we described in our ANPR, and that we are
confronting in our review.
    Chairman Brown. It did not seem to be a concern that--it
seemed to be a bit of a distant concern because of just the
slowness of getting to this. OK.
    Senator Reed.
    Senator Reed. Thank you, Mr. Chairman.
    We are talking about simply two categories, Mr. Gibson,
4(k) and 4(o) operations. So let us look a moment at 4(k)
complementary authority, which requires the Fed to make a
determination that the activity is to produce benefits to the
public, such as greater convenience, increased competition, or
gains in efficiency, that outweigh possible adverse effects,
such as undue concentration of resources, decreased or unfair
competition, conflicts of interest, or unsound banking
practices.
    Just as a specific interest point, how do you measure this
issue of undue concentration of resources?
    Mr. Gibson. When that net benefit test is looked at in
connection with the 4(k) complementary authority, it is a
general balancing of all of those issues and trying to get a
sense of on balance do the benefits exceed the costs. But I do
not think we have a specific methodology that produces a number
that would be that specific.
    Senator Reed. It is very subjective.
    Mr. Gibson. Yes, it is subjective.
    Senator Reed. So now you have made the determination under
the 4(k) authority that it passes this subjective test. Do you
continuously evaluate whether it continues to serve the public
interest or do it on a regular basis?
    Mr. Gibson. Generally, the way it works under the Section
4(k) authority is that a bank comes and requests permission to
engage in a particular activity.
    Senator Reed. Right.
    Mr. Gibson. And then we do the review that is required.
Once the approval is granted, then we are focused on the risks
on an ongoing basis, safety and soundness considerations,
making sure that the bank has adequate risk management and
capital.
    Senator Reed. So the public interest aspects of the test
sort of go by the wayside, and the concentration is on simply
the safety and soundness of the banking institution and risks
that they might be taking. That is what you just said.
    Mr. Gibson. That is what we focus on in our ongoing
supervision.
    Senator Reed. Yes. That is what you just said, so the
public interest test, it is fire and forget. So you clear that
first hurdle, and their activities over time, if they serve the
public interest that is incidental to your interest. I mean, I
am not putting words in your mouth, but it----
    Mr. Gibson. That is the way it is set up in the statute,
but as part of our review, we have asked questions about what
information people can give us on the net benefits and costs on
those specific factors you mentioned.
    Senator Reed. So in this issue of being complementary, for
example, it could be complementary for a financial holding
company to own physical assets, which, through business
decisions that are prudent, could increase the value of their
financial holdings. Is that what we mean by--even though it
would produce additional costs to the public, is that
complementary?
    Mr. Gibson. No. What is meant by complementary is that
there is some activity that a bank is engaging in that is a
financial activity where the physical commodity or other
activity is closely related to it. That is what is meant by
complementary.
    Senator Reed. But you do not look at the interaction
between holding that physical commodity in some way, shape, or
form and the investment portfolio of the banks, the holdings of
the banks, and what they are doing? If it is just generically,
well, we trade in gold and we can own gold, is that the test?
    Mr. Gibson. We would look at conflicts. We would expect
banks to have policies and procedures in place to manage
conflicts of interest that could arise from the fact that they
might be trading something on one side and investing in
something on another side. That is a general issue that we
would always worry about and insist on.
    Senator Reed. Sure. But I think the point--and this is one
of the reasons why we have seen these problems that the FERC
has reacted to, we all react to, is having a policy and that is
what you look at as fine, but having the capacity to look on a
fairly regular basis at what they are actually doing, do you
have that capacity at the Fed?
    Mr. Gibson. Yes, we do look at what they are actually
doing.
    Senator Reed. So you are looking at their trading activity,
is it in any way related to decisions by their commodities
subsidiary in terms of pricing, in terms of access to materials
in the marketplace? Do you make those judgments?
    Mr. Gibson. We are generally looking at the activities that
the firms are engaging in, the risks, the risk management that
they have around those activities, and the capital. So----
    Senator Reed. But you are not looking at the effect on the
market in terms of, for example, the brewers, that the price of
aluminum is going up dramatically, that you have people that
are dealing in financial matters and also dealing in the
commodities, you are not concerned about that, or you do not do
that?
    Mr. Gibson. We are not the regulator of commodity markets,
so if there is market manipulation that is going on in
commodity markets, it is not our primary----
    Senator Reed. I know, but when things happen, they come to
you. And you also are responsible for the management of all of
these companies, that they have the capacity to manage it, that
they just do not have risk policies in place but they are
actually doing things that are, according to the 4(k) order at
least, in the public interest.
    Mr. Gibson. And we have seen a lot of problems at banks
recently with having inadequate compliance functions and
inadequate controls.
    Senator Reed. And what steps have you taken besides
reporting----
    Mr. Gibson. We take supervisory measures, and we take
enforcement actions. And this is broader than just commodity
activities. We have seen----
    Senator Reed. I understand that, but what enforcement
actions have you taken with respect to commodity activities?
    Mr. Gibson. Well, again, with respect to commodity market
manipulation, that would not be our province because we are not
the market regulator. With respect to----
    Senator Reed. Well, then, what do you do when you discover
it?
    Mr. Gibson. With respect to banks having inadequate
controls or compliance functions----
    Senator Reed. No, no. When you discover--your people who
are in those banks every day, unlike FERC, what happens when
you suspect that there is something amiss?
    Mr. Gibson. If we find a problem, the first thing we would
do is raise it and require the bank to fix the problem. And if
it requires an enforcement action, then we would take that
extra step to do an enforcement action, put it in writing, and
follow it to make sure the problem gets fixed.
    Senator Reed. And how many enforcement actions have you
taken in this regard?
    Mr. Gibson. I do not have a particular count of exactly how
many enforcement actions----
    Senator Reed. Can you----
    Mr. Gibson. We can find out.
    Senator Reed. Thank you. I appreciate that.
    And then, again, two, in the 4(k) realm, I am under the
impression that in this process, which is not unusual or unique
to the bank holding company or financial holding company, there
are certain representations that are made with respect to what
they will do. Are you checking those? For example, I have been
informed that in order to own some of these ships, the
financial holding company represented, that they put age
limitations on vessels that are carrying oil and requiring such
vessels to carry maximum insurance for oil pollution. Do you
regularly check that?
    Mr. Gibson. Yes, we do. There are a number of limits that
are imposed as part of the 4(k) orders that we have done. And
as part of our follow-up supervision, we look at those, and we
follow up on those.
    Senator Reed. Just a final point because my time is
expiring. One of the issues that becomes so clear from 1999
here to today is that the vision of these integrated companies
that provide services to their clients, and some of it in a
more cost-effective way and a more efficient way, is a good
vision. But the presumption is that the company itself has the
managerial capacity to do it well, and that Federal regulators
have the managerial capacity to supervise them. And there is
always this dogging question in my mind of whether you have the
capacity--I think you have the intent; I think all of you have
the intent, but whether you have the capacity both legally and
operationally, with personnel, et cetera, to do this and are
doing it on a regular basis so that you can assure not only
myself and my colleagues but, more importantly, people that you
are on it. For example, those energy prices that are very, very
high are not the result of decisions that are being made in
these organizations that control both the physical resource and
have huge financial levers to move markets.
    Can you give us that assurance? Do you have that capacity?
    Mr. Gibson. Our mission in bank supervision is to make sure
the banks operate in a safe and sound manner.
    Senator Reed. Well, see, there is a difference with safety
and soundness. I think we found that out. There can be a lot of
safe and sound institutions that are not providing significant
public benefits versus private benefits which they are earning,
which goes to the safety and soundness. A lot of the decisions
that were made prior to the collapse were simply because
regulators were more concerned about safety and soundness than
they were about consumer protections, fair market operations,
you know, et cetera. So the notion of that, ``Well, we make
sure they are safe and sound,'' that is somewhat reassuring,
but that is not the entire scope.
    Mr. Gibson. Yes, I understand, and I already explained
others are focused more on market oversight and market
manipulation. But we do pay attention to compliance and
controls.
    Senator Reed. I appreciate your response, and thank you.
    Thank you, Mr. Chairman.
    Chairman Brown. Senator Merkley.
    Senator Merkley. Thank you very much, Mr. Chairman.
    Mr. Gibson, the AE-10 notice that the Fed put out
yesterday, what is behind the timing of this?
    Mr. Gibson. The timing of the ANPR that we put out
yesterday? We have had a review underway for a while now on the
risks associated with financial holding companies' commodity
activities, and we felt like we were at the stage where it was
the right time to put out to the public what our concerns were
with the risks, what the structure of the legal authorities
that we have talked about here today is, and ask for public
input on what actions or remedies might be desirable.
    Senator Merkley. So this conflict between commodities and
holding and trading has been in existence a long time. Why not
4 years ago?
    Mr. Gibson. It was in 2008 when the Fed got oversight for a
lot of commodity activities that were previously done in
securities firms that became bank holding companies or were
acquired by bank holding companies. So after that, we really
staffed up in our supervisory function to look at some of these
new activities that had not previously been that significant
within financial holding companies. Based on what we started to
learn with the examination starting in 2009 and going forward,
that built up then into the policy review that took us to
yesterday putting out the ANPR detailing the concerns and
asking for public input.
    Senator Merkley. There have been various articles saying
that the FERC was really paying a lot of attention to these
types of issues and that the Fed was asleep. Is that a fair
characterization?
    Mr. Gibson. Which type of issues?
    Senator Merkley. They were paying a lot of attention to
commodities issues, particularly the trading of electricity,
which is in their jurisdiction, but the Fed in its area had
been asleep. Is that a fair characterization, the Fed just woke
up?
    Mr. Gibson. No. I would say that FERC----
    Senator Merkley. OK. Let me ask you this question: Firms
argue that they have a Chinese wall, that they can own vast
amounts of commodities, including the means for delivering
those commodities, in one part of their firm. Another part of
the firm that is deeply involved in trading through their
market making, through their wealth management, that no
information travels back and forth, there is no advantage. Do
you believe that that is the case?
    Mr. Gibson. Well, we require firms to have policies
around----
    Senator Merkley. No, not policies. Do you believe that a
Chinese wall is a perfect creation? And let me just remind you,
the public has been following not only what happened in the
case of power manipulation with Enron but power manipulation
with Goldman Sachs--excuse me, JPMorgan. They have been
following the LIBOR manipulation, the hard currency
manipulation. Does a Chinese wall--is it a powerful separation
in firms that no information passes back and forth?
    Mr. Gibson. I think there have been a lot of problems in
some of the firms that you mentioned around market
manipulation, and we have seen a lot of investigations, and we
have seen a lot of enforcement actions----
    Senator Merkley. OK. Let me ask all three of you the same
question. It is a pretty simple yes or no. Is a Chinese wall a
perfect instrument and we should rest easy that you can do
these two things in the same firm without information passing
back and forth? Mr. McGonagle, is it a perfect instrument, the
Chinese wall?
    Mr. McGonagle. When people are involved, no instrument is
perfect.
    Senator Merkley. Thank you.
    Mr. Bay.
    Mr. Bay. I would hesitate to rely on that alone, Senator
Merkley.
    Senator Merkley. Thank you.
    Mr. Gibson, one more chance to answer the question.
    Mr. Gibson. No, no Chinese wall is perfect.
    Senator Merkley. OK. So since under your 4(k) authority you
are supposed to be looking out for the soundness of the
financial system generally, is this an area you--you are
seeking information from the outside, you know, comment if you
will. But is there--why allow this to exist? If you were in a
policy mode, would you say this is a good policy to allow these
two activities to take place where a firm with enormous assets
can control the supply and demand of a product while at the
same time trading on the product? Is that a good policy
strategy if you were advising us on what Congress should
pursue?
    Mr. Gibson. What we have highlighted in our ANPR that is
asking for comment is the fact that there are a lot of risks
which are difficult to size, difficult to dimension, could be
very large, associated with some of the commodities activities
that financial holding companies are engaged in now. And we
learned in the financial crisis about the fragility and
contagion risks that those companies are subject to, and that
is one of the factors that is making us rethink the current
situation.
    Senator Merkley. OK. Let me ask you about the 4(o) portion.
If such a conflict of interest is inappropriate for firms that
are currently banks, why should new groups that were, if you
will, outside the commercial banking world but then get a
commercial banking license, why should they be allowed to do
the activity? Why should Goldman be allowed to do it, why
should Morgan Stanley be allowed to do it, if other entities in
that space are not allowed to do it?
    Mr. Gibson. Congress created the 4(o)----
    Senator Merkley. I understand. I am asking a policy
question. I am not asking a history lesson.
    Mr. Gibson. I think it is a good question why some
companies should have different authority than others, and
broader authority.
    Senator Merkley. So it is reasonable to assume that if the
risks are such that this rule applies to some groups, that risk
would inherently exist for the other firms that are coming in
through a doorway that bypasses that restriction.
    Mr. Gibson. Yes, and we talk about in our ANPR the fact
that some of the risks are the same. But the limits and
restrictions are different because of the different
authorities.
    Senator Merkley. Does the trading--does the fact a firm
might hold a lot of aluminum warehouses and proceed to control
the supply and demand of aluminum or in any other commodity
like that, is that kind of equivalent to a tax on the financial
system by inflating the costs that the end user pays?
    Mr. Gibson. Are you asking me?
    Senator Merkley. Yes.
    Mr. Gibson. I would not call it a tax. I would call it--the
way the companies choose to organize themselves, they are
dealing with their customers and they are providing the service
to their customers. And what we look at is more are they doing
it in a safe and sound manner, do they have enough capital to
back up the risks that they are taking as they provide those
services.
    Senator Merkley. But aren't you also supposed to look at
the impact on the financial system generally?
    Mr. Gibson. Yes.
    Senator Merkley. And does it impose higher costs on--does
everyone buying aluminum cans to put their beer in pay a little
bit higher price because of that type of control over supply
and demand?
    Mr. Gibson. I do not know the answer to that question.
    Senator Merkley. Would anyone else like to comment on this
and whether there are costs passed on to the end user as a
result of some of these conflicts of interest?
    Mr. McGonagle. Certainly for the CFTC, one thing that we
would be evaluating and trying to get a handle on, market
position or price impact, is the size of a position that any
trader might hold, and concentration of a position can lead to
concerns about impact on price. So that is going to be an area
that we would be focused on.
    Senator Merkley. Thank you, Mr. McGonagle.
    And, Mr. Bay, in the case of electricity trading, do you
see an impact on the end user?
    Mr. Bay. Anytime there is fraud or manipulation, there is
an impact on the end user, and, invariably, that cost is borne
by consumers.
    Senator Merkley. Thank you all very much.
    Chairman Brown. Thank you, Senator Merkley.
    Senator Warren.
    Senator Warren. Thank you, Mr. Chairman. Thank you for
holding this hearing and for your leadership in this area. I
think your focus on this set of issues has already benefited
consumers and helped some small businesses. I think you are
starting to move things. And I want to echo your comments about
the Fed's decision yesterday, certainly a step forward but a
meager one.
    I think we already have ample evidence that the Fed needs
to place additional restrictions on how banks trade and
warehouse physical commodities to reduce systemic risk and to
protect consumers from market manipulation. And I hope once the
public comment period ends that the Fed will act quickly to put
those restrictions in place.
    You know, the Fed history here is very troubling. We still
have not recovered from the failures of the Fed and the other
banking agencies to limit systemic risk and protect consumers
leading up to the 2008 financial crisis. And as important as it
is for the Fed to put time and resources into monetary
policymaking, we have learned the hard way that there is also a
need for the Fed to pay a lot more attention on the front end
through their regulatory functions and to better protect us
all.
    So let me just start with a quick question for Mr. Gibson.
If we reinstituted the protections of the Glass-Steagall Act,
as the bill I introduced with Senators McCain, Cantwell, and
King would do, would the Fed still be in the position where it
had to decide whether trading in zinc is OK but trading in
aluminum is not, or how much insurance an oil tanker should
carry? Mr. Gibson.
    Mr. Gibson. I do not know the detailed provisions of your
bill, but there certainly would--if the authorizations that
financial holding companies have to do these commodities
activities were removed, then, no, we would not have to worry
about that.
    Senator Warren. So the Fed would not be in that business?
    Mr. Gibson. Right, because it would not be a permitted
activity, period.
    Senator Warren. That is right. Well, I have to say that
sounds pretty appealing to me.
    I want to turn to the enforcement side of this issue as
well. Senator Markey and I sent a letter to FERC in July with
some questions about the settlement with JPMorgan over claims
of energy market manipulation. And I appreciated the very
prompt and very thorough response that I received back from the
FERC Chairman, and I have a few follow-up questions about FERC
and the FTC--FCTC--I am saying it backwards--the CFTC's
coordination in this area.
    So in its response to my letter, FERC said that it needed
access to the CFTC's large trader report so that it could
effectively look for possible manipulation in the energy
markets. And the large trader report identifies individuals and
institutions that have made large transactions in the futures
market.
    Mr. Bay, could we start by having you explain briefly why
access to the large trader report is so important to FERC's
efforts to monitor the energy market and energy market
manipulation?
    Mr. Bay. Thank you, Senator Warren. So FERC receives data
on the physical gas and power markets, and the Commission has
issued a number of rulemakings over the years to get even more
data. That data has been very helpful for us in terms of
beefing up our market surveillance. But the regulatory
construct behind FERC and the CFTC was fashioned years ago when
there was basically a physical market for energy and then there
was a very, very small financial market.
    For example, the first oil derivative was not issued by
NYMEX until 1978. The first natural gas futures contract was
not issued on NYMEX until 1990. The first electricity
derivatives was not issued on NYMEX until sometime after that.
    But what has happened is that whereas at one time the
physical market was much bigger than the financial market, that
is, the derivatives market, the converse has now occurred. And
with respect to cross-product manipulation, you can think of
them as having three components: there is a tool, there is a
target, and there is a benefiting position.
    Typically the tool is some sort of trading activity that
affects the value of a physical commodity product, right? So
you do something, you trade maybe in a way that is even
uneconomic with respect to the physical transaction, but you
are doing that because you are trying to move prices.
    But then, to complete the manipulation, you need to have a
benefiting position, and that benefiting position invariably in
the investigations that we have done involving cross-product
manipulation has involved a financial product.
    And so if we had access to more financial data, it would
allow us to create both more sophisticated but also more
sensitive and efficient algorithms, screens that we would run
against the data that we receive.
    I am pleased to say, however, that FERC and the CFTC
entered into an MOU in which the CFTC agreed to provide data to
us for surveillance purposes, and we look forward to having
discussions with the CFTC to get that data.
    Senator Warren. Well, so that was actually my question in
this because I wanted to follow up about the coordination
between the two agencies. It is not just that you decided to do
it. Dodd-Frank required that the CFTC and FERC agree on
principles for sharing data, so the two agencies together could
more effectively monitor market manipulation than either one of
you would be able to do alone.
    It took 3\1/2\ years for you to work this out, but I
understand that it was 2 weeks ago that you just entered into
an agreement for how to share data. But as I understand it, the
CFTC at that point did not commit to share the large trader
report with FERC. So I am concerned about this and just want to
make sure that I understand this.
    Mr. McGonagle, I am concerned if the CFTC is unwilling to
share this piece of information. Is it right that you have not
yet agreed to that? And if so, can you explain why?
    Mr. McGonagle. Thank you, Senator. With respect to
surveillance, access to information, we have invited FERC staff
to come to CFTC premises while we work out a protocol that
ensures that the information that we receive within our records
and rules, as mandated by Congress for confidentiality
concerns, that that information can be transferred and shared
in a way that satisfies our obligations. And so in the interim,
we have offered to work with FERC staff so that they can have
access to the information.
    I should also point out that certainly since 2005 and
before, as part of the 2005 Memorandum of Understanding that we
have with the FERC, and just as an overall matter, our
cooperative enforcement relationships with all other Federal
regulators, when it comes to information sharing, particularly
with respect to enforcement investigations, we have worked very
diligently with FERC, received information from FERC as well,
as we do with other agencies. And so this is one additional
aspect, surveillance, layered onto what I view as an already
strong, cooperative enforcement relationship.
    Senator Warren. So let me just make sure that I understand
this, Mr. McGonagle. I do not want to miss this. So you are
making the large trader report available to FERC people in any
investigation. They have to come to your place to do it, but it
is available? Is that right?
    Mr. McGonagle. That is right, and then----
    Senator Warren. Fully available?
    Mr. McGonagle. Fully available.
    Senator Warren. OK. And that is your understanding, too,
Mr. Bay, that it is now fully available?
    Mr. Bay. We sent staff to the CFTC last week, and they were
able to access the large trader report. That was a step
forward. What we are hoping to receive at some point--and this
is a detail to be worked out under the MOU. We believe that the
MOU supports this. What we are hoping to receive is an ongoing
live data stream of the relevant financial data for the gas and
power markets from the large trader report.
    Senator Warren. OK. And, Mr. McGonagle, I understand from
you that the only reason this has not been done is that you
have concerns about working out the details about
confidentiality. That is what I thought I heard in your answer,
that there is more that FERC needs to do in order to reassure
you about the confidentiality of the data they are receiving?
Is that right?
    Mr. McGonagle. That is effectively correct. The FERC has
guaranteed that they would maintain the confidentiality
provisions that we are also obligated to under Section 8. The
questions--there are questions sort of around data transfer
issues, and the technical personnel need to work those things
out, and that process is ongoing.
    Senator Warren. I am sorry. So you are saying that the
confidentiality issues have been worked out, but you have still
got some technical data issues. Forgive me for pushing on this,
but I think it is a really important point. Market manipulators
do not respect jurisdictional boundaries between agencies. In
fact, they try to exploit those boundaries and take advantage
of gaps in oversight and in data sharing. And that is why it is
absolutely critical that the Commodity Futures Trading
Commission be willing to share these data on an ongoing, timely
basis with FERC.
    And so the reason I ask about this is I want to hear that
we are going to protect consumers, we are going to protect the
public by making sure that these data are shared. I will follow
up on this, but I sincerely hope I will not need to because all
of this is resolved and that those data are going smoothly and
quickly over to FERC as well. Thank you.
    Thank you, Mr. Chairman.
    Chairman Brown. Thank you, Senator Warren.
    Before we move on, I want to ask unanimous consent that the
following two documents be included in the record of today's
hearing: the letter which I cited from Commissioner Chilton and
a statement from the North American Die Casting Association,
which has been affected by this issue. Without objection, so
ordered.
    Mr. Gibson, back to you. You give 4(k) orders. You can take
them away, right?
    Mr. Gibson. Yes, that is right.
    Chairman Brown. OK. There is an old adage that it is easier
to ask forgiveness than it is to get permission. That seems to
be the way that Wall Street has approached this in a number of
cases. Let me give you an example.
    In 2005, JPMorgan requested the authority to engage in
complementary activities, requesting the ability to ``make or
take physical delivery of, and in some instances store, certain
commodities.'' The Board's 4(k) complementary order for
JPMorgan said it is not authorized to own, operate, or invest
in facilities for the extraction, transportation, storage, or
distribution of commodities to protect the bank from storage
risk, transportation risk, and legal and environmental risk.
They cited--in this complementary order they cited the risks.
    Five years later, JPMorgan Chase--or JPMorgan, excuse me,
purchased assets from RBS Sempra, including the Henry Bath
Company, which owns an LME warehouse. We still do not know the
outcome, but we do know that they were turned down for a
complementary order in 2005, but in 2010 it still seems to be
pending, the 5-year clock not expired by using a different
legal provision. Instead of complementary, they are using
merchant banking.
    But if the risks are there, the risks exist to the
financial system that JPMorgan wanted to purchase something in
2005, the risks were there under the complementary order, why
would the Fed allow this to happen under the merchant banking
provision?
    Mr. Gibson. The risks of certain activity exist regardless
of which authority a financial holding company is using, but as
we talk about in the ANPR, the restrictions that we can impose
and the legal treatment are different, depending on which
authority they are using. One of the things we have to evaluate
going forward as we look for what actions to take is we might
have an ultimate goal that might require different actions with
respect to 4(k) authority or with respect to merchant banking,
and we already talked about 4(o) authority gives us even less
ability to impose restrictions.
    Chairman Brown. So 4(k), under 4(k) authority, you do not
have an ability to find a way to minimize that risk to JPMorgan
in this case, but under merchant banking you might be able to
minimize the risk for the same purchase of the same entity?
    Mr. Gibson. We have the most ability and have imposed the
most limits on the 4(k) authorities that we have granted, and
we have imposed, as you mentioned, tight limits----
    Chairman Brown. I said it backwards.
    Mr. Gibson. Oh, OK. Under merchant banking there is pretty
broad authority granted in Gramm-Leach-Bliley, which does not
require any approval, to invest in nonfinancial businesses.
Now, one of the limits that is imposed on that is there is a
time limit, so it is a 10- or 15-year time limit for merchant
banking investments. The company is not allowed to manage or
operate it. And we do have capital requirements, which are
relatively tough, on merchant banking investments.
    Chairman Brown. And under the merchant banking provision,
you expect them to buy it and sell it. That is the purpose of
the merchant banking provision.
    Mr. Gibson. Yes.
    Chairman Brown. And they have 10 years to do that.
    Mr. Gibson. That is right.
    Chairman Brown. And they bought this in 2010, and you have
not yet given them retroactive, for want of a better word,
permission, correct?
    Mr. Gibson. You are talking about Henry Bath?
    Chairman Brown. Yes.
    Mr. Gibson. They purchased it in 2010. It was part of a
larger acquisition, as you mentioned, and the way we look at
acquisitions like that is that if the bulk of the acquisition
is a permissible activity, they are allowed to include a small
amount of impermissible activities, but then they are required
to divest it. And that is the basis on which they purchased the
Henry Bath business. They have not been given any authorization
to permanently hold it, and they are in the process of
divesting it.
    Chairman Brown. They are in the process of divesting it.
What does that mean?
    Mr. Gibson. It means we have given them a time limit, and
they are giving us quarterly reports on their progress at
divestiture. They have presented a plan for how they are
marketing the business, and we are having quarterly updates
from them, monitoring their progress on the plan, and they have
an ultimate time limit.
    Chairman Brown. And leading up to this hearing, a number
of--a couple three reporters said, well, is this still an
issue? Because these financial institutions are starting to
sell some of these commodities and some of these things they
own, but there is no real evidence that they have actually sold
them, which sort of begs the question how hard it is to do
this. The Fed's order, 2005 order, limited JPMorgan to only
exchange-traded derivatives to prevent investments in things
like real estate that, in the Fed's words, ``lacked fungibility
and liquidity.'' Now that they own fiscal assets, there are
reports that the process of selling these warehouses has been
awkward and challenging, which isn't that the exact risk the
Fed was trying to avoid, to prevent these institutions from
investing in things like real estate? Isn't that--I mean, why
do we allow these acquisitions when there is some likelihood
that they will be very hard to divest themselves of at some
point in the future?
    Mr. Gibson. Again, the different authorities allow
financial holding companies to do different things. Under
merchant banking authority, firms are typically investing in
whole companies, which are not very liquid, and that is why
there is a long holding period attached to that, because it is
intended to be a long-term investment.
    Under the 4(k) authorities that we have granted for
ownership of physical commodities, those have been limited to a
small number of commodities that are judged to be liquid, which
the general standard is traded on an exchange or futures
exchange. Under those authorities it is a limited set, and it
is intended to be liquid. We have turned down applications for
certain commodities to be added to the list because they were
deemed not liquid enough. But that is separate from the
merchant banking authority, which is for long-term investments
that could very well be illiquid.
    Chairman Brown. OK. Mr. Gensler--I am sorry, Mr. McGonagle.
It is Chairman Gensler. Sorry about that. In 2013, then-
Chairman Gensler testify before the Senate Banking Committee
that the CFTC ``has clear authority to police markets for
fraud, manipulation, and other abuses.'' After Goldman Sachs
and other financial companies bought LME warehouses, aluminum
delivery queues increased, as we discussed in the hearing in
July, and as the New York Times wrote about, increased from
approximately 7 months in 2011 to more than 550 days last year.
This Subcommittee heard testimony from an aluminum consumer who
described a variety of unnatural market forces driving up
delivery times, increasing the price of aluminum. The LME in
its report said it found the fundamental role of the queues is
to increase premiums. The evidence shows that as queues
increased, so did premiums, 10 cents per ton, roughly, to a
record high 19 cents per ton last week.
    Do you agree that with the LME, queues increase aluminum
prices?
    Mr. McGonagle. Thank you, Chairman. I agree that the issue
is something that requires some degree of evaluation by CFTC,
particularly as it relates to the fact that the LME has applied
for registration as a foreign board of trade. And so by doing
that, they will represent and have to speak with us, and we are
engaged with LME and with U.K. FCA, the LME's regulator, with
respect to how this warehousing issue, these questions
concerning premiums, rents, incentives, where are the
legitimate forces of supply and demand, and how is this
activity consistent with commercial practices and potentially
where is it not or where can it be fixed.
    You began your question by pointing to the former
Chairman's authority, discussion of authority for fraud and
manipulation, and certainly with respect any price effect, to
the extent that there is any conduct that interferes with the
price of a commodity in interstate commerce, CFTC separately
has jurisdiction for fraud and manipulation, and they would
undertake that authority pursuant to a nonpublic investigatory
process.
    Chairman Brown. So do you consider this manipulation of
queues which leads to higher premiums and higher aluminum
prices, do you consider this commodities manipulation under the
Commodities Exchange Act?
    Mr. McGonagle. I consider the activity with respect to what
is the basis for the premium and whether it is due to
legitimate commercial activity as an area that can be explored
by CFTC through the application process by LME for a foreign
board of trade. Separately--and so I do not offer an opinion
here whether there is information concerning any activity with
respect to any commodity, frankly, that is not borne out by
legitimate forces of supply and demand--that can be subject to
an enforcement investigation. So I am not making that
determination here. I have seen a lot of information certainly
in connection with the warehousing study that the LME put
forward in November and its proposals going forward, which we
are evaluating from a regulatory standpoint within my Division.
    Chairman Brown. Can you use the no-action letter and the
FBOT approval process as leverage to force changes? Does that
give you the authority to do that?
    Mr. McGonagle. Ultimately we can revoke or suspend any no-
action letter that is issued by the Division of Market
Oversight. My expectation and hope would be, to the extent that
we can effect real change short of revoking registration, that
we would explore those opportunities. But that is certainly
available as a remedy.
    Chairman Brown. Commissioner Chilton said, ``Frankly, my
experience in this matter is there is surprisingly little CFTC
interest, shockingly little interest in physical ownership of
banks that could impact derivative markets.''
    Mr. McGonagle. The focus of CFTC is for price discovery in
connection with the derivatives market that we have direct
oversight authority for. Our connection to cash markets
authority is driven primarily through enforcement and ensuring
that there is no fraud or manipulation with respect to
commodities and interstate commerce. So to the extent that a
bank, for example, has an ownership interest or a trading
position on an exchange, they will have reporting obligations
already to the CFTC, and we can get further information about
their activity. If there is not a trading position, a
regulatory sort of mandate about cash market activity I think
is a different conversation for the Commission and for this
body to consider with respect to what is our current focus,
which are derivatives markets and price discovery versus
oversight over particular entities in cash market positions.
    Chairman Brown. Thank you.
    Senator Warren, other questions?
    Senator Warren. No.
    Chairman Brown. You are done? OK. Thank you.
    Thank you to the panel. I want to close with a couple
comments. These activities have been justified during this
hearing and in other ways by the benefits they are supposed to
provide to individuals and companies in the real economy. We
are told that they improve the markets that produce the cans
that hold your drinks, the gas that fuels your car, the energy
that lights your home. But in many ways, speculation in the
commodities futures and derivatives markets has become an end
in itself. The issue is as much about financial institutions
becoming industrial businesses as it is about the
financialization of the real economy. It is an important issue
because it forces us to ask whom ultimately we want our economy
to serve. In my mind, it is time for us to pick workers and
consumers and taxpayers over the speculators, over the ``too
big to fail'' banks. I do not think we have done that yet. I
think we know what our mission is. Thank you.
    Anyone that has some--please, if you would, any additional
questions anybody on the panel asks, if they would send you
letters, you would get answers back to those as quickly as you
could. Thanks very much.
    The hearing is adjourned.
    [Whereupon, at 3:20 p.m., the hearing was adjourned.]
    [Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
                  PREPARED STATEMENT OF NORMAN C. BAY
 Director, Office of Enforcement, Federal Energy Regulatory Commission
                            January 15, 2014
    Mr. Chairman, Ranking Member Toomey, and Members of the
Subcommittee: Thank you for inviting me to testify today. My name is
Norman Bay. I am the Director of the Office of Enforcement of the
Federal Energy Regulatory Commission (FERC or the Commission). I appear
before you as a staff witness, and the views I present are not
necessarily those of the Commission or any individual Commissioner. In
the testimony that follows, I provide an overview of the Commission's
Office of Enforcement, focusing on our efforts to combat fraud and
market manipulation, and in so doing will respond to the specific
questions the Subcommittee asked me to address in its January 6, 2014,
letter.
    The Commission's core legal authority for investigating and
enforcing Congress's prohibition on fraud and market manipulation in
FERC-jurisdictional electric and natural gas markets is the Energy
Policy Act of 2005 (EPAct 2005) (which added a section prohibiting
energy market manipulation to both the Federal Power Act and the
Natural Gas Act). In this Act, passed in the wake of Enron's
manipulation of Western energy markets, Congress gave the Commission
broad authority to protect energy market consumers from any type of
fraud or market manipulation affecting FERC-regulated wholesale
physical natural gas and electric markets. Congress patterned EPAct's
fraud and manipulation prohibition on the similarly broad antifraud and
manipulation provisions in the Securities and Exchange Act of 1934--
which the Securities and Exchange Commission (SEC) relies on to police
misconduct in the securities markets. Shortly after EPAct 2005 was
passed, the Commission implemented this statute through its
antimanipulation regulations, codified at 18 CFR 1c. The Office of
Enforcement relies on the antimanipulation statute and regulations to
investigate potential fraud or market manipulation and, when a matter
cannot settle on terms favorable to the public interest, bring
enforcement actions against companies or individuals who engage in
fraud or manipulation affecting FERC-regulated markets.
    Another key aspect of EPAct 2005 is its enhanced civil penalty
provisions. Before EPAct 2005, maximum civil penalties for violations
of many Commission rules, including acts of fraud and manipulation,
were only $10,000 per violation per day. EPAct 2005 granted the
Commission the authority to impose up to $1 million per violation per
day for fraud and market manipulation (and other violations). To date,
the Commission has imposed and collected approximately $873 million in
civil penalties and disgorgement following EPAct 2005. This consists of
approximately $577 million in civil penalties, which goes to the U.S.
Treasury, and approximately $296 million in disgorgement of unjust
profits. (This amount does not include fines in electric market
manipulation matters to be reviewed in Federal court, for example, the
approximately $453 million civil penalties assessed by the Commission
in the Barclays market manipulation matter.)
    Now I would like to address the Subcommittee's request for an
assessment of the Commission's ability to detect, investigate, and
enforce violations of EPAct 2005's fraud and antimanipulation rules. My
view is that with EPAct 2005's antifraud and market manipulation
provisions and civil penalty authority, the Commission's implementing
regulations, and the Office of Enforcement's enhanced surveillance and
investigative capabilities (briefly summarized below), we do have the
tools necessary to effectively police FERC-regulated markets to deter
fraud and market manipulation. Of course, we continue to think about
ways we can expand our capabilities. But we feel we are to up this
important task that Congress has given us.
    Over the past few years, the Commission's Office of Enforcement has
substantially expanded its investigative and analytical capabilities
and has developed extensive new surveillance tools. Among the most
important achievements is the creation, in February 2012, of the Office
of Enforcement's Division of Analytics and Surveillance (DAS). DAS
develops surveillance tools, conducts surveillance, and analyzes
transactional and market data to detect potential manipulation,
anticompetitive behavior, and other anomalous activity in the wholesale
electricity and natural gas markets. DAS staff includes approximately
45 professionals, including, for example, economists, energy industry
analysts, former traders, and former risk managers.
    For its surveillance efforts, DAS has created internal market
screens--both for the electric and natural gas markets--that use
behavioral and statistical measures and techniques to detect abnormal
trading patterns. Statistical analyses are performed through automated
market screens that employ disparate market data to detect anomalies
and suspicious trading patterns. The data, both physical and financial,
is gathered from numerous sources, and the Commission has taken
significant steps in rulemakings over the past few years to expand
these sources. With more data, and experience learned from past and
current investigations, DAS continues to enhance its surveillance
screens.
    DAS staff also works hand in hand with the Office of Enforcement's
Division of Investigations--which houses the attorneys and other staff
that conduct investigations, negotiate settlements, and bring
enforcement actions. The Division of Investigations has strengthened
its staff of attorneys in the past few years, and now has approximately
45 attorneys, including former Federal prosecutors as well as civil
litigators and energy regulatory lawyers from top law firms.
    I know the Subcommittee is interested in learning more about fraud
and market manipulation conduct by financial institutions that has
occurred in FERC-regulated markets. As you have asked, let me provide a
high-level description of the mechanics of potential manipulation
involving the interplay between financial and physical energy markets.
Although the mechanics of a manipulative scheme can be highly detailed
and complex, and each investigation is different from the next, there
is a general framework that cuts across many of the manipulation
matters involving the trading of energy products that we have
investigated and are currently investigating.
    A fundamental point necessary to understanding many of our
manipulation cases is that financial and physical energy markets are
interrelated: physical natural gas or electric transactions can help
set energy prices on which financial products are based, so that a
manipulator can use physical trades (or other energy transactions that
affect physical prices) to move prices in a way that benefits his
overall financial position. One useful way of looking at manipulation
is that the physical transaction is a ``tool'' that is used to
``target'' a physical price. For example, the physical tool could be a
physical power flow scheduled in a day ahead electricity market at a
particular ``node'' and the target could be the day ahead price
established by the market operator for that node. Or the physical tool
could be a purchase of natural gas at a trading point located near a
pipeline, and the target could be a published index price corresponding
to that trading point. The purpose of using the tool to target a
physical price is to raise or lower that price in a way that will
increase the value of a ``benefiting position'' (like a Financial
Transmission Right or FTR product in energy markets, a swap, a futures
contract, or other derivative).
    Increasing the value of the benefiting position is the goal or
motive of the manipulative scheme. The manipulator may lose money in
its physical trades, but the scheme is profitable because the financial
positions are benefited above and beyond the physical losses.
Understanding the nature and scope of a manipulator's benefiting
financial positions--and how they relate to the physical positions--is
a key focus of our manipulation cases. This is for the simple reason
that our antifraud and manipulation rule (like the SEC's) is an intent-
based rule: a finding of manipulation requires proving that the
manipulator intended (or in some cases, acted recklessly) to move
prices or otherwise distort the proper functioning of the energy
markets the Commission regulates. A company can put on a large physical
trade that may affect market prices, but if the purpose of that trade
is to hedge risk or speculate based on market fundamentals--rather
than, for example, the intent to move prices to benefit a related
financial position--this conduct, without more, would not violate our
antifraud and manipulation rule.
    Another key point is that the physical trading (the tool) may and
usually does occur in FERC-regulated markets, but the benefiting
financial position may be held in a non-FERC regulated market such as a
futures or swaps market exchange regulated by the Commodity Futures
Trading Commission (CFTC). This is not always the case: for example, we
have investigated manipulation in which the financial benefiting
position is within FERC markets. But, often, the physical trading
occurs in FERC markets and the benefiting position is established
outside of FERC markets.
    We have numerous public examples of market manipulation that fit
into this general description (and many others that remain nonpublic).
The public matters are either in the form of settlements or ``Order to
Show Cause'' proceedings in matters that have not settled and may be
headed to trial. In either case, the settlement or other order sets
forth a description of the facts and a discussion of why the Commission
concludes that the facts support a finding of market manipulation. (In
all instances, the settlement or order will be published on the
Commission's Web site, at www.ferc.gov.)
    A recent settlement fitting the manipulation framework above is our
January 2013 settlement with Deutsche Bank. See Deutsche Bank Energy
Trading, LLC, 142 FERC Par. 61,056 (2013). Let me briefly describe the
mechanics of the manipulative scheme here. Deutsche Bank held a type of
energy contract commonly used to hedge against, or profit from, the
``congestion'' on a transmission line that occurs when, for various
technical reasons, the line cannot carry all the electricity needed at
a particular supply or delivery point on the grid. These contracts are
often called Financial Transmission Rights or FTRs--though in the
California Independent System Operator (CAISO) market at issue in the
Deutsche Bank matter, they are called Congestion Revenue Rights (CRRs).
In early 2010, Deutsche Bank began to lose money on its CRR contracts.
The company initially sought to limit its losses by purchasing new CRRs
in the CAISO market to reduce its exposure to congestion. But these new
CRR purchases did not fully cover its losses. So Deutsche Bank energy
traders devised and implemented a manipulative scheme that involved
buying and selling physical electricity so as to alter congestion
levels, and resulting market prices, at the same point corresponding to
their CRR contracts. These physical transactions (in addition to
violating the CAISO tariff) were unprofitable and inconsistent with
market fundamentals, but did have the effect of increasing the value
(i.e., by limiting losses) of Deutsche Bank's CRRs.
    In short, to use the framework above, Deutsche Bank used a ``tool''
of physical energy transactions to ``target'' congestion levels and
corresponding energy prices within CAISO in order to increase the value
of CRR ``benefiting positions''--in violation of EPAct 2005 and the
Commission's antimanipulation rule.
    A recent order also fitting this framework is the Commission's July
2013 Order Assessing Civil Penalties in Barclays. See Barclays Bank,
PLC, et al., 144 FERC Par. 61,041 (2013). The Commission's assessment
of civil penalties and disgorgement in Barclays will be reviewed in
Federal district court, so the litigation is ongoing and my comments
will have to be limited. That being said, I can nonetheless provide a
brief description consistent with published Commission orders.
    Barclays and its energy traders amassed substantial positions of
physical electricity contracts through their transactions on the
IntercontinentalExchange (ICE) trading platform. Barclays and its
traders also assembled a financial swaps position at four important
trading points in Western energy markets, whose value was pegged to
published electricity price indices set by the physical electric
contracts Barclays traded. The Commission found that Barclays engaged
in manipulative physical trades to ``flatten out'' the physical
electricity positions it had amassed on its trading books in a manner
designed to influence the index prices that determined the value of its
swaps. Barclays's physical trading was uneconomic and not based on
market fundamentals; indeed, the company often lost money in the
physical markets. But Barclays's physical trading nonetheless profited
the company overall because its trades helped move the index price that
set the value of its larger financial swaps benefiting position.
    Fraud and manipulation can take other forms, and many of our
manipulation matters, including with financial institutions, do not
neatly fit within the tool-target-benefiting position framework
described above. A notable example is the Commission's July 2013
settlement with a wholly owned subsidiary of JPMorgan which, among
other terms, required JPMorgan to pay a combined $410 million in civil
penalties and disgorgement to ratepayers. See In Re ``Make-Whole
Payments and Related Bidding Strategies'', 144 FERC Par. 61,068 (2013).
    This settlement resolved the Office of Enforcement's investigation
into 12 manipulative bidding strategies designed to make profits from
power plants that were usually out of the money in the marketplace. In
these manipulative strategies, which are described in greater detail in
the settlement agreement and order approving it, the JPMorgan
subsidiary defrauded market operators in California (CAISO) and
Michigan (MISO) by making bids into these markets that were not
grounded in the normal forces of supply and demand, and were expected
to, and did, lose money at market rates. The JPMorgan subsidiary's
purpose in submitting these bids was not to make money based on market
fundamentals, but to create artificial conditions that would cause the
CAISO system to pay the company outside the market at premium rates.
Enforcement staff also determined that JPMorgan knew that the CAISO and
MISO markets received no benefit from making these inflated payments
and, thus, the company defrauded these market operators by obtaining
payments for benefits they did not deliver.
    The Subcommittee has also asked whether there are regulatory
limitations on the Commission's antifraud and manipulation oversight
efforts. There are two such limitations I would like to highlight
today. The first concerns our ability to obtain certain financial data
that is of great importance to our surveillance and investigation
efforts. I have noted above that financial and physical natural gas and
electric markets are interrelated--and have also noted that our
surveillance screens, among other features, seek to detect anomalies in
both physical and financial trading. But our surveillance program has
limitations because we do not have access at present to certain
financial data from the related financial markets. This missing
financial data creates a gap in the Commission's ability to conduct
effective and comprehensive surveillance of the natural gas and
electric markets.
    Much of the relevant financial data we seek is traded on markets
regulated by the CFTC. Despite negotiations over several years, the
CFTC has not yet provided FERC with access to the financial information
and data our Office of Enforcement needs, except on an ad hoc case-by-
case basis. This obstacle prevents Commission staff from seeing the
complete picture of what is occurring in its jurisdictional markets and
from fully integrating the financial information into its automated
screens. Although the Commission's screening program is robust and has
enabled Commission staff to detect potential manipulation, this program
would be improved with access to the CFTC data. However, earlier this
month, FERC and the CFTC signed a Memorandum of Understanding that is
intended to result in broader information sharing than currently occurs
and is, therefore, a first step toward sharing appropriate data in a
timely manner. It will be essential for the agencies to work together
and to make an institutional commitment to, as well as the resources
necessary for, the day-to-day, nuts-and-bolts implementation of the
concepts established in this Memorandum of Understanding.
    A second limitation follows from the decision by the U.S. Court of
Appeals for the District of Columbia Circuit last year in Hunter v.
FERC, 711 F.3d 155 (D.C. Cir. 2013). In Hunter, the court ruled that
the CFTC's exclusive jurisdiction over futures contracts deprives FERC
of authority to bring an action based on manipulation in the futures
market, even if the activity affected prices in the physical markets
for which FERC has exclusive jurisdiction. Although the Commission
reads the Hunter decision as narrow in scope, some market participants
interpret the decision more broadly to cover not only manipulation in
the futures market, but also many additional transactions and products,
including those squarely within FERC's jurisdictional markets.
Accordingly, a legislative fix to eliminate uncertainty on this matter
could ensure that FERC has the full authority needed to police
manipulation of wholesale physical natural gas and electric markets.
    The Subcommittee has also asked about the potential market risks
and economic consequences of financial holding companies' direct
involvement in FERC-jurisdictional markets. The Commission has not
taken any view on the participation in its regulated markets by
financial holding companies (or any trading firm, bank, or other
financial institution) versus more traditional energy companies like
generators, utilities, or natural gas pipeline owners. Instead, the
Commission's general view has been that financial institutions of all
kinds, as well as energy companies of all kinds, can benefit markets in
numerous ways, for example, by providing liquidity to market
participants who may want to hedge their risk. However, the Commission
expects financial institutions, like all other participants in FERC-
regulated markets, to have good compliance programs, transact in a
manner that follows market rules in letter and spirit, work
cooperatively with grid operators and the Commission when there are
concerns, and self-report potential violations. The Subcommittee has
asked for information about written guidance the Commission has issued
internally or otherwise regarding the direct activities of financial
institutions in the energy market. I am not aware of any specific rules
under our Federal Power Act ratemaking authority that would apply
uniquely to financial institutions that participate in Commission-
jurisdictional markets. However, any rules that govern those markets
would apply equally to financial institutions as well, such as the
rules governing the eligibility for market-based rate authority, rules
prohibiting market manipulation, creditworthiness rules in the
organized markets, and any tariff rules governing the organized
markets, including those regarding bidding into the markets. Further,
financial institutions that are public utilities by virtue of their
ownership or operation of jurisdictional facilities are subject to the
requirements of section 203 of the FPA concerning the acquisition or
disposition of jurisdictional facilities.
    With respect to whether there are emerging trends, including fraud
and manipulation associated with financial institutions' operations in
the energy market, I note that banks and financial holding companies
have generally played a role in the physical wholesale electric market.
Based on year-to-date electric industry reports to the Commission,
sales by banks and financial holdings companies represent 13 percent of
total revenues for energy and ``booked out power'' (energy or capacity
contractually committed for delivery but not actually delivered because
of an offsetting trade). Moreover, full year electric sales by
financial institutions were approximately $15 billion in 2012, down
from $45 billion in 2008 for those companies, when sales represented
approximately 20 percent of the market. Combined bank and financial
institution revenues from electricity sales have declined during this
time by tens of billions of dollars; Commission electric sales data,
however, do not include sales in the ElectricReliability Council of
Texas, which are nonjurisdictional.
    Banks and financial institutions also play a role in the direct
ownership of physical electric assets--owning less than 4 percent of
total U.S. generator nameplate capacity (basically, the maximum rated
output of a generator) as of June 2013. (Banks and financial
institutions may have greater economic rights to revenues from
generators through leasing arrangements called tolling agreements; but
the percentage of direct ownership has been relatively small.)
    Banks also play a role in the ownership of U.S. natural gas storage
facilities and pipelines. For example, financial institutions own less
than 1 percent of total U.S. natural gas storage capacity and about 14
percent of total U.S. natural gas pipeline miles (both intrastate and
interstate).
    With respect to natural gas, FERC data shows that physical natural
gas sales by banks represented about 6 percent of total U.S. reported
sales in 2012, down from 8 percent in 2011. This decrease may be due to
a combination of low volatility and low prices in natural gas markets,
which has caused banks and other financial institutions to shift their
capital to more profitable opportunities in other markets. Sales by
nonbank financial institutions represented only 2 percent of total
reported sales in both 2011 and 2012.
    I would also like to note, because it is especially relevant to
manipulative conduct, that the market share of a given bank or
financial institution at a particular natural gas trading hub or
electric market trading point could nonetheless be high and have a
significant effect on the price formed at that hub or point. That is,
banks and financial institutions as a whole may have a relatively lower
percentage of sales and generation ownership interest compared to more
traditional energy companies, but, as we have seen in our
investigations, they may retain the ability to move prices in a
manipulative manner.
    In response to the Subcommittee's question about trends, I would
also like to note that although the Commission has recently approved
settlements and orders assessing civil penalties against banks and
financial institutions, in a few of these matters the manipulative
conduct occurred several years ago, including as far back as 2006-2007.
Also, now that the Office of Enforcement has had several years to
implement a robust enforcement regime following EPAct 2005, the
Commission is in a better position to promptly detect, investigate, and
seek sanctions against fraudulent and manipulative conduct. In
particular, I would highlight the surveillance efforts and
sophisticated staff we have developed, as discussed earlier in my
testimony. Given that the Commission's enhanced enforcement
capabilities are relatively new, it is difficult for me to draw
conclusions that there are emerging trends associated with financial
institutions' potential misconduct in FERC-jurisdictional markets. Our
recently announced manipulation matters, in other words, may be as much
a product of our enhanced detection and enforcement abilities over the
past few years rather than any uptick in manipulative conduct by
financial institutions or other market participants.
    The Subcommittee has asked for a description of our coordination
efforts with other U.S. banking or financial market regulators. With
respect to investigations, the Commission's Office of Enforcement has
coordinated or shared information regarding various matters with other
Federal Government agencies, in particular, the Department of Justice
and United States Attorneys' Offices, the CFTC, the SEC, the Federal
Trade Commission, the Federal Reserve, and the Environmental Protection
Agency. Our coordination on investigations with the CFTC has been
routine given the relationship between electricity and natural gas
products traded on CFTC-regulated futures and derivatives markets and
FERC-jurisdictional physical markets. Notwithstanding the above-noted
concerns over the need for greater information sharing, FERC and CFTC
enforcement staff have worked together on manipulation investigations
involving improper trading conduct. We have also worked with the
Department of Justice and the Federal Reserve in providing information
about investigations involving financial institutions. And we have
consulted with the SEC enforcement office, particularly relating to
``best practices'' in market surveillance and investigative techniques
and procedures. The details of our coordination between FERC and these
agencies, including the information we have provided, is nonpublic
under Commission regulations, but we are happy to report to the
Subcommittee that we have worked with these other Federal Government
regulators and will continue to do so as a matter of good Government
and for the good of our Nation's energy markets.
    We are also happy to report that we are working with international
regulators. In our discussions with them, they have commented on our
innovation and leadership in market surveillance and oversight and in
our use of sophisticated algorithmic screens to sift through vast
amounts of trade data to detect potential manipulation in the wholesale
gas and power markets. We have consulted with or provided technical
assistance to regulators from a number of different countries, and we
are exploring information sharing MOUs with international regulators.
That being said, we are always looking for ways to upgrade our
capabilities and to do our best to protect and to advance the public
interest.
    In conclusion, I want to thank the Subcommittee again for this
opportunity to testify today.
                                 ______

                PREPARED STATEMENT OF VINCENT MCGONAGLE
   Director, Division of Market Oversight, Commodity Futures Trading
                               Commission
                            January 15, 2014
    Chairman Brown, Ranking Member Toomey, and Members of the
Subcommittee, thank you for the opportunity to appear before you today.
I am Vincent McGonagle and I am the Director of the Division of Market
Oversight of the Commodity Futures Trading Commission (CFTC).
Background on Commodity Exchange Act and the CFTC Mission
    The purpose of the Commodity Exchange Act (CEA) is to serve the
public interest by providing a means for managing and assuming price
risks, discovering prices, or disseminating pricing information.
Consistent with its mission statement and statutory charge under the
CEA, the CFTC is tasked with protecting market participants and the
public from fraud, manipulation, abusive practices and systemic risk
related to derivatives--both futures and swaps--and to foster
transparent, open, competitive, and financially sound markets. In
carrying out its mission and statutory charge, and to promote market
integrity, the Commission polices derivatives markets for various
abuses and works to ensure the protection of customer funds. Further,
the agency seeks to lower the risk of the futures and swaps markets to
the economy and the public. To fulfill these roles, the Commission
oversees designated contract markets (DCMs), swap execution facilities
(SEFs), derivatives clearing organizations, swap data repositories,
swap dealers, futures commission merchants, commodity pool operators,
and other intermediaries.
    The CEA has for many years required that any futures transaction,
unless subject to an exemption, be conducted on or subject to the rules
of a board of trade which has been designated by the CFTC as a DCM.
Sections 5 and 6 of the CEA and Part 38 of the Commission's regulations
provide the legal framework for the Commission to designate DCMs, along
with each DCM's compliance requirements with respect to the trading of
commodity futures contracts. With the passage of the Dodd-Frank Wall
Street Reform and Consumer Protection Act (Dodd-Frank Act), DCMs were
also permitted to list swap contracts. Along with this expansion of
product lines that can be listed on DCMs, the Dodd-Frank Act also
amended various substantive DCM requirements, under CEA Section 5, and
adopted a new regulatory category for exchanges that provide for the
trading of swaps (SEFs). \1\ The Commission revised its DCM regulations
to reflect these new requirements, and also adopted regulations to
implement the Dodd-Frank Act's SEF requirements.
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     \1\ In addition to the provisions regarding listing of swaps on
DCMs and SEFs, the Dodd-Frank Act provides that, unless a clearing
exception applies and is elected, a swap that is subject to a clearing
requirement must be executed on a DCM, SEF, or SEF that is exempt from
registration under CEA, unless no such DCM or SEF makes the swap
available to trade.
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    Under the CEA and the Commission's contract and rule review
regulations, all new product terms and conditions, and subsequent
associated amendments, are submitted to the Commission before
implementation. In submitting new products and associated amendments,
DCMs and SEFs are legally obligated to meet certain core principles;
one of the most significant being the prohibition, in DCM and SEF Core
Principle 3, on listing contracts that are readily susceptible to
manipulation. \2\ DCMs and SEFs self-certify most of their products to
the Commission, as allowed under the CEA, \3\ and self-certified
contracts may be listed for trading shortly after submission. \4\ The
Commission has provided Guidance to DCMs and SEFs on meeting Core
Principle 3 in Appendix C to Part 38 of the Commission's regulations.
Failure of a DCM or SEF to adopt and maintain practices that adhere to
these requirements may lead to the Commission's initiation of
proceedings to secure compliance.
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     \2\ DCM and SEF Core Principle 3 states, ``Contract Not Readily
Subject to Manipulation--The board of trade shall list on the contract
market only contracts that are not readily susceptible to
manipulation.''
     \3\ For example, while contracts can be submitted for approval, of
the almost 5,000 contracts submitted by DCMs and SEFs since the Dodd-
Frank Act was enacted, all were submitted on a self-certification
basis, and over 2,000 contracts were certified in calendar year 2013
alone.
     \4\ A DCM or SEF need wait only one full business day after the
contract has been submitted to list the contract for trading.
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    Among other things, a DCM or SEF that lists a contract that is
settled by physical delivery should design its contracts in such a way
as to avoid any impediments to the delivery of the commodity in order
to promote convergence between the price of the futures contract and
the cash market value of the commodity at the time of delivery. The
specified terms and conditions considered as a whole should result in a
deliverable supply that is sufficient to ensure that the contract is
not susceptible to price manipulation or distortion. \5\ The contract
terms and conditions should describe or define all of the economically
significant characteristics or attributes of the commodity underlying
the contract, including: quality standards that reflect those used in
transactions in the commodity in normal cash marketing channels;
delivery points at a location or locations where the underlying cash
commodity is normally transacted or stored; conditions that delivery
facility operators must meet in order to be eligible for delivery,
including considerations of the extent to which ownership of such
facilities is concentrated and whether the level of concentration would
render the futures contract susceptible to manipulation; delivery
procedures that seek to minimize or eliminate any impediment to making
or taking delivery by both deliverers and takers of delivery to help
ensure convergence of cash and futures at the expiration of a futures
delivery month.
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     \5\ Deliverable supply means the quantity of the commodity meeting
the contract's delivery specification that reasonably can be expected
to be readily available to short traders and salable by long traders at
its market value in normal cash marketing channels at the contract's
delivery points during the specified delivery period, barring abnormal
movement in interstate commerce.
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    Commission staff utilizes considerable discretion and can request
that DCMs and SEFs provide full explanations of their compliance with
the Commission's product requirements. Commission staff may ask a DCM
or SEF at any time for a detailed justification of its continuing
compliance with core principles, including information demonstrating
that any contract certified to the Commission for listing on that
exchange meets the requirements of the Act and DCM or SEF Core
Principle 3.
Expansion of CFTC Enforcement Authority Under Dodd-Frank
    The Commission's responsibilities under the CEA include mandates to
prevent and deter fraud and manipulation. The Dodd-Frank Act enhanced
the Commission's enforcement authority by expanding it to the swaps
markets. The Commission adopted a rule to implement its new authorities
to police against fraud and manipulative schemes. In the past, the CFTC
had the ability to prosecute manipulation, but to prevail, it had to
prove the specific intent of the accused to affect prices and the
existence of an artificial price. Under the new law and rules
implementing it, the Commission's antimanipulation reach is extended to
prohibit the reckless use of manipulative schemes. Specifically,
Section 6(c)(3) of the CEA now makes it unlawful for any person,
directly or indirectly, to manipulate or attempt to manipulate the
price of any swap, or of any commodity in interstate commerce, or for
future delivery on or subject to the rules of any registered entity. In
addition, Section 4c(a) of the CEA now explicitly prohibits disruptive
trading practices and the Commission has issued an Interpretive
Guidance and Policy Statement on Disruptive Practices. \6\
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     \6\ Antidisruptive Practices Authority, 78 FR 31890 (May 28,
2013), http://www.cftc.gov/ucm/groups/public/@lrfederalregister/
documents/file/2013-12365a.pdf.
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    In addition, the Dodd-Frank Act established a registration regime
for any foreign board of trade (FBOT) and associated clearing
organization who seeks to offer U.S. customers direct access to its
electronic trading and order matching system. Applicants for FBOT
registration must demonstrate, among other things, that they are
subject to comprehensive supervision and regulation by the appropriate
governmental authorities in their home country or countries that is
comparable to the comprehensive supervision and regulation to which
Commission-designated contract markets and registered derivatives
clearing organizations are respectively subject.
CFTC Coordination with Foreign and Domestic Regulators
    The Commission recognizes that commodity markets are international
in nature and, accordingly, regularly consults with other countries'
regulators. In particular, staff regularly consult with staff of the
FCA (the LME's home regulatory authority) as to market conditions with
respect to products of mutual interest, including the LME's recent
introduction of warehouse reforms. The two agencies also participate in
mutual information-sharing agreements for both market surveillance and
enforcement purposes.
    Similarly, the Commission formally and informally consults and
coordinates with other domestic financial regulators. For example, the
CFTC and the Federal Energy Regulatory Commission (FERC) have had a
memorandum of understanding (MOU) in place since 2005 that provides for
information exchange related to oversight or investigations. Earlier
this month, FERC and the CFTC signed two Memoranda of Understanding
(MOU) to address circumstances of overlapping jurisdiction and to share
information in connection with market surveillance and investigations
into potential market manipulation, fraud or abuse. The MOUs allow the
agencies to promote effective and efficient regulation to protect the
Nation's energy markets and increased cooperation between the agencies.
    Again, thank you for the opportunity to appear before the
Subcommittee. I will be pleased to respond to any questions you may
have.
                                 ______

                PREPARED STATEMENT OF MICHAEL S. GIBSON
  Director, Division of Banking Supervision and Regulation, Board of
                Governors of the Federal Reserve System
                            January 15, 2014
    Chairman Brown, Ranking Member Toomey, and other Members of the
Subcommittee, thank you for the opportunity to testify at today's
hearing. First, I will discuss the history of bank and bank holding
company engagement in physical commodity activities. I will then
address the Federal Reserve's approach to supervising financial
institutions engaged in physical commodities activities. I will close
my remarks by discussing the Federal Reserve's ongoing review of the
physical commodities activities of the institutions we supervise.
History of Physical Commodities Authority
    Before the enactment of the Gramm-Leach-Bliley Act in 1999 (GLB
Act), bank holding companies were authorized to engage in a limited set
of commodities activities that were considered to be ``so closely
related to banking as to be a proper incident thereto.'' \1\ These
activities included the authority to buy, sell, and store certain
precious metals (for example, gold, silver, platinum, and palladium)
and copper, which are activities that national banks were generally
permitted to conduct at the time. Bank holding companies were also
authorized to engage as principals in cash-settled derivative contracts
based on commodities. In addition, bank holding companies were
permitted to engage in commodity derivatives that allowed for physical
settlement if the bank holding company made reasonable efforts to avoid
delivery of the commodity.
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     \1\ Section 4(c)(8) of the Bank Holding Company Act, 12 U.S.C.
1843(c)(8).
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    Additionally, under the National Bank Act, the Office of the
Comptroller of the Currency (OCC) has authority to approve national
banks to engage in commodity-related activities under national banks'
authority to ``exercise . . . all such incidental powers as shall be
necessary to carry on the business of banking.'' \2\ The OCC has
approved some national banks to engage in customer-driven, perfectly
matched, cash-settled derivative transactions referencing commodities;
certain types of commodity derivatives transactions settled by
transitory title transfer; the purchase and sale of coin and bullion,
precious metals, and copper; and the holding of physical commodities to
hedge customer-driven, bank-permissible derivative transactions.
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     \2\ 12 U.S.C. 24 (seventh).
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    Under the GLB Act, Congress created the financial holding company
framework, which allowed bank holding companies with bank subsidiaries
that are well capitalized and well managed \3\ that elect such status
to engage in expanded financial activities. \4\ There are three
provisions in the GLB Act that have enabled a limited number of
financial holding companies to engage in commodities activities. The
first provision--section 4(k)(1)(B) of the Bank Holding Company Act--
authorizes a financial holding company to engage in any activity that
the Board finds to be ``complementary to a financial activity.'' This
provision in the GLB Act enables financial holding companies to engage
in commercial activities that complement their financial activities, so
long as the activities do not pose a substantial risk to the safety and
soundness of depository institutions or the financial system generally.
\5\ In reviewing requests for complementary authority, the Board is
required to consider whether performance of the activity can reasonably
be expected to produce benefits to the public--such as greater
convenience, increased competition, or gains in efficiency--that
outweigh possible adverse effects, such as undue concentration of
resources, decreased or unfair competition, conflicts of interest, or
unsound banking practices. \6\
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     \3\ In addition to the capital and management requirements, the
GLB Act also requires the subsidiary depository institutions of
financial holding companies to have at least a ``Satisfactory'' rating
under the Community Reinvestment Act. The Dodd-Frank Wall Street Reform
and Consumer Protection Act added a requirement that the financial
holding companies themselves must be well capitalized and well managed.
     \4\ Many bank holding companies of various sizes are financial
holding companies. The Board maintains a list of financial holding
companies on its Web site at www.federalreserve.gov/bankinforeg/
fhc.htm.
     \5\ Section 4(k)(1)(B) of the Bank Holding Company Act, 12 U.S.C.
1843(k)(1)(B).
     \6\ 12 U.S.C. 1843(j)(2).
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    Beginning in 2003, the Board issued a series of orders permitting
individual financial holding companies to engage in specified
commodities-related activities as 4(k) complementary activities. These
activities included physical settlement of commodities derivative
contracts and spot trading of certain approved commodities. \7\ A dozen
financial holding companies currently have this 4(k) authority. \8\
---------------------------------------------------------------------------
     \7\ This authority is generally limited to commodities for which
derivatives contracts have been approved by the Commodity Futures
Trading Commission for trading on a U.S. exchange. In a few cases,
other commodities with comparable fungibility, liquidity, and other
relevant characteristics have been approved.
     \8\ The financial holdings companies currently authorized by the
Board to engage in complementary physical commodities activities are
Bank of America Corporation, Barclays Bank PLC, BNP Paribas, Citigroup
Inc., Credit Suisse Group, Deutsche Bank AG, JPMorgan Chase & Co.,
Scotiabank, Societe Generale, The Royal Bank of Scotland Group pie, UBS
AG, and Wells Fargo & Company. The Board's approvals regarding section
4(k) are publicly available.
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    In addition, a subset of these companies has been granted
additional authority to engage in energy tolling and energy-management
activities. Energy tolling involves making fixed, periodic payments to
power plant owners that compensate the owners for their fixed costs in
exchange for the right to all or part of their plants' power output.
Energy-management activities are transactional and advisory services
provided to power plant owners.
    The Board's orders placed prudential limits on financial holding
companies that engage in commodities activities under complementary
authority. The Board limited the total market value of all commodities
held under this authority, including periodic payments under tolling
agreements, to 5 percent of the financial holding company's tier 1
capital. In addition, the Board prohibited financial holding companies
from owning commodity transportation, storage, extraction, or refining
facilities under complementary authority. Moreover, firms are required
to demonstrate risk-management processes sufficient to support their
activities and to put in place additional risk mitigants, such as
insurance.
    A second provision that Congress included in the GLB Act permits
financial holding companies to make merchant banking investments,
without prior Board approval, in companies engaged in activities not
otherwise permitted for financial holding companies. \9\ There are a
number of conditions imposed by statute on merchant banking
investments. These include restrictions on the ability of a financial
holding company to routinely manage or operate a merchant banking
portfolio company and requirements that merchant banking investments be
held for a limited period. The Board's regulations require merchant
banking investments to be disposed of within 10 years after purchase
(or within 15 years for investments made through a qualifying private
equity fund). As a result, merchant banking investments must be limited
in duration and generally must be passively managed.
---------------------------------------------------------------------------
     \9\ 12 U.S.C. 1843(k)(4)(H). The merchant banking authority
permits a financial holding company to acquire or control any amount of
shares, assets, or ownership interests of any company or other entity
that is engaged in an activity not otherwise authorized for the
financial holding company under section 4 of the BHC Act.
---------------------------------------------------------------------------
    Congress included a third provision in the GLB Act that is relevant
to the commodities trading activities of financial holding companies.
Under section 4(o) of the Bank Holding Company Act, a company that is
not a bank holding company and becomes a financial holding company
after November 12, 1999, may continue to engage in activities related
to the trading, sale, or investment in commodities that were not
permissible activities for bank holding companies if the company was
engaged in the United States in such activities as of September 30,
1997. \10\ This grandfather provision allows these activities up to 5
percent of the company's total consolidated assets. In contrast to
section 4(k) complementary authority, this authority is automatic--
meaning no approval by or notice to the Board is required for a company
to rely on this authority for its commodities activities. Also, unlike
the firms subject to 4(k), the 4(o) grandfathered firms are able to
engage in the transportation, storage, extraction, and refining of
commodities. And, the cap on activities under section 4(o) is 5 percent
of the firm's total assets, while the cap on complementary activities
is much lower at 5 percent of tier 1 capital. Only two financial
holding companies currently qualify for these grandfather rights--
Goldman Sachs and Morgan Stanley.
---------------------------------------------------------------------------
     \10\ 12 U.S.C. 1843(o).
---------------------------------------------------------------------------
    The commodities activities of financial holding companies expanded
considerably as the composition of the banking sector shifted in the
wake of the financial crisis. During 2008, several firms with
significant commodities operations either became financial holding
companies or were acquired by financial holding companies. Goldman
Sachs and Morgan Stanley became bank holding companies and elected
financial holding company status. Both companies claim the right to
conduct commodities activities under the grandfather provision found in
section 4(o). In addition, during this same period, JPMorgan Chase &
Co. acquired Bear Steams and Bank of America Corporation acquired
Merrill Lynch; both Bear Steams and Merrill Lynch engaged in a
substantial amount of commodity trading activities. However, the range
of permissible physical commodities activities of these companies is
limited because they are not grandfathered under section 4(o).
Federal Reserve Supervision of Commodities Activities
    The Federal Reserve has supervisory authority for State member
banks, bank holding companies (including financial holding companies),
and savings and loan holding companies, as well as foreign banks that
operate branches or agencies in the United States. The Federal
Reserve's basic supervisory responsibility is to oversee the financial
soundness of these institutions and their adherence to applicable
banking laws. To this end, we monitor the largest of these institutions
on a continuous basis and routinely conduct inspections and
examinations of all of these firms to encourage their safe and sound
operation.
    The Federal Reserve has no direct role in the supervision of the
commodities markets generally. The Commodity Futures Trading Commission
(CFTC) was created by Congress in 1974 as an independent agency with
the mandate to regulate commodity futures and option markets. Congress
significantly expanded the authority of the CFTC to regulate the over-
the-counter commodity derivative markets in the Dodd-Frank Wall Street
Reform and Consumer Protection Act. Additionally, the Securities and
Exchange Commission (SEC) oversees our Nation's securities exchanges
and markets and disclosures by public companies, among other things.
Other independent agencies, such as the Federal Energy Regulatory
Commission (FERC), also regulate segments of the physical commodity
market.
    The prudential supervision of the largest, most complex banking
firms is a cooperative effort in which the Federal Reserve acts as the
prudential regulator and supervisor of the consolidated holding
companies, but with some of the principal business activities of such
firms supervised by other functional regulators. The Federal Reserve's
supervisory program focuses on the enterprise-wide risk profile and
risk management of those firms, with particular focus on financial
strength, corporate governance, and risk-management practices and
competencies of the firm as a whole.
    As a result of lessons learned from the financial crisis, the
Federal Reserve has taken a number of steps to strengthen its ongoing
supervision of the largest, most complex banking firms. Most
importantly, we established the Large Institution Supervision
Coordinating Committee (LISCC) to ensure that oversight and supervision
of the largest firms incorporates a broader range of internal
perspectives and expertise; involves regular, simultaneous, horizontal
(cross-firm) supervisory exercises; and is overseen in a centralized
process to facilitate consistent supervision and the resolution of
challenges that may be present in more than one firm. The committee
includes senior bank supervisors from the Board and relevant Reserve
Banks as well as senior Federal Reserve staff from the research, legal,
and other divisions at the Board and from the markets and payment
systems groups at the Federal Reserve Bank of New York. To date, the
LISCC has developed and administered several horizontal supervisory
exercises, notably the capital stress tests and related comprehensive
capital reviews of the Nation's largest bank holding companies. The
LISCC has also been actively engaged in the supervision of physical
commodities activities.
    Bank holding companies that conduct commodities activities pursuant
to either section 4(k) complementary, merchant banking, or section 4(o)
grandfather authority are typically subject to continuous supervision
by the Federal Reserve. That supervisory oversight, for example,
includes review of internal management reports, periodic meetings with
the personnel responsible for managing and controlling the risks of the
firm's commodities activities, and targeted examinations of those
activities. The primary goals of our supervision of commodities
activities are to monitor the management of risks of those activities
to the financial holding company and assess the adequacy of the firms'
control environments relating to commodities.
    As the scale and complexity of commodities activities of financial
holding companies accelerated in 2008 in the wake of the financial
crisis, the Federal Reserve expanded the scope of its examination and
review of the firms engaged in physical commodities activities.
Additional targeted reviews were completed by examination staff
specializing in commodities risk management practices. During these
reviews, the teams have examined exposures, valuations, and risk-
management practices across all relevant firms, and conducted deeper
reviews of the firms' operational risk quantification methodologies. On
an ongoing basis, supervisory experts have monitored the firms'
exposures and assessed the strength of the corresponding risk
management and control processes.
    The Board requires financial holding companies that engage in
commodities activities to hold regulatory capital to absorb potential
losses from those activities. Financial holding companies have long
been required to hold capital against the counterparty credit risk from
commodity derivatives (and other types of over-the-counter derivatives)
and against the market risk of all commodity positions. Moreover,
following the financial crisis, the Board has strengthened its capital
requirements for the credit risk and market risk of these transactions.
Further, under the Basel III advanced approaches capital rules,
financial holding companies would be required to hold capital against
the operational risk of their activities, including their commodities
activities.
Federal Reserve Review of Physical Commodities Activities
    Firms engaged in physical commodities activities rely on a variety
of legal structures that attempt to limit liability for catastrophic
and environmental events, as well as on the purchase of insurance and
the allocation of capital aimed at mitigating operational risk.
However, physical commodities activities can pose unique risks to
financial holding companies. Indeed, estimating probabilities and costs
related to environmental or catastrophic incidents is an imperfect
science at best.
    The Federal Reserve has been conducting a detailed policy review of
the commodities activities and investments of financial holding
companies. We are performing this review for a number of reasons. As I
noted above, there has been a substantial increase since 2008 in the
amount and types of commodities activities conducted by the firms we
supervise. Moreover, recent catastrophic events involving physical
commodities have increased concerns regarding the ability of companies
to mitigate potentially extraordinary tail and other risks. Finally,
the financial crisis demonstrated the effects of market contagion and
highlighted the danger of underappreciated tail risks associated with
certain activities.
    The scope of our ongoing review covers commodities activities and
investments under section 4(k) complementary authority, merchant
banking authority, and section 4(o) grandfather authority. The Federal
Reserve recently sought public comment through an advance notice of
proposed rulemaking on a range of issues related to the commodities
activities of financial holding companies, and we expect to engage in
additional rulemaking in this area. As the notice explains, we are
exploring what further prudential restrictions or limitations on the
ability of financial holding companies to engage in commodities-related
activities as a complementary activity are warranted to mitigate the
risks associated with these activities. Such additional restrictions on
complementary commodities activities could include reductions in the
maximum amount of assets or revenue attributable to such activities,
increased capital or insurance requirements on such activities; and
prohibitions on holding specific types of physical commodities that
pose undue risk to the company. We also are exploring what restrictions
or limitations on investments made through the merchant banking
authority in companies engaged in physical commodities activities would
appropriately address those or similar risks.
    The Federal Reserve is also considering whether additional
restrictions on physical commodities activities grandfathered under
section 4(o) could help ensure that such activities do not pose undue
risks to the safety and soundness of financial holding companies and
their subsidiary depository institutions, or to financial stability.
However, our ability to address the broad scope of activities
specifically permitted by statute under the grandfather provision in
section 4(o) is more limited than it is for complementary and merchant
banking activities. Further, the amount of exposure to commodities
activities authorized by Congress under section 4(o)--which is up to 5
percent of the organization's total assets--is much greater than the
level of activity permitted by the Board under the section 4(k)
complementary authority--which is up to 5 percent of tier 1 capital.
Conclusion
    Our review of the commodity-related activities of our supervised
firms is ongoing. We intend to do a careful and thorough assessment of
the costs and benefits of financial holding company engagement in these
activities. We are committed to using our supervisory and regulatory
authorities to the maximum extent possible to protect financial holding
companies and the financial system from the safety and soundness risks
or other potential adverse effects of combining banking and physical
commodities activities in a single corporate enterprise.
        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN BROWN
                       FROM NORMAN C. BAY

Q.1. To address market surveillance and interagency
coordination issues, the CFTC invited the FERC to CFTC premises
to gain access to market surveillance data while information
sharing protocols are being finalized. The CFTC expressed
concerns about confidentiality, specifically that information
shared with the FERC is protected in a way that satisfies
CFTC's congressionally mandated confidentiality obligations.
    Please elaborate more specifically on these concerns and
how the FERC is addressing them.

A.1. We believe we have resolved any issues related to data
confidentiality or creating a secure data transfer. On March 5,
2014, the CFTC made an initial transfer of data to FERC under
the information-sharing MOU. FERC and the CFTC also announced
the creation of an interagency surveillance and data analytics
working group.

Q.2. When will these protocols be finalized?

A.2. We believe the protocols have been finalized.

Q.3. Are there any obstacles in the way of finalizing the
protocol? If there are, please describe what they are, and how
are they being addressed?

A.3. As noted above, we believe the protocols have been
finalized.

Q.4. A document released to the New York Times on FERC's
investigation into JPMorgan's manipulative pricing schemes in
California and Michigan's electricity market revealed that FERC
investigators believed that Ms. Blythe Masters, the head of
JPMorgan's commodities operation, had ``falsely'' denied under
oath her awareness of the activities. Reportedly, the document
also found that JPMorgan made ``scores of false and misleading
statements and material omissions'' to FERC authorities.
Ultimately, JPMorgan agreed to pay $410 million without
admitting wrong doing, including Ms. Masters.
    Could you provide a copy of the document to Members of the
Senate Banking Committee?

A.4. FERC did not release any internal documents to the New
York Times or any other media outlet. The only documents
relating to FERC's investigation of JPMorgan that were publicly
released were the Commission Order approving the JPMorgan
settlement and the settlement agreement itself. The Commission
does not make staffs ``Wells Notice'' public even after an
investigation concludes. When, as occurred in the JPMorgan
matter, the investigation leads to a settlement that the
Commission finds to be in the public interest, the settlement
agreement itself typically provides details about the conduct
underlying the investigation. The JPMorgan settlement agreement
contains stipulated facts about JPMorgan's conduct, and both
the settlement agreement and the Commission's Order approving
the settlement set forth conclusions reached by Enforcement
staff and the Commission. If the Committee feels that it is
necessary to obtain access to certain nonpublic materials from
the investigation, we certainly would be willing to discuss the
matter.

Q.5. Can you speak to the challenges associated with holding
Wall Street executives individually accountable for their
illegal actions, as was presumably the case in the JPMorgan
settlement? Can you please explain the specific decision made
in this case, including the process and rationale for this
decision.

A.5. Fraud and market manipulation cases, particularly against
large, sophisticated institutions, can present challenges in
holding the entity as well as its executives accountable.
Similar to white collar matters, these cases can be challenging
to investigate and litigate, particularly where the
participants take steps to communicate in ways that are not
memorialized or are otherwise difficult to discover.
Notwithstanding these challenges, PERC's Office of Enforcement
has been and remains committed to holding entities and
individuals accountable for fraud, manipulation, and other
serious misconduct.
    Reflecting that ongoing commitment, the Commission is fully
prepared to proceed against executives and individuals when
that course of action is in the public interest. We have done
so in the past in both enforcement actions and settlements, and
will continue to do so. For example, the Commission is
currently litigating the Barclays market manipulation matter in
Federal district court and is pursuing claims and civil
penalties not only against Barclays Bank PLC, but also against
four individual traders. (See FERC v. Barclays Bank PLC, Daniel
Erin, Scott Connelly, Karen Levine, and Ryan Smith, Case No.
2:13-cv-02093-TLN-DAD (E.D. Cal. 2013).)
    In the JPMorgan case, however, the Commission determined
that acceptance of the settlement was in the public interest as
it provided a fair, equitable, and timely resolution of the
investigation. In particular, the JPMorgan settlement: (a)
guaranteed full and complete relief to California Independent
System Operator (CAISO) and Midcontinent Independent System
Operator (MISO) ratepayers through the disgorgement of $125
million, along with the assurance that CAISO ratepayers would
not be exposed to additional claims from JPMorgan that CAISO
calculates have a value of $262 million; (b) ensured that
JPMorgan paid a civil penalty of $285 million, which goes to
the U.S. Treasury; (c) sent a strong message to market
participants about the types of behavior the Commission
considers manipulative, through the inclusion of a detailed set
of facts to which JPMorgan stipulated; (d) highlighted for
market participants the consequences of engaging in
manipulative activity; and (e) memorialized that the traders
who engaged in the manipulative conduct would no longer
participate in bidding in PERC-jurisdictional markets while
employed by JPMorgan. The Commission concluded that, on
balance, acceptance of the settlement containing these
substantial, immediate benefits for ratepayers and the public
was preferable to jeopardizing those benefits through the
considerable delay and uncertainty posed by pursuing actions
against individual JPMorgan employees.
    It is worth highlighting one aspect of the JPMorgan
settlement agreement relating to the individual traders
involved in the alleged misconduct. The agreement memorialized
the fact that the traders who engaged in the bidding strategies
at issue had been reassigned and were no longer participating
in bidding generation into the organized markets, or otherwise
engaged in power market trading. Because the Federal Power Act
does not give the Commission the authority to ban traders from
electricity markets for market manipulation, this result could
not have been achieved by taking the matter to trial.

Q.6. How can regulators more effectively hold these firms,
particularly individual executives, accountable in order to
deter manipulative and fraudulent activities in markets that
have a direct impact on consumers?

A.6. In my view, there are several preconditions that must be
met for an enforcement office to improve its capability to
deter market manipulation and fraud. First, the agency must
have the legal authority to pursue wrongdoing, with strong
enforcement tools and a civil penalty authority that creates
adequate deterrence. FERC received such an authority in the
Energy Policy Act of 2005, which includes a broad
antimanipulation authority based on Rule 1 Ob-5 in the
Securities and Exchange Act of 1934 and a penalty authority of
up to $1,000,000 a day per violation.
    Second, the agency must have the resources and human
capital--the technical and legal expertise--to detect,
investigate, and prosecute market manipulation. These are not
easy cases, and they require highly qualified staff who
understand the markets and the products traded on them. FERC's
Office of Enforcement has almost 200 staff and includes
auditors and accountants, former traders and risk managers,
economists, energy analysts with highly quantitative skill sets
with backgrounds in engineering, statistics, mathematics, and
physics, and lawyers who are skilled investigators and
litigators, including former Federal prosecutors and lawyers
with extensive litigation experience.
    Third, the agency must create a robust oversight and
surveillance program that has the capability to track market
fundamentals and to identify market anomalies. In order to
create a surveillance program, the agency must receive the
relevant trading data and devise algorithms to screen the data.
This, in turn, requires technical staff who have the
quantitative and analytical skill sets to create the
algorithms, as well as the necessary IT support and
infrastructure. FERC's Office of Enforcement has created
algorithms that it uses to screen the natural gas and electric
markets for suspicious trading patterns, and it continually
looks for ways to enhance its surveillance capabilities.
    Fourth, to further good Government and to better protect
the public interest, the agency must work closely with other
agencies and share information on matters of mutual concern.
With respect to investigations, FERC's Office of Enforcement
has coordinated or shared information with other Federal
Government agencies, including the Department of Justice, the
CFTC, the SEC, the FTC, the Federal Reserve, and the EPA. We
have also established relationships with international
regulators and consulted with or provided technical assistance
to them.
    Fifth, as a matter of policy, the agency must be committed
to the core principle of holding wrongdoers accountable. This
means that in appropriate cases individuals, and not just
firms, are held responsible for their misconduct. To promote
accountability and deterrence, the agency should also shed
light on unlawful conduct through detailed settlement
agreements and Orders to Show Cause and bring enforcement
actions when a settlement cannot be achieved that is in the
public interest. FERC has sought to do all of that in its
enforcement actions. A recent example is Barclays in which the
Commission issued a penalty assessment of $453 million against
the firm and four traders. The matter is currently being
litigated in Federal court in the Eastern District of
California.
    Finally, regulators must never become complacent in their
market oversight and surveillance. Markets are not static
constructs, and as they change, regulators must be aware of the
change and their oversight and surveillance program must evolve
as well.
    I am pleased to say that enforcement staff at FERC have
worked hard to implement these measures since EPAct 2005, will
do so in the future, and will continue to look for ways to
improve our ability to detect and remedy fraud and
manipulation.
                                ------


        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN BROWN
                     FROM VINCENT MCGONAGLE

Q.1. On the issue of market surveillance and interagency
coordination, you stated the CFTC has invited FERC to CFTC
premises to gain access to market surveillance data while
information sharing protocols are finalized. You further shared
the CFTC's concerns about confidentiality, specifically that
information is shared and protected in a way that satisfies
CFTC's congressionally mandated confidentiality obligations.
    Please elaborate more specifically on these concerns.

A.1. Pursuant to section 8(e) of the Commodity Exchange Act, 7
U.S.C. 12(e) (CEA), the Commission may furnish to any
department or agency of the United States Government acting
within the scope of its jurisdiction any information in its
possession obtained in connection with the administration of
the CEA. However, any information furnished under this
provision cannot be further disclosed except in an action or
proceeding under the laws of the United States to which the
recipient agency or department, the Commission or the United
States is a party. Accordingly, when undertaking to share
nonpublic information with another Federal agency or
department, the CFTC must satisfy itself that such information
is received and used consistent with these confidentiality
obligations. As a threshold matter, on January 2, 2014, the
CFTC and FERC executed a Memorandum of Understanding Regarding
Information Sharing and Treatment of Proprietary Trading and
Other Information (Information-Sharing MOU) establishing the
commitments of the two agencies with respect to the sharing of
nonpublic material and the treatment of proprietary and/or
privileged information, including appropriate restrictions on
the onward sharing of such information. The Commission's
initial transmission of market data to FERC commenced on March
5, 2014. Pursuant to and consistent with the Information-
Sharing MOU, this transmission was preceded by written
undertakings by FERC, dated March 5, 2014, with respect to data
transmission and logistics and management of CFTC confidential
information.

Q.2. What protocols would alleviate the CFTC's confidentiality
requirements?

A.2. The Information-Sharing MOU substantially addressed the
Commission's concerns related to its statutory confidentiality
requirements and set forth the general terms and conditions for
future information sharing. FERC's initial information request
to the CFTC under the MOU was accompanied by a letter dated
March 5, 2014, which: (1) articulated specific encryption
protocols to be followed for the secure transmission of data
from the CFTC to FERC; (2) included an undertaking by FERC to
work with the CFTC to establish and maintain appropriate
safeguards to protect the confidentiality of files for which
access is granted and the information derived therefrom; and
(3) included a specific commitment to keep confidential any
information furnished by the CFTC, consistent with the
provisions of the MOU and section 8(e) of the CEA.

Q.3. When will these protocols be finalized?

A.3. The above-described MOU was finalized on January 2, 2014;
FERC provided associated written undertakings by letter dated
March 5, 2014.

Q.4. Are there any obstacles in the way of finalizing this
protocol? If there are, please describe what they are, and how
are they being addressed?

A.4. The essential elements of the confidentiality protocols
have been finalized and information sharing has commenced.

Q.5. When asked about the CFTC's jurisdiction over the London
Metal Exchange (LME) aluminum warehouses, you stated, ``the
issue is something that requires some degree of evaluation by
the CFTC, particularly as it relates to the fact that the LME
has applied for registration as a foreign board of trade . . .
we [CFTC] are engaged with LME and with the U.K.'s FCA
[Financial Conduct Authority], the LME's regulator, with
respect to how this warehousing issue, these questions
concerning premiums, rents, incentives . . . [and] where are
the legitimate forces of supply and demand and . . .
potentially where can it be fixed.''
    Please elaborate on the ``degree of evaluation'' the CFTC
has taken on the LME aluminum warehouse issue.

A.5. Under the registration regime established by the Dodd-
Frank Act, registration as a foreign board of trade (FBOT)
pertains to FBOTs who seek to offer U.S. customers direct
access to their electronic trading and order matching system
separate from other means of trading access; FBOT registration
is not otherwise required.
    As part of the FBOT review process, Commission staff are
examining LME's aluminum warehouse operations including, among
other things, how the warehouses operate, the relationships
between LME and the warehouse operators, how storage policies
and prices are determined, how effective the load-out rate is
and the basis for incentives charged by warehouse operators.
    On November 7, 2013, LME provided notice to the market of
its adoption of a 12-item package of measures, which it
described as ``designed to further enhance the LME's physical
delivery network, optimize contract price convergence, and
continue to deliver best-in-class price discovery and hedging
solutions for all market users.'' (LME Notice 13/326 : A312 :
W125) As provided by that Notice, the package was to take
effect on April 1, 2014. These reforms and their associated
reports can be accessed at the LME Web site: http://
www.lme.com/trading/warehousing-and-brands/warehousing/
warehouse-consultation/.
    However, on March 27, 2014, in response to a complaint by
United Company Rusal plc (Rusal), a U.K. High Court of Justice
handed down a judgment in respect to one aspect of LME's 12-
item package--LME's proposal to implement a linked load-in
load-out rule, which was intended to address warehouse issues.
Although metal buyers backed stricter rules to cut wait times
for aluminum and other metals, some producers disagreed. And
Rusal, a large aluminum producer, filed a U.K. lawsuit this
past December that challenged LME's changes to its warehouse
policy. In its filing, Rusal described the changes as
``irrational and disproportionate. The High Court decided to
uphold certain aspects of Rusal's complaint and so quashed the
LME's implementation of the linked load-in load-out rule. On
April 7, LME stated that ``the LME's commitment to address
queues, and their consequent impact on efficient price
discovery, remains unchanged. The LME is taking legal advice to
establish the quickest effective route by which action can be
taken to reduce queue lengths at Affected Warehouses.'' (LME
Notice 14/121 : A117 : W056)
    While this decision prevented an April 1 implementation of
the linked load-in load-out rule, it did not interfere with the
implementation of the other items of LME's package, which are
also aspects of LME's plan to improve warehouse operations.
These other measures came into effect on April 1st of this
year, and the Division is currently reviewing the impact of
those changes. We are also considering what additional steps
are appropriate in light of the delayed implementation of the
linked load-in load-out rule.

Q.6. Please describe how the CFTC has engaged the LME and the
U.K.'s FCA, including the frequency with which the CFTC has
communicated with the LME FCA and any outcomes from these
meetings.

A.6. Since July of 2013, staff has been in contact with LME on
an ongoing basis to discuss LME's plan to address the warehouse
issues. More recently, staff met with LME and has had at least
three telephone conferences since early January. Staff has also
been in contact with the FCA on several occasions. Both the LME
and the FCA have consistently voiced the desire to resolve the
warehouse situation.

Q.7. Have there been any challenges working with the FCA on
this issue?

A.7. The Division is satisfied that it has a good working
relationship with FCA on this matter.

Q.8. There is a no-action letter between the CFTC and the LME
allowing the LME to operate in the U.S. country provided the
LME ensures fairness to market participants. You stated that,
``ultimately, we [CFTC] can revoke or suspend any no-action
letter that is issued by the Division of Market Oversight.''
    Do you view the current activities of the LME and the LME
warehouses as consistent or inconsistent with the existing no-
action letter?

A.8. The existing no-action letter, issued on March 12, 2001,
generally provides, in pertinent part, that subject to LME's
compliance with the terms and conditions stated in the no-
action letter, the Division of Trading and Markets, (now the
Division of Market Oversight) will not recommend that the
Commission institute enforcement action against LME or its
members solely based upon LME's failure to seek designation as
a DCM or registration as a DTEF pursuant to Sections 5 or 5a,
respectively, of the CEA, if LME makes its electronic trading
and order matching system, known as LMEselect, available to LME
members in the U.S. (now referred to as direct access).
Although the no-action letter policy for permitting direct
access was superseded by the Dodd-Frank Act's FBOT Registration
policy, found in section 4(b)(1) of the CEA and Commission
regulation Part 48, LME may continue to provide for direct
access pursuant to the no-action letter until such time as the
Commission addresses its application for registration.
    No-action letters such as the one issued to the LME were
issued after a thorough evaluation of, among other things, the
Exchange's trading system, rule enforcement practices,
disciplinary system, etc., to determine if persons in the U.S.
could reliably and safely trade on the Exchange.
    In addition, there is a condition in LME's no-action letter
that states as follows: ``The laws, systems, rules, and
compliance mechanisms of the United Kingdom applicable to LME
will continue to require LME to maintain fair and orderly
markets; prohibit fraud, abuse, and market manipulation; and
provide that such requirements are subject to the oversight of
the FSA (now FCA).'' In the U.K., the Financial Services and
Markets Act 2000 (FSMA) prohibits market abuse including, among
other things, misuse of nonpublic material information, the
creation of false or misleading market impressions, and market
distortion. As a Recognized Investment Exchange pursuant to the
FSMA, LME is subject to a comprehensive regulatory regime in
the United Kingdom which includes, among other things,
reporting and record keeping requirements, procedures governing
the treatment of customer funds and property, conduct of
business standards, provisions designed to protect the
integrity of the markets, and statutory prohibitions on fraud,
abuse, and market manipulation.

Q.9. You further stated that it was your expectation that the
issue could be addressed without revoking the letter, and those
opportunities were being explored. Can you please elaborate on
the opportunities and solutions being explored by the CFTC?

A.9. As with all no-action letters, the issuing Division, in
its discretion, retains the authority to condition further,
modify, suspend, terminate, or otherwise restrict the terms of
the no-action relief provided. The Division is continuing to
monitor the effectiveness of the steps that LME has taken to
address the issue of warehouse congestion. Steps included:
changes to LME's Warehousing Agreement (giving LME enhanced
powers to investigate the formation of queues, and to impose
additional load-out obligations on warehouses that have paid
incentive fees in order to artificially create or maintain
queues), and the formation of: (1) a Logistical Review group
(to ``provide LME with an independent view on reasonable
operational expectations and requirements for the loading in,
holding and loading out of metals''); and (2) a Physical Market
Committee (to ``provide a forum for all sectors of the physical
industry to represent their views to the Exchange''). As noted
above, LME's intention to implement a ``linked load-in load-out
requirement'' was blocked by a U.K. court on March 27, 2014.
Going forward, the Division intends to review the steps LME
takes in response to the court's decision.
    The Division will also continue discussions with LME's
primary regulator, the U.K. FCA, regarding its review of the
effectiveness of the warehousing steps. If the outcome of LME's
corrective measures is unsatisfactory, the Division may require
additional or alternative measures to address warehouse
congestion as a condition of its no-action relief. Moreover, as
noted above, Commission staff is examining the current
activities of LME and the LME warehouses' operations as part of
staff's review of LME's FBOT application.

Q.10. At what point would revoking the no-action letter be an
appropriate remedy to the LME aluminum warehouse issue? If you
need more information to answer this question, what steps have
you taken or do you need to take to get the information you
need?

A.10. Revoking FBOT no-action letters may be an appropriate
remedy where there has been a determination that the FBOT no
longer meets the conditions required in its no-action letter to
retain relief, and where an FBOT is not responsive to
Commission staff-suggested corrective measures. Commission
staff is taking a number of steps to evaluate aluminum pricing
within the United States as set forth in further detail above.

Q.11. In 2006, the CFTC subpoenaed Platts, the leading provider
of spot and contract prices in the global metals market, to
investigate the accuracy of trade data submitted to Platts.
McGraw-Hill, Platts's parent company, publicly acknowledged
that ``some energy companies and individual traders have
repeatedly attempted to manipulate the price indexes produced
by publishers such as Platts.'' In 2002, during another CFTC
investigation regarding energy prices, two power companies
``disclosed that some of their traders provided inaccurate
pricing information to Platts.'' Such benchmarks by ``price
reporting agencies'' based on producer announcements,
negotiations, or gathering of market information have come
under scrutiny. The first thing that comes to mind is LIBOR.
    What was the outcome of the CFTC's investigation into the
Platt's pricing mechanism?

A.11. As part of its investigations of possible misconduct in
the energy markets, including whether traders at certain energy
companies submitted trade data reflecting manipulated prices to
Platts for use in calculating index prices of natural gas
published by Platts in order to benefit financial trading
positions tied to the same index, the Commission filed four
actions in the United States District Courts court to compel
the McGraw-Hill Companies, Inc.'s production of energy
reporting-related documents requested in an administrative
procedure. In each of these actions, McGraw-Hill was compelled
by a Federal court, overcoming McGraw-Hill's claim of
privilege, to comply in substantial part with CFTC subpoenas
directed to McGraw-Hill. See CFTC v. McGraw-Hill Companies,
Inc., 507 F. Supp.2d 45 (D.D.C. 2007); CFTC v. McGraw-Hill
Companies, Inc., 390 F. Supp.2d 27 (D.D.C. 2005); CFTC v.
Whitney, 441 F. Supp.2d 61 (D.D.C. 2006); and CFTC v. Bradley,
et al., Case No. 05-cv-62, 2006 WL 2045847 (N.D. Okla. July 20,
2006).
    From December 2002 through July 2007, the Commission filed
28 enforcement actions charging, in part, false reporting and
attempted manipulation relating to natural gas price indexes in
the energy markets, and obtained over $280 million in
settlement of these matters. See In re Dynegy Marketing &
Trade, et al., CFTC Docket No. 03-03 (CFTC filed Dec. 18, 2002)
($5 million civil monetary penalty); In re El Paso Merchant
Energy, L.P., Docket No. 03-09 (CFTC filed March 26, 2003) ($20
million civil monetary penalty); In re WD Energy Services Inc.,
Docket No. 03-20 (CFTC filed July 28, 2003) ($20 million civil
monetary penalty); In re Williams Energy Marketing And Trading,
et al., Docket No. 03-21 (CFTC filed July 29, 2003) ($20
million civil monetary penalty); In re Enserco Energy, Inc.,
Docket No. 03-22 (CFTC filed July 31, 2003) ($3 million civil
monetary penalty); In re Duke Energy Trading And Marketing,
L.L.C., Docket No. 03-26 (CFTC filed Sept. 17, 2003) ($28
million civil monetary penalty); CFTC v. American Electric
Power Company, Inc., et al., No. C2 03 891 (S.D. Ohio filed
Sept. 30, 2003) ($30 million civil monetary penalty); In re CMS
Marketing Services and Trading Company, et al., Docket No. 04-
05 (CFTC filed Nov. 25, 2003) ($16 million civil monetary
penalty); In re Reliant Energy Services, Inc., Docket No. 04-06
(CFTC filed Nov. 25, 2003) ($18 million civil monetary
penalty); In re Aquila Merchant Services, Inc., Docket No. 04-
08 (CFTC filed Jan. 28, 2004) ($26.5 million civil monetary
penalty); In re Calpine Energy Services, L.P., CFTC Docket No.
04-11 (CFTC filed Jan. 28, 2004) ($1.5 million civil monetary
penalty); In re ONEOK Energy Marketing And Trading Company,
L.P., et al., Docket No. 04-09 (CFTC filed Jan. 28, 2004) ($3
million civil monetary penalty); In re Entergy-Koch Trading,
LP, Docket No. 04-10 (CFTC filed Jan. 28, 2004) ($3 million
civil monetary penalty); In re e prime, Inc., Docket No. 04-12
(CFTC filed Jan. 28, 2004) (a wholly owned subsidiary of Xcel
Energy, Inc.; $16 million civil monetary penalty); In re
Knauth, Docket No. 04-15 (CFTC filed May 10, 2004) ($25,000
civil monetary penalty); In re Western Gas Resources, Inc.,
Docket No. 04-17 (CFTC filed July 1, 2004) ($7 million civil
monetary penalty); In re Coral Energy Resources, L.P., Docket
No. 04-21 (CFTC filed July 28, 2004) ($30 million civil
monetary penalty); In re Cinergy, CFTC Docket No. 05-03 (CFTC
filed November 16, 2004) ($3 million civil monetary penalty);
In re Mirant, CFTC Docket No. 05-05 (CFTC filed Dec. 6, 2004)
($12.5 million civil monetary penalty); In re Dominion
Resources, Inc., CFTC Docket No. 06-06 (CFTC Sept. 27, 2006)
($4,250,000 civil monetary penalty); CFTC v. Foley, No. 2:05
849 (S.D. Ohio filed Sept. 14, 2005, settled Sept. 28, 2006)
($350,000 civil monetary penalty); CFTC v. McDonald, et al.,
No. 1:05-CV-0293 (N.D. Ga. filed Feb. 1, 2005, settled Nov. 17,
2006, Nov. 7, 2007) ($750,000 total civil monetary penalties);
CFTC v. NRG Energy, Inc., No. 04-cv-3090 MJD/JGL (D. Minn.
filed July 1, 2004) ($2 million civil monetary penalty); CFTC
v. Reed, et al., No. 05-D-178 (D. Colo. filed Feb. 1, 2005,
settled March 13, 2007, Nov. 13, 2000) (total $2,075,000 civil
monetary penalties); CFTC v. Richmond, No. 05-M-668 (OES) (D.
Colo. filed April 12, 2005, settled March 20, 2007) ($60,000
civil monetary penalty); CFTC v. Bradley, et al., No. 05CV62-
CVE-FHM (N.D. Okla. filed Feb. 1, 2005, settled May 25 and June
25, 2007) (Bradley $100,000 civil monetary penalty; Martin
$25,000 civil monetary penalty); CFTC v. Johnson, et al., No.
H-05-0332 (S.D. Texas filed Feb. 1, 2005, settled Nov. 7, 2007)
(Johnson, Moore, Tracy, Harp and Dyer $1 million civil monetary
penalty; April 24, 2008 judgment for Dizona); CFTC v. Whitney,
No. H 05-333 (S.D. Texas filed Feb. 1, 2005, settled March 5,
2008) ($55,000 civil monetary penalty); and CFTC v. Energy
Transfer Partners, L.P., et al., No. 3-07CV1301-K (N.D. Tex.
filed July 26, 2007, settled March 17, 2008) ($10 million civil
monetary penalty).

Q.12. Why is this benchmark used to determine the price of
aluminum?

A.12. One benchmark used in the aluminum market is the LME
futures price adjusted by the ``Midwest premium.'' As stated by
Platts, the Midwest premium (or discount) is determined by an
analysis by Platts of ``physical spot deals, bids and offers
reported through a daily survey of spot buyers and sellers,
using a representative sample of producers, traders and
different types of end users.'' (See http://www.platts.com/
IM.Platts.Content/methodologyreferences/methodologyspecs/
metals.pdf).
    According to Platts, some privately negotiated ``floating''
term contracts and swaps settle on the basis of the spot price
as determined by Platts. (See http://www.apdtesting.com/
wordpress/wp-content/uploads/2012/11/2011-5-
12_platts_karen_mcBeth_copper_aluminum_magnesium.pdf).
    Our understanding is that aluminum end users execute swaps
that are priced off of a Platts reported price of the LME price
plus an additional premium--the published Midwest premium--plus
shipping to their specific location. The LME price is not
location-specific and delivery of LME stock can occur at any of
their global warehouses. Therefore, end users who need aluminum
at a specific location may use other instruments (swaps) that
give them certainty of delivery location as well certainty of
timing of delivery.
                                ------


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR TOOMEY
                     FROM VINCENT MCGONAGLE

Q.1. Is the CFTC working with the U.K. and European regulators
to ensure that the LME proceeds with the transparency
commitments announced late last year? Do you have a sense of
the timetable?

A.1. CFTC market oversight staff hold routine, periodic
telephone conference calls with counterparts at the U.K.
Financial Conduct Authority (FCA). During the course of these
calls in 2013 and 2014, CFTC and FCA staff discussed concerns
raised by aluminum market participants relating to slow load-
out rates of metals stored in LME approved warehouses. The
purpose of these conversations was to learn what steps the FCA
was taking with regard to LME and the status of any reforms. We
have not had any formal discussions with other European
regulators in this regard, as the FCA is the only European
regulator responsible for oversight of LME.
    In this regard, many of the reforms adopted by the LME
following its 2013 consultation were, as noted above,
implemented on April 1. These reforms and their associated
reports, as well as LME's statements of March 27 (LME Notice
14/106 : A103 : W046), and of April 7, 2014 (LME Notice 14/121
: A117 : W056), both issued in response to the decision of the
U.K. High Court, can be accessed at the LME Web site: http://
www.lme.com/trading/warehousing-and-brands/warehousing/
warehouse-consultation/.
    While most of the changes adopted by LME were implemented
on April 1, 2014, timeline for the implementation of the linked
load-in load-out rule, was, as noted above, affected by the
March 27, 2014, decision of the U.K. High Court, issued in
response to the U.K. lawsuit filed this December 2013 by Rusal.
According to its statement of April 7, ``the LME's commitment
to address queues, and their consequent impact on efficient
price discovery, remains unchanged. The LME is taking legal
advice to establish the quickest effective route by which
action can be taken to reduce queue lengths at Affected
Warehouses.'' (LME Notice 14/121 : A117 : W056)
                                ------


        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN BROWN
                     FROM MICHAEL S. GIBSON

Q.1. In your testimony, you stated the FRB's primary concern is
the safety and soundness of individual financial institutions
and the financial system as a whole, while market oversight is
entirely the task of Commodity Futures Trading Commission
(CFTC), Federal Energy Regulatory Commission (FERC) and other
market regulators.
    What is the specific statutory language that explicitly
relieves the FRB of broader oversight responsibilities given
the FRB's function as the consolidated regulator of Financial
Holding Companies (FHCs) and systemic risk?

A.1. The Board's supervisory and regulatory authority regarding
financial holding companies and systemic risk is limited to
that granted by statute, in particular, the Bank Holding
Company Act (BHC Act) and the recently enacted, Dodd-Frank Wall
Street Reform and Consumer Protection Act (Dodd-Frank Act). \1\
The BHC Act directs the Board to monitor through reports and
examination the operations and financial condition of bank
holding companies and ``compliance of the bank holding company
and the subsidiary with (I) [the BHC) Act; (II) Federal laws
that the Board has specific jurisdiction to enforce against the
company or subsidiary; and (III) other than in the case of an
insured depository institution or functionally regulated
subsidiary, any other applicable provisions of Federal law.''
\2\ The BHC Act specifically includes within the definition of
``functionally regulated subsidiary'' ``an entity that is
subject to regulation by, or registration with, the Commodity
Futures Trading Commission'' with respect to activities subject
to the CFTC's jurisdiction. \3\ In addition, the BHC Act
specifically provides that, in exercising its authority, the
Board must, to the fullest extent possible, rely on examination
reports made by other Federal or State regulatory agencies and
avoid duplication of examination activities, reporting
requirements, and requests for information. \4\
---------------------------------------------------------------------------
     \1\ See, e.g., Board of Governors v. Dimension Financial Corp.,
474 U.S. 361 (1986); Western Bancshares, Inc. v. Board of Governors,
480 F.2d 749 (10th Cir. 1973). The Board also has authority to take
supervisory actions, including enforcement actions, to prevent or
address unsafe and unsound practices. 12 U.S.C. 1818(b)(3).
     \2\ 12 U.S.C. 1844.
     \3\ Id.
     \4\ Id.
---------------------------------------------------------------------------
    The authority to oversee the securities, derivatives, and
commodities markets is vested in agencies such as the Commodity
Futures Trading Commission, Federal Energy Regulatory
Commission, and Securities and Exchange Commission, which have
specific oversight authority including the jurisdiction to
address market manipulation. In addition, these agencies have
access to information regarding the practices of a wide range
of market participants, whereas the Federal Reserve only has
access to the activities of the participants that are banking
firms. As a result, the agencies with direct market oversight
authority are in the best position to tell whether certain
practices deviate from market practices, including trading and
pricing practices.
    However, if Federal Reserve staff suspects a problem as a
result of its review, staff would refer and cooperate with the
appropriate market regulator(s).

Q.2. Independent of the FRB's request for public comment on the
issue of FHC ownership of physical commodities and energy
assets through the Advanced Notice of Proposed Rulemaking
(ANPR), does the FRB consider the ability of a FHC to combine
its trading and dealing in commodity derivatives with direct
ownership of the underlying physical commodity, such as
ownership of the physical infrastructure to extract, store,
deliver and transport commodities, as potentially systemically
risky, unfair or dangerous from the viewpoint of market
integrity, consumer protection, and macroeconomic stability?

A.2. Because of its concern that ownership of the physical
infrastructure to extract, store, deliver, and transport
commodities may pose risks to the safety and soundness of bank
holding companies, the Board has not approved bank holding
companies to engage in these activities. Indeed, the Board's
exercise of authority under section 4(k) of the BHC Act
permitting financial holding companies to engage in activities
that are complementary to financial activities specifically
prohibited financial holding companies from using that
authority to engage in extraction, storage, delivery, or
transportation of physical commodities.
    A limited number of financial holding companies engage in
these activities under authority specifically provided by
statute that does not require Board approval: grandfathering
authority under section 4(o) of the BHC Act and merchant
banking authority under sections 4(k)(4)(H) and (I) of the Act.
These authorities are broad and place no limits on their
combination with other authorities or activities.
    As part of the January 2014 advance notice of proposed
rulemaking (ANPR), the Board will consider how to address the
potential risks to safety and soundness and U.S. financial
stability that may be presented by the activities authorized
under sections 4(o), 4(k)(4)(H), and 4(k)(4)(I) and whether
additional prudential requirements such as capital, liquidity,
reporting, or disclosure requirements, could help ensure such
activities do not pose undue risks to the safety and soundness
of the bank holding company or to financial stability.

Q.3. You stated the FRB's supervision staff held meetings to
review FHCs' physical commodity activities since 2008.
According to your testimony, these reviews raised a number of
concerns about certain risks systemically important financial
institutions' commodities activities can pose to financial
stability. Many of these concerns are posed in the ANPR the FRB
issued on January 14, 2014.
    Please publicly disclose the discussion minutes and any
policy conclusions made at the staff-level meetings on the
issue of FHC ownership of physical commodities. Specifically,
elaborate on the FRB's policy concerns beyond issues associated
with the institutions' safety and soundness to include a
detailed list of the policy concerns discussed, and the number
of meeting, with specific dates.

A.3. Since 2009, Federal Reserve staff has conducted a series
of horizontal examinations of the commodities activities of
certain financial holding companies, including Bank of America
Corporation, JPMorgan Chase & Co., Goldman Sachs, and Morgan
Stanley. In 2008, Goldman Sachs and Morgan Stanley became bank
holding companies, and Bank of America Corporation and JPMorgan
Chase & Co. acquired companies with substantial commodities
activities. Ongoing continuous monitoring work on the
commodities activities of the firms has also been conducted.
    The overall conclusions of these examinations helped to
inform the ANPR, including the concerns reflected in the ANPR
regarding the potential tail risk of physical commodities
activities, the limitations of insurance and capital
requirements to mitigate the potential risks of commodities
activities, and the difficulty to quantify these risks. \5\
---------------------------------------------------------------------------
     \5\ See 79 Fed. Reg. 3329, 3332-34 (January 21, 2014).
---------------------------------------------------------------------------
    The content of the meetings held, and examinations
conducted, by Federal Reserve staff regarding physical
commodities activities involves confidential supervisory
information and trade secrets. Disclosure of this information
could prejudice the examination process and is subject to
protections from disclosure under Federal law.

Q.4. Please describe the subsequent actions the Fed staff has
taken to address each of these policy concerns, and demonstrate
how the FRB communicated these concerns with the FHCs through
orders granted or approval of specific activities or
acquisitions in the course of supervising and monitoring FHCs'
commodities and energy activities.

A.4. In cases where Federal Reserve examiners identified risk
management or other weaknesses as part of the horizontal
examination of the firms involved in physical commodities
activities, this information was communicated to each of the
firms, and examiners monitored the firms to ensure that the
firms were taking appropriate steps to remediate these
weaknesses. For example, Federal Reserve examiners have
required:

    modification of value-at-risk calculations
        pertaining to commodities positions,

    more granular risk limits for commodities
        positions,

    consistent valuations of physical and derivative
        positions in the same commodity,

    divestiture of impermissible commodity assets, and

    a more robust compliance function for commodities
        activities.

    In the case of JPMorgan Chase & Co., Federal Reserve staff
notified the firm that Henry Bath & Sons Ltd (Henry Bath) was
not a bona fide merchant banking investment and consequently,
JPMorgan Chase & Co. is required to divest its investment in
Henry Bath.

Q.5. Aside from the vote held by FRB Governors to approve the
ANPR, are there any plans for any board-level meetings on this
subject? If not, why has this issue not been considered or
discussed by the Board?

A.5. A key purpose of the ANPR is to provide the Board with
additional information in order to determine the appropriate
course of action to address the risks of physical commodities
activities. The Board will consider appropriate additional
steps to address these risks after the comment period on the
ANPR concludes. Currently, the comment period is scheduled to
close on April 16, 2014.

Q.6. You stated in your testimony that FHCs publicly disclose
in their quarterly filings with the FRB one metric directly
related to their physical commodity holdings, which presents an
aggregate market value of physical commodities on their balance
sheet.
    How does this metric help the FRB and the public understand
the specific physical commodity activities these institutions
conduct, including the commodity and energy companies they own
or control, or the influence the FHCs may, or may not, have on
the prices of individual commodities?

A.6. The Board's Reporting Form Y-9C and its schedules provide
disclosure on commodities, including commodity and other
exposures, gross fair value of commodity contracts, gross fair
value of physical commodities held in inventory, commodities
specified according to derivative position indicators, and the
notional principal amount of commodity contracts. This
information helps the Board track compliance with the limits it
has placed on the commodity activities of firms relying on
complementary authority, but the Board does not solely rely on
this information to understand the breadth of commodities
activities that these firms conduct or the risks that those
activities pose. This disclosure informs the public of the size
of physical commodity activities that the institutions conduct.
The ANPR solicits comments on a broad array of issues
concerning physical commodities' impact on safety and soundness
and what additional criteria the Board should consider
concerning physical commodities, including whether the public
has a need for more information in this area that exceeds the
burden that would be imposed on the financial holding companies
to supply that information.

Q.7. Is the FRB considering other disclosure alternatives given
this line item only provides an aggregate number of all
commodities activities conducted by a single FHC?

A.7. Yes, the Board inquires in its ANPR about the advantages
and disadvantages of requesting additional reporting or
disclosure requirements for bank holding companies and requests
suggestions on how the Board should formulate such
requirements. In addition, the Board specifically stated in the
ANPR that it is considering a number of actions to address the
potential risks associated with merchant banking investments,
including enhanced reporting to the Board or public disclosures
regarding merchant banking investments.

Q.8. You also mentioned that FHCs disclose their physical
commodities activities in their SEC filings. Bank holding
company (BHC) disclosures are governed by Guide 3, a rule
promulgated in the 1970s, well prior to the Gramm-Leach-Bliley
Act. Guide 3 only requires disclosure of the securities held in
a BHC's investment portfolio. Should these rules be revised to
provide better disclosures of commodities activities?

A.8. The Board supports robust disclosures that result in
transparency and encourage market discipline. The SEC's Guide 3
governs certain types of required disclosures and may not
govern all physical commodity activities or investments. The
SEC is best able to determine whether Guide 3 is consistent
with the mandate in the Federal securities laws.

Q.9. The following questions address the process by which the
FRB scrutinized, authorized, and continues to oversee the
former investment banks', i.e., Goldman Sachs and Morgan
Stanley, physical commodities and energy holdings after their
conversion from investment banks to FHCs:
    When Goldman Sachs and Morgan Stanley applied to the FRB to
be registered as FHCs in the fall of 2008, did the FRB staff
conduct a review of their existing commodities assets and
investments?

A.9. The Board approved applications by Morgan Stanley and
Goldman Sachs to become bank holding companies in September
2008. In light of the unusual and exigent circumstances
affecting the financial markets at the time, the Board
determined that emergency conditions existed that justified
expeditious action and waiver of public notice of the
applications. In approving the applications, the Board
considered all of the statutory factors required under the BHC
Act. In connection with its review of the Morgan Stanley and
Goldman Sachs applications, the Board did not conduct a
targeted review of the commodities activities and investments
of the two organizations. Section 4(a)(2) of the Bank Holding
Company Act permits a newly formed bank holding company to
retain any otherwise impermissible activities for up to 2
years, with the possibility of three 1-year extensions.
Moreover, section 4(o) of the BHC Act permits a qualifying
financial holding company to engage in physical commodity
activities without seeking or obtaining Board approval. Both
Morgan Stanley and Goldman Sachs are section 4(o) qualifying
financial holding companies.
    Morgan Stanley and Goldman Sachs also filed elections to
become financial holding companies that ultimately became
effective. Morgan Stanley's election was filed in August 2008,
Goldman Sachs' in July 2009. These elections were considered
under the factors enumerated in the Bank Holding Company Act
and the Board's Regulation Y at the time, including the
requirement that all of the depository institution subsidiaries
of the bank holding company be well capitalized and well
managed.

Q.10. If yes, please describe the scope of the review, and
explain how this review found these institutions' commodity
holdings did not pose sufficient risks to the financial system?

A.10. Please see response for Question 9.

Q.11. If not, why wasn't a review of these activities
conducted?

A.11. Please see response for Question 9.

Q.12. Please describe any discussions between the FRB
supervisors and representatives from Goldman Sachs and/or
Morgan Stanley held between 2008 and present with respect to
their ability to continue, and to expand, their pre-2008
physical commodity activities under any legal authority after
their conversion into bank holding companies. For example, was
the Fed aware of, and did it approve, Goldman Sachs'
acquisition of Metro International in 2010?

A.12. As discussed more fully in the response to Question 9,
the 2008 Morgan Stanley and Goldman Sachs applications were
processed using expedited procedures due to the emergency
conditions that existed at the time.
    Goldman Sachs has indicated that it is holding Metro
International under merchant banking authority. Merchant
banking investments are not subject to prior approval of the
Federal Reserve. The policies and procedures that Goldman Sachs
employs to ensure that its merchant banking investments conform
with the Federal Reserve's merchant banking rules have been
reviewed by supervision staff, as has the control framework
that Goldman Sachs uses to minimize the financial and
reputational risks posed by such investments. Subsequent to
Goldman Sachs and Morgan Stanley becoming bank holding
companies, supervision staff conducted extensive reviews of the
commodities activities of both companies. The reviews
catalogued the activities in which the two firms engaged, and
assessed the control environment that the two firms utilize to
manage their commodities business. Supervisory staff has
periodic discussions with Goldman Sachs and Morgan Stanley
regarding their physical commodities activities including the
authorities under which they are engaging in the activities.

Q.13. Please describe specific factors and reasoning for the
FRB's decision to allow JPMorgan to acquire Henry Bath, a metal
warehouse business, and other commodity assets from RBS Sempra
in 2010.

A.13. The BHC Act and the Board's Regulation Y permit financial
holding companies to make acquisitions of firms that engage in
various activities that are financial in nature. Financial
holding companies often seek to acquire firms that engage in
financial activities, but are not subject to the BHC Act and
its restrictions. These firms often engage in some amount of
activities that are related to the firm's financial business,
but are not permissible for bank holding companies to conduct
under the BHC Act. To address this, the Board's Regulation Y
permits a financial holding company to acquire a firm that is
engaged in a mix of permissible financial activities and
impermissible activities under certain conditions. In
particular, at least 85 percent of the activities of the target
firm (as measured by assets and revenues) must be permissible
financial activities, and the acquiring financial holding
company must divest or otherwise conform the impermissible
activities within 2 years of the acquisition, unless a limited
extension is granted by the Board. JPMorgan Chase & Co.
acquired Henry Bath as part of the acquisition of the financial
businesses and assets of RBS Sempra. The Board's Regulation Y
required JPMorgan Chase to conform, terminate or divest its
investment in Henry Bath within 2 years of its acquisition,
subject to limited extensions.
    In connection with the RBS Sempra acquisition, the Board
approved JPMorgan Chase's request to engage in energy tolling
and energy management services as complementary activities
under section 4(k) of the BHC Act. The Board did not approve
the retention of Henry Bath under this authority. The Board
subsequently informed JPMorgan Chase that its investment in
Henry Bath would not qualify as a merchant banking investment.

Q.14. If an investment bank applied to the FRB to be registered
as a FHC under normal circumstances (i.e., not under the crisis
conditions when Goldman Sachs and Morgan Stanley became FHCs),
what would have been the review process of these institutions
physical commodity and energy activities? Please describe the
types of inquiries the Fed would have made, and specific
criteria it would have used, to assess whether these
applicants' existing commodity activities complied with the
requirements of the Bank Holding Company Act (BHCA) and were
consistent with the public interest in preserving systemic
financial stability in the long-term?

A.14. A company seeking to become a financial holding company
must make at least two filings with the Federal Reserve, an
application to become a bank holding company (as a result of
either acquiring a bank or converting an existing depository
institution subsidiary into a bank) and a declaration stating
that the company elected, and qualified for, financial holding
company status. \6\ In connection with these filings, the
Federal Reserve would request that the applicant describe its
nonbanking activities and the legal authority for conducting
these activities. In approving a bank holding company
application, the Federal Reserve is required to consider, among
other things, the financial and managerial resources and future
prospects of the companies and banks concerned. A company's
commodities-related and energy-related activities, like its
other activities, would be considered in this context.
---------------------------------------------------------------------------
     \6\ See 12 U.S.C. 1842, 1843; 12 CFR225.11, 225.82.
---------------------------------------------------------------------------
    A company, such as Goldman Sachs or Morgan Stanley, that
meets the requirements of section 4(o) of the Bank Holding
Company Act may engage in commodities-related activities
without the approval of the Board. By its terms, section 4(o)
authorizes certain companies that become financial holding
companies to engage in physical commodity activities that are
not otherwise permissible for financial holding companies and
have not been authorized by the Board.
    A financial holding company may also seek Board approval to
engage in activities that are complementary to financial
activities. \7\ In connection with requests under this section,
the Federal Reserve obtains information about the types and
scope of the requested activities, the financial condition of
the applicant, the programs for monitoring and limiting risk
from the activities, and other relevant information. Based on
all the information available to the Board, the Board then
considers whether the proposed activity is complementary to a
financial activity, would pose risk to the safety and soundness
of depository institutions or the financial system, and whether
the public benefits, such as greater convenience, increased
competition, or gains in efficiency, outweigh the possible
adverse effects, such as undue concentration of resources,
decreased or unfair competition, conflicts of interests,
unsound banking practices, or risk to the stability of the
United States banking or financial system.
---------------------------------------------------------------------------
     \7\ See 12 U.S.C. 1843(k)(1)(B).

Q.15. The following are questions related to the FRB's legal
and supervisory interpretation and use of the Section 4(o)'s
grandfather provision under the BHCA. During the hearing, you
stated that you are not a lawyer and thus could not offer an
interpretation of what section 4(o) means.
    How does the FRB's legal staff interpret the scope of the
commodity grandfathering provision in Section 4(o)? Does the
term ``any such activities'' permit an institution eligible for
grandfathered treatment to engage in all commodities and
physical asset trading an ownership of they were engaged in the
ownership or trading of a single commodity or physical asset
prior to 1997?

A.15. Section 4(o) of the BHC Act provides that ``a company
that is not a bank holding company or foreign bank and becomes
a financial holding company as of November 12, 1999, may
continue to engage in, or directly or indirectly own or control
shares of a company engaged in, activities related to the
trading, sale, or investment in commodities and underlying
physical properties that were not permissible for bank holding
companies to conduct in the United States as of September 30,
1997, if the holding company, or any subsidiary of the holding
company, lawfully was engaged, directly or indirectly, in any
of such activities as of September 30, 1997, in the United
States'' and certain other requirements \8\ are met.
---------------------------------------------------------------------------
     \8\ Section 4(o) also limits such activities and investments to 5
percent of the financial holding company's total consolidated assets
and prohibits cross-marketing activities between subsidiaries held
pursuant to section 4(o) and affiliated depository institutions. 12
U.S.C. 1843(o)(2)-(3).
---------------------------------------------------------------------------
    Through this provision, Congress specifically authorized
any company that becomes a financial holding company after
November 1999 to engage in physical commodities activities
(i.e., the physical commodities activities authorized by the
provision) that were not otherwise permissible for bank holding
companies to conduct in September, 1997. Companies that qualify
for this statutory grandfather provision may continue to engage
in commodities activities to the extent permitted by that
provision without obtaining the Federal Reserve's approval.
    Prior to September 30, 1997, bank holding companies
claiming grandfather rights under section 4(o) were engaged in
a broad range of commodities related activities that the Board
had not authorized for bank holding companies. These included
trading, mining, storing or transporting coal, oil, natural
gas, fertilizer, electricity, and various metals. Thus, even
under the narrowest reading of the statute, grandfathered bank
holding companies are permitted by statute to engage in a broad
range of commodities-related activities.
    Some have argued that the statute is plain on its face that
a grandfathered firm engaged in any commodity activity prior to
the relevant date may engage after the relevant date in all of
the commodities activities listed in the statute, namely
``activities related to the trading, sale, or investment in
commodities and underlying physical properties that were not
permissible for bank holding companies to conduct in the United
States as of September 30, 1997,'' in addition to the
activities noted above that these firms conducted prior to the
grandfather date. This reading would permit a grandfathered
bank holding company to expand its commodities activities after
the grandfather date.
    As part of the ANPR, the Board will consider the scope of
the grandfather provision in section 4(o). In addition, the
Board will consider how to address the potential risks to
safety and soundness and U.S. financial stability that may be
presented by the activities authorized under section 4(o) and
whether additional prudential requirements such as capital,
liquidity, reporting, or disclosure requirements, could help
ensure such activities do not pose undue risks to the safety
and soundness of the bank holding company or to financial
stability.

Q.16. Does that provision impose any limitations--including
limitations related to the nature, volume, range-on the
relevant FHC's physical commodities assets and activities?
Would any such limitations help to limit potential risks
presented by grandfathered commodity activities?

A.16. In addition to the scope of the grandfathered activities
and investments discussed above, section 4(o) imposes two
requirements: (1) the attributed aggregate consolidated assets
of the company held by the financial holding company
grandfathered pursuant to section 4(o), and not otherwise
permitted to be held by a financial holding company, must not
be more than 5 percent of the total consolidated assets of the
financial holding company; and (2) the financial holding
company must not permit any company, the shares of which it
owns or controls pursuant to section 4(o), to offer or market
any product or service of an affiliated depository institution
or any affiliated depository institution to offer or market any
product or service of any company, the shares of which are
owned or controlled by such holding company pursuant to section
4(o).
    As the Board noted in the ANPR, financial holding companies
grandfathered under section 4(o) may engage in a broader set of
physical commodities activities than financial holding
companies may otherwise conduct. Moreover, financial holding
companies that engage in physical commodities activities under
section 4(k)(1)(B) (complementary authority) or make merchant
banking investments in companies engaged in physical
commodities activities must conform to more restrictive
prudential limitations than those of section 4(o) described
above.
    As noted in the ANPR, the Board is considering how to
address the potential risks to safety and soundness and
financial stability that may be presented by activities
authorized under section 4(o). The ANPR seeks public comment on
whether additional prudential requirements could help ensure
that activities conducted under section 4(o) of the BHC Act do
not pose undue risks to the safety and soundness of the bank
holding company or its subsidiary depository institutions, or
to financial stability.

Q.17. Please describe any internal discussions among the FRB
staff, between 2008 and now, on the proper interpretation of
the scope and purpose of Section 4(o). Were there any competing
interpretations and, if so, what was the basis for the current
view to prevail?

A.17. As noted in the response to question 5, part a, there are
multiple possible interpretations of section 4(o) of the BHC
Act. The Board will consider this matter in connection with its
review of physical commodities activities.

Q.18. What type of research and analysis did the FRB staff
conduct to arrive at its current interpretation?

A.18. The scope of section 4(o) of the BHC Act is an issue of
statutory interpretation. Therefore, staffs research and
analysis employed the tools associated with statutory
interpretation, which included the language of section 4(o),
applicable maxims of statutory construction, the legislative
history of the Gramm-Leach-Bliley Act (GLB Act), and the
purpose of the GLB Act and the BHC Act.

Q.19. As we discussed, Section 5 of the Bank Holding Company
Act authorizes the FRB to force the sale of a nonbank affiliate
if it threatens the safety and soundness of an insured
depository institution. If a particular grandfathered activity
poses a serious risk to the safety and soundness of the FHC,
its deposit-taking subsidiary, or long-term stability of the
U.S. financial system, would the Fed be both justified and
obligated to use its powers under Section 5 of the Bank Holding
Company Act, including its power to order the relevant
institution to terminate such an activity?

A.19. Section 5(e) of the BHC Act permits the Board, under
limited circumstances, to require a bank holding company to
either terminate an activity or terminate the company's control
of its subsidiary bank(s). The Board may require action under
section 5(e) ``notwithstanding any other provision of [the BHC]
Act,'' which would include section 4(o) of the BHC Act.
    As noted, the circumstances under which the Board may act
under section 5(e) are limited. The Board must have
``reasonable cause to believe that the continuation by a bank
holding company of any activity or of ownership or control of
any of its nonbank subsidiaries, other than a nonbank
subsidiary of a bank, [(1)] constitutes a serious risk to the
financial safety, soundness, or stability of a bank holding
company subsidiary bank and [(2)] is inconsistent with sound
banking principles or with the purposes of [the BHC] Act or
with the Financial Institutions Supervisory Act of 1966.''
Section 5(e) requires the Board to make both findings.
Moreover, the first required finding (i.e., ``a serious risk to
the financial safety, soundness, or stability of a bank holding
company subsidiary bank''), is focused on risk to the
subsidiary bank.Section 5(e) also includes procedural
requirements; the Board must provide the bank holding company
due notice and an opportunity for a hearing and consider the
views of the bank's primary supervisor. Moreover, section 5(e)
leaves the bank holding company, not the Board, the choice
whether to divest the activity or divest the affiliated
depository institution.
    Finally, section 5(e) does not obligate the Board to act.
Rather, section 5(e) provides an additional authority by which
the Board may choose to address serious supervisory concerns
with a bank holding company. The Board has successfully
addressed a range of concerns related to the safety and
soundness of bank holding companies and their subsidiary
depository institutions, as well as financial stability
concerns, through other authorities such as Board supervision,
applications functions, and lesser enforcement actions.

Q.20. The following are questions related to the FRB's legal
and supervisory interpretation and use of the Section 4(k)'s
complementary provisions under the BHCA:
    Please describe how exactly the FRB monitors and supervises
FHCs' physical commodity activities and investments made under
the ``complementary'' authority.

A.20. Similar to other aspects of its program for prudential
supervision, the focus of the Federal Reserve's assessment of
physical commodities activities is the risk management
framework that supports them. The primary goals of the Federal
Reserve's supervisory oversight of commodities activities are
to (1) monitor the management of risks of those activities to
the financial holding company, and (2) assess the adequacy of
the firms' control environments relating to commodities. The
supervisory oversight, for example, includes a review of
internal management reports, periodic meetings with the
personnel responsible for managing and controlling the risks of
the firm's commodities activities, and targeted examinations of
the activities. Supervisory staff also reviews policies and
procedures, risk limits, risk mitigants, and internal audit
coverage at institutions relating to physical commodities
activities.
    The Federal Reserve has a number of supervisory staff with
knowledge and expertise in physical commodities activities.
These experts work to understand the exposures, risks, risk
management, accounting treatment, and broader commodities
markets extensively. They evaluate the different manner in
which commodities could present risks to financial holding
companies, including from a market, operational, legal and
reputational risk perspective.
    Staff has conducted horizontal reviews on physical
commodities, based on the greater involvement of the largest
financial holding companies in commodities activities, to
better compare risks and practices across institutions,
providing feedback to institutions where appropriate. During
these reviews, the teams have examined exposures, valuations,
and risk management practices across all relevant firms, and
conducted deeper reviews of the firms' operational risk
quantification methodologies that relate to commodities.
    Financial holding companies that engage in commodities
activities also must hold regulatory capital to absorb
potential losses from those activities. Financial holding
companies have long been required to hold capital against the
market risk of all commodity positions. Moreover, following the
financial crisis, the Federal Reserve strengthened its capital
requirements for the credit risk and market risk of these
transactions. Further, under the Board's advanced approaches
capital rules (12 CFR part 217, subpart E), financial holding
companies subject to these rules are required to hold capital
against the operational risk of their activities, including
their commodities activities.
    As stated previously, the Federal Reserve is seeking public
comment in the ANPR on the sufficiency of its current
supervisory and regulatory framework for constraining the risks
in the physical commodities activities of financial holding
companies.

Q.21. How does the FRB supervisory staff ensure that such
policies and procedures are, in fact, effective in addressing
all of the potential risks posed by such activities?

A.21. Please see response for Question 20.

Q.22. In your testimony, you stated the FRB has the authority
to rescind any previously authorized ``complementary'' powers
to any individual FHC.
    On what grounds can the FRB rescind a 4(k) order?

A.22. An activity is permissible under section 4(k)(1)(B) of
the BHC Act only if the activity, in the Board's determination,
is ``complementary to a financial activity and does not pose a
substantial risk to the safety and soundness of depository
institutions or the financial system generally.'' As noted in
its advance notice of proposed rulemaking released January 14,
2014, the Board is considering whether the physical commodities
activities continue to meet the requirements of section
4(k)(1)(B). Also as noted, the Board is evaluating the
potential costs and other burdens (to financial holding
companies and the public generally) associated with narrowing
or eliminating the authority to engage in such activities.

Q.23. Can a 4(k) order be reversed if the terms of the order
itself, as established by the FRB, are violated?

A.23. The Board noted in its orders approving certain financial
holding companies to engage in specified physical commodities
activities under section 4(k)(1)(B) of the BHC Act that the
Board's decisions are specifically conditioned on compliance
with all the commitments made in connection with each company's
notice to the Board. Moreover, the commitments and conditions
relied on in reaching such decisions are enforceable in
proceedings under applicable law.

Q.24. Section 4(j) requires a determination that a
complementary activity ``can reasonably be expected to produce
benefits to the public, such as greater convenience, increased
competition, or gains in efficiency, that outweigh possible
adverse effects, such as undue concentration of resources,
decreased or unfair competition, conflicts of interests,
unsound banking practices, or risk to the stability of the
United States banking or financial system.'' Can a 4(k) order
be revoked if the conditions laid out in section 4(j) no longer
apply?

A.24. Section 4(j) of the Bank Holding Company Act requires, in
connection with a notice under the subsection, the Board to
consider whether the performance of the proposed activity by
the bank holding company can reasonably be expected to produce
benefits to the public that outweigh possible adverse effects.
In its ANPR regarding physical commodities activities, the
Board also has requested comment on this matter.

Q.25. In light of public discussions on this issue, is the FRB
considering rescinding its prior grants of ``complementary''
powers to engage in physical commodity activities to individual
FHCs? If not, please explain public policy reasons for not
ordering individual FHCs to cease some or all of their
``complementary'' commodity activities.

A.25. As noted in its ANPR regarding physical commodities
activities, the Board is evaluating the potential costs and
burdens on financial holding companies and the public
associated with narrowing or eliminating the authority to
engage in Complementary Commodities Activities. The ANPR
specifically poses the question about the ways in which
financial holding companies would be disadvantaged if they did
not have authority to engage in Complementary Commodities
Activities, and how the elimination of the authority might
affect financial holding company customers and the relevant
markets.

Q.26. The following are questions related to the FRB's legal
interpretation and use of the Section 4(k)'s merchant banking
provision under the BHCA:
    Please describe how the FRB monitors and supervises FHCs'
physical commodity activities and investments made under the
merchant banking authority.

A.26. The Federal Reserve's examinations of the merchant
banking activity of financial holding companies focus on a
firm's merchant banking risk management policies and
procedures, compliance and audit, and portfolio risk ratings.
Federal Reserve staff meets regularly with the largest
financial holding companies to assess their merchant banking
activities.
    These meetings focus on the performance of merchant banking
investments and on changes in business strategy that might
warrant a closer examination. Federal Reserve staff also
reminds the firms of their obligation to avoid involvement in
the routine management of portfolio companies held under
merchant banking authority.
    The Federal Reserve's capital rules for bank holding
companies also impose significant risk based capital
requirements on merchant banking investments. \9\
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     \9\ See 12 CFR part 225, Appendix A, section II.B.5.; 12 CFR
217.152.
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    In addition, the ANPR regarding physical commodities
activities seeks comment on whether the Federal Reserve should
revise its implementing regulation for merchant banking
authority or otherwise change its supervisory or regulatory
approach to merchant banking activities of financial holding
companies. The Board is interested in public comment on ways to
better constrain the risks of merchant banking activities and
ways to better ensure that holding companies avoid engagement
in the day-to-day operations of portfolio companies.

Q.27. How does the FRB supervisory staff verify that such
policies and procedures are effectively in compliance with the
spirit and intent of the law that prohibits the use of merchant
banking authority as a way for FHCs to get into impermissible
commercial businesses?

A.27. Please see response for Question 26.

Q.28. Does the FRB collect and analyze specific data on
individual FHCs' merchant banking portfolios, other than the
information on their market value?

A.28. The Federal Reserve collects the Annual Report of
Merchant Banking Investments Held for an Extended Period
(schedule FR Y-12A). This report collects data on merchant
banking investments that are approaching the end of the holding
period permissible under Regulation Y. Data collected include
the name and location of company held, primary activity of
company held, type of interest held by the financial holding
company (e.g., common stock, preferred stock, general partner,
limited partner), percent of ownership, acquisition cost,
carrying value, and plan and schedule for disposition of the
covered investment. A financial holding company generally has
to submit an FR Y-12A if it holds shares, assets, or other
ownership interests of companies engaged in nonfinancial
activities for longer than 8 years (or 13 years in the case of
an investment held through a qualifying private equity fund).

Q.29. What are the penalties for violating the relevant
provisions of section 4 of the Bank Holding Company Act?

A.29. Section 8 of the BHC Act provides civil and criminal
penalties for companies and individuals that violate provisions
of the act or regulations or orders issued thereunder. \10\
Civil and criminal monetary penalties in amounts of up to
$25,000 and $1,000,000, respectively, may be assessed for each
day during which the violation continues. \11\ Violations of
section 8 of the BHC Act also may result in up to 5 years of
imprisonment for criminal violations. \12\ A company that fails
to make, submit, or publish reports or information required
under the BHC Act or the Board's regulations issued thereunder
or that submits or publishes any false or misleading report or
information is subject to fines ranging from $2,000 to
$1,000,000 (or 1 percent of the total assets of the company, if
such amount is less than $1,000,000). \13\
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     \10\ 12 U.S.C. 1847.
     \11\ Id. Fines of more than $100,000 per violation per day only
may be assessed for knowing violations made with the intent to deceive,
defraud, or profit significantly. Id.
     \12\ Id. Imprisonment for a term of more than 1 year per violation
only may be assessed for knowing violations made with the intent to
deceive, defraud, or profit significantly. Id.
     \13\ Id. Section 8 of the BHC Act provides a tiered penalty
structure for such actions generally based on the seriousness of the
violation. Id.
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