[Federal Register Volume 68, Number 128 (Thursday, July 3, 2003)]
[Rules and Regulations]
[Pages 39807-39810]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-16835]


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FEDERAL RESERVE SYSTEM

12 CFR Part 225

[Regulation Y; Docket No. R-1146]


Bank Holding Companies and Change in Bank Control

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Final rule.

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SUMMARY: The Board of Governors of the Federal Reserve System is 
adopting an

[[Page 39808]]

amendment to Regulation Y that would permit bank holding companies to 
(i) take and make delivery of title to commodities underlying commodity 
derivative contracts on an instantaneous, pass-through basis; and (ii) 
enter into certain commodity derivative contracts that do not require 
cash settlement or specifically provide for assignment, termination, or 
offset prior to delivery.

DATES: The final rule is effective August 4, 2003.

FOR FURTHER INFORMATION CONTACT: Mark E. Van Der Weide, Counsel (202/
452-2263), or Andrew S. Baer, Counsel (202/452-2246), Legal Division. 
For users of Telecommunications Device for the Deaf (TDD) only, contact 
202/263-4869.

SUPPLEMENTARY INFORMATION:

Background

    The Board's Regulation Y currently authorizes bank holding 
companies (``BHCs'') to engage as principal in forward contracts, 
options, futures, options on futures, swaps, and similar contracts, 
whether traded on exchanges or not, based on a rate, price, financial 
asset, nonfinancial asset, or group of assets (other than a bank-
ineligible security) (``Commodity Contracts''). A BHC's authority to 
enter into Commodity Contracts is subject to certain restrictions that 
are designed to limit the BHC's activity to trading and investing in 
financial instruments rather than dealing directly in commodities. In 
particular, Regulation Y provides that a BHC may enter into a Commodity 
Contract only if (i) the commodity underlying the contract is eligible 
for investment by a state member bank; or (ii) the contract requires 
cash settlement; or (iii) the contract allows for assignment, 
termination, or offset prior to delivery or expiration (the 
``Contractual Offset Requirement''), and the BHC makes every reasonable 
effort to avoid taking or making delivery of the underlying commodity 
(the ``Delivery Avoidance Requirement'').\1\
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    \1\ 12 CFR 225.28(b)(8)(ii)(B).
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    The effect of these restrictions is to allow a BHC to engage as 
principal in cash-settled derivative contracts involving any type of 
commodity (other than certain derivative contracts involving bank-
ineligible securities) but to limit the authority of a BHC to engage in 
physically settled derivative contracts. Under these restrictions, a 
BHC may take and make delivery on physically settled derivatives 
involving commodities that a state member bank is permitted to own.\2\ 
For all other types of physically settled derivatives,\3\ a BHC must 
make reasonable efforts to avoid delivery, and the contract must have 
assignment, termination, or offset provisions.
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    \2\ State member banks may own, for example, investment grade 
corporate debt securities, U.S. government and municipal securities, 
foreign exchange, and certain precious metals.
    \3\ These would include derivative contracts based on, for 
example, energy-related commodities and agricultural commodities.
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    The Bank Holding Company Act (``BHC Act''), as amended by the 
Gramm-Leach-Bliley Act (Pub. L. 106-102, 113 Stat. 1338 (1999)) (``GLB 
Act''), permits a BHC to engage in activities that the Board had 
determined were closely related to banking, by regulation or order, 
prior to November 12, 1999. A BHC must conduct these activities in 
accordance with the terms and conditions contained in such regulations 
and orders, unless modified by the Board.
    In response to requests by Citigroup Inc., New York, New York 
(``Citigroup''), and UBS AG, Zurich, Switzerland (``UBS''), the Board 
issued a proposal in March 2003 that would modify the restrictions in 
Regulation Y to allow BHCs to enter into derivative contracts that 
typically result in taking and making delivery of title to, but not 
physical possession of, commodities on an instantaneous, pass-through 
basis (regardless of whether the contracts contain specific assignment, 
termination, or offset provisions).\4\ The Board received six public 
comments on the proposal: two from banking organizations, three from 
financial services trade associations, and one from an individual. The 
five financial services commenters supported the proposal and offered 
no general or specific criticisms of the proposal. These commenters 
believed that the Board's proposal would enhance the ability of banking 
organizations to serve as financial intermediaries and satisfy customer 
needs and would improve liquidity and competition in a number of 
commodity markets.
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    \4\ See 68 FR 12316, March 14, 2003. Citigroup and UBS also have 
asked the Board to allow financial holding companies to take and 
make physical delivery of a limited amount of commodities as an 
activity that is incidental or complementary to engaging as 
principal in BHC-permissible Commodity Contracts. The Board 
continues to review these broader requests. Several commenters on 
the proposed rule expressed support for Board approval of these 
broader requests by Citigroup and UBS.
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    The individual commenter expressed opposition to the proposal. The 
commenter asserted that the proposal would reduce the stability of the 
financial system by permitting banking organizations to engage in risky 
activities. The commenter also contended that permitting banking 
organizations to participate in a wider variety of derivatives markets 
would increase the scope of potential conflicts of interest for banking 
organizations.

Final Rule

    After carefully reviewing the public comments on the proposal, the 
Board has determined to modify the conditions that the Board imposed in 
Regulation Y on the permissible derivatives activities of BHCs to 
permit BHCs to enter into Commodity Contracts that are settled by the 
BHC receiving and transferring title to the underlying commodity 
instantaneously, by operation of contract, and without taking physical 
possession of the commodity. The final rule also modifies the existing 
condition in Regulation Y that generally prevents BHCs from engaging as 
principal in a physically settled Commodity Contract unless the 
contract specifically provides for assignment, termination, or offset 
prior to delivery.
    The Board adopted the restrictions in Regulation Y on the types of 
Commodity Contracts that a BHC may enter into as principal to reduce 
the potential that BHCs would become involved in and bear the risks of 
physical possession, transport, storage, delivery, and sale of bank-
ineligible commodities. The restrictions ensure that the commodity 
derivatives business of a BHC is largely limited to acting as a 
financial intermediary that facilitates transactions for customers who 
use or produce commodities or are otherwise exposed to commodity price 
risk as part of their regular business.
    The Regulation Y derivatives restrictions, however, have impeded 
the ability of BHCs to participate substantially in certain derivatives 
markets. Notably, in some over-the-counter forward markets (U.S. energy 
markets, for example), the physically settled derivative contracts 
traded by market participants do not specifically provide for 
assignment, termination, or offset prior to delivery and, thus, do not 
conform to the Contractual Offset Requirement of Regulation Y. 
Moreover, participants in these markets generally settle contracts by 
temporarily taking and making delivery of title to the underlying 
commodities and, thus, do not comply with the Delivery Avoidance 
Requirement of Regulation Y.
    Financial intermediary participants in these markets generally 
enter into back-to-back derivative contracts with third parties that 
effectively offset each other.

[[Page 39809]]

That is, financial intermediaries in these markets that enter into a 
contract to buy, for example, a certain number of barrels of oil from a 
certain counterparty in a certain future month generally also will 
enter into another contract, prior to the expiration of the original 
contract, to sell the same number of barrels of oil to another 
counterparty in the same future month on substantially identical 
delivery terms. These market practices typically result in the creation 
of a chain of contractual relationships that begins with a commodity 
producer, passes through a number of intermediaries who have entered 
into matched contracts both to buy and sell the same commodity at the 
same future time, and ends with a purchaser that intends to take 
physical delivery of the commodity. On the maturity date of the 
derivative contracts, the producer will be responsible for making 
physical delivery and the ultimate buyer will be responsible for 
accepting physical delivery, while each intermediate participant in the 
chain will be deemed, by operation of contract, to have instantaneously 
received and transferred legal title to the commodity.
    The Board believes that a BHC that takes title to a commodity on an 
instantaneous, pass-through basis takes no risk that is greater than or 
different in kind from the risk that the BHC has as a holder of a 
commodity derivative contract that meets the current requirements of 
Regulation Y. Instantaneous receipt and transfer of title to (but not 
physical possession of) commodities does not appear to involve the 
usual activities relating to, or risks attendant on, commodity 
ownership. Instead, such transactions involve the routine operations 
functions of passing notices, documents, and payments--functions that 
BHCs regularly perform in their role as financial intermediaries in 
other markets. Moreover, although BHCs that receive and transfer title 
to commodities on an instantaneous, pass-through basis face default 
risks, they are not significantly different than the default risks 
associated with cash-settled derivative contracts or derivative 
contracts that include the assignment, termination, or offset 
provisions currently required by Regulation Y.\5\
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    \5\ Although one commenter expressed concern that the rule would 
facilitate excessive risk taking by BHCs, the commenter provided no 
evidence in support of this position. For the reasons discussed 
above, the Board does not believe that the rule will expose BHCs to 
different types or heightened levels of risk.
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    The final rule's modifications to Regulation Y will enable BHCs 
that participate in commodity derivatives markets to provide their 
customers with a more comprehensive range of financial intermediation 
and risk management services. In addition, the final rule should 
enhance the ability of BHCs to compete effectively with non-BHC 
participants in the commodity derivatives markets (who currently are 
able to engage in physically settled derivative transactions with 
customers). Moreover, by expanding the types of derivative transactions 
in which BHCs may engage, the final rule should augment the capacity of 
BHCs to understand commodity markets and to diversify the market, 
credit, and other risks involved in derivatives trading.
    In addition, the Board does not believe that the final rule will 
materially increase the conflicts of interest faced by BHCs that 
participate in the commodity derivatives markets or result in any other 
material adverse effects. Although the final rule will enable 
derivatives affiliates of BHCs to use a wider variety of transaction 
formats, the rule will not expand the types of commodities that may 
serve as the basis for derivative transactions engaged in by BHCs. 
Importantly, banking organizations are subject to a number of Federal 
banking laws designed to prevent conflicts of interest, including 
sections 23A and 23B of the Federal Reserve Act and section 106 of the 
Bank Holding Company Act Amendments of 1970.\6\ Moreover, banking 
organizations that engage in derivatives activities, including the 
commodity derivatives activities newly authorized by the final rule, 
would remain subject to the general securities, commodities, and energy 
laws and the rules and regulations of the Securities and Exchange 
Commission, the Commodity Futures Trading Commission (``CFTC''), and 
the Federal Energy Regulatory Commission.\7\
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    \6\ See 12 U.S.C. 371c, 371c-1, 1972.
    \7\ Although one commenter asserted that the rule would result 
in increased conflicts of interest for BHCs, the Board is not aware 
of, and the commenter has not presented, any evidence in support of 
this position. For the reasons discussed above, the Board does not 
believe that the rule will materially increase the conflicts of 
interest faced by BHCs that trade commodity derivatives.
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    For these reasons, the Board's final rule modifies Regulation Y by 
changing the Delivery Avoidance Requirement to allow BHCs to take or 
make delivery of title to commodities underlying commodity derivative 
transactions on an instantaneous, pass-through basis. A BHC takes and 
makes delivery of title to a commodity on an instantaneous, pass-
through basis for purposes of the final rule only if the BHC takes 
delivery of title to the commodity from a seller and immediately 
thereafter makes delivery of title to the commodity to a buyer. 
Accordingly, the revised Delivery Avoidance Requirement would not 
provide authority for a BHC to take physical delivery of commodities 
for use or investment or to make physical delivery of commodities out 
of the inventory of the BHC. In other words, the BHC must not be the 
original seller of the commodity in the initial position in the 
delivery chain or the ultimate buyer of the commodity in the last 
position in the delivery chain.
    The Board's final rule also modifies Regulation Y by changing the 
Contractual Offset Requirement to permit BHCs to participate in 
physically settled derivative markets where the standard industry 
documentation does not allow for assignment, termination, or offset. In 
particular, the rule would allow BHCs to enter into Commodity Contracts 
that do not require cash settlement or specifically provide for 
assignment, termination, or offset prior to delivery so long as the 
contracts involve commodities for which futures contracts have been 
approved for trading on a U.S. futures exchange by the CFTC (and the 
BHC complies with the revised Delivery Avoidance Requirement).\8\
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    \8\ The CFTC publishes annually a list of the CFTC-approved 
commodity contracts. See Commodity Futures Trading Commission, FY 
2001 Annual Report to Congress 126. With respect to granularity, the 
Board intends this requirement to include all types of a listed 
commodity. For example, any type of coal or coal derivative contract 
would satisfy this requirement, even though the CFTC list 
specifically approves only Central Appalachian coal.
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    A number of commenters expressed specific support for this 
modification of the Contractual Offset Requirement. Because derivative 
contracts based on commodities approved for exchange trading are more 
likely to have reasonably liquid markets than derivatives based on non-
approved commodities, this modified requirement should continue to 
provide some assurance that BHCs would be able to avoid physical 
delivery of commodities underlying derivative contracts. This 
requirement would, therefore, serve the same purpose as the current 
Contractual Offset Requirement, which facilitates the financial 
settlement of Commodity Contracts by requiring BHCs to have contractual 
rights to avoid taking or making delivery of the underlying 
commodities.\9\
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    \9\ One commenter asked whether the rule would authorize BHCs to 
engage in activities incidental to engaging in the derivative 
transaction types newly authorized by the rule, such as entering 
into service arrangements with operators of pipelines, power grids, 
and similar facilities. A BHC may engage in any incidental 
activities that are necessary to allow the BHC to engage in the 
derivative transaction types newly authorized by the rule. 12 CFR 
225.21(a)(2).

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[[Page 39810]]

    These modifications to the derivatives provisions in Regulation Y 
would be effective for all BHCs. The GLB Act preserved the Board's 
authority to modify the terms and conditions that apply to any BHC 
activity approved by the Board before November 11, 1999.\10\ The Board 
had authorized BHCs to engage as principal in commodity derivative 
transactions prior to November 11, 1999. The final rule would represent 
a relaxation of the current limitations that apply to the conduct of a 
derivatives activity already approved by the Board under Regulation Y, 
and would not create a new permissible activity for BHCs.\11\
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    \10\ See 12 U.S.C. 1843(c)(8).
    \11\ The Board notes that, subsequent to the Board's issuance of 
the proposed rule, the Office of the Comptroller of the Currency 
(``OCC'') approved a request by Bank of America, N.A., to engage in 
customer-driven electricity derivative transactions that involve the 
transitory transfer of title to electricity. See OCC Interpretive 
Letter No. 962 (April 21, 2003).
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Plain Language

    Section 722 of the GLB Act requires the Board to use ``plain 
language'' in all proposed and final rules published after January 1, 
2000. In light of this requirement, the Board has sought to present the 
final rule in a simple and straightforward manner. No commenter on the 
proposed rule asked the Board to take additional steps to make the rule 
easier to understand.

Regulatory Flexibility Act

    In accordance with section 3(a) of the Regulatory Flexibility Act 
(5 U.S.C. 603(a)), the Board must publish a final regulatory 
flexibility analysis with this final rule. The final rule expands the 
scope of permissible commodity derivatives activities for a bank 
holding company. A description of the reasons for the Board's decision 
to issue the final rule and a statement of the objectives of, and legal 
basis for, the rule are contained in the supplementary material 
provided above. The final rule applies to bank holding companies 
regardless of their size and should enhance the ability of all bank 
holding companies, including small ones, to compete with other 
providers of financial services in the United States and to respond to 
changes in the marketplace in which banking organizations compete. The 
comments received by the Board on the proposed rule did not indicate 
that the rule would impose burden on bank holding companies of any 
size.

Paperwork Reduction Act

    In accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
3506; 5 CFR 1320 Appendix A.1), the Board has reviewed the final rule 
under authority delegated to the Board by the Office of Management and 
Budget. The rule contains no collections of information pursuant to the 
Paperwork Reduction Act.

List of Subjects in 12 CFR Part 225

    Administrative practice and procedures, Banks, Banking, Federal 
Reserve System, Holding companies, Reporting and recordkeeping 
requirements, Securities.

Authority and Issuance

0
For the reasons set forth in the preamble, the Board amends 12 CFR part 
225 as follows:

PART 225--BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL 
(REGULATION Y)

0
1. The authority citation for part 225 continues to read as follows:

    Authority: 12 U.S.C. 1817(j)(13), 1818, 1828(o), 1831i, 1831p-1, 
1843(c)(8), 1843(k), 1844(b), 1972(1), 3106, 3108, 3310, 3331-3351, 
3907, and 3909.


0
2. Section 225.28 is amended by revising paragraph (b)(8)(ii)(B) to 
read as follows:


Sec.  225.28  List of permissible nonbanking activities

* * * * *
    (b) * * *
    (8) * * *
    (ii) * * *
    (B) Forward contracts, options, futures, options on futures, swaps, 
and similar contracts, whether traded on exchanges or not, based on any 
rate, price, financial asset (including gold, silver, platinum, 
palladium, copper, or any other metal approved by the Board), 
nonfinancial asset, or group of assets, other than a bank-ineligible 
security,\12\ if:
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    \12\ A bank-ineligible security is any security that a state 
member bank is not permitted to underwrite or deal in under 12 
U.S.C. 24 and 335.
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    (1) A state member bank is authorized to invest in the asset 
underlying the contract;
    (2) The contract requires cash settlement;
    (3) The contract allows for assignment, termination, or offset 
prior to delivery or expiration, and the company--
    (i) Makes every reasonable effort to avoid taking or making 
delivery of the asset underlying the contract; or
    (ii) Receives and instantaneously transfers title to the underlying 
asset, by operation of contract and without taking or making physical 
delivery of the asset; or
    (4) The contract does not allow for assignment, termination, or 
offset prior to delivery or expiration and is based on an asset for 
which futures contracts or options on futures contracts have been 
approved for trading on a U.S. contract market by the Commodity Futures 
Trading Commission, and the company--
    (i) Makes every reasonable effort to avoid taking or making 
delivery of the asset underlying the contract; or
    (ii) Receives and instantaneously transfers title to the underlying 
asset, by operation of contract and without taking or making physical 
delivery of the asset.
* * * * *

    By order of the Board of Governors of the Federal Reserve 
System, June 27, 2003.
Jennifer J. Johnson,
Secretary of the Board.
[FR Doc. 03-16835 Filed 7-2-03; 8:45 am]
BILLING CODE 6210-01-P