OCC Bulletin 2015-35 | August 4, 2015

Risk Management of Financial Derivatives: Quantitative Limits on Physical Commodity Transactions

To

Chief Executive Officers of National Banks and Federal Branches and Agencies of Foreign Banks; All Department and Division Heads; All Examining Personnel; and Other Interested Parties

Summary

This bulletin clarifies the Office of the Comptroller of the Currency's (OCC) expectations regarding the extent to which national banks and federal branches or agencies of a foreign bank (collectively, banks) may make or take delivery of a physical commodity to hedge commodity derivatives transactions.¹ Specifically, the bulletin provides calculation guidance for determining whether physical hedging activities are a nominal portion of risk management activities. The OCC considers physical hedging positions to be nominal only when the bank's commodity position is no more than 5 percent of the notional value of the bank's derivatives that (1) are in that same particular commodity and (2) allow for physical settlement within 30 days. This bulletin supplements Banking Circular 277 (BC-277), "Risk Management of Financial Derivatives" (October 27, 1993).

Note for Community Banks

This guidance applies to commodity derivatives transactions in which a bank, including a community bank, hedges its exposure by owning a physical commodity. Community banks rarely engage in commodity derivatives, and even more rarely use a physical commodity to hedge such a transaction.

Highlights

This bulletin

supplements BC-277, which outlines the OCC's supervisory expectations for prudent risk management of financial derivatives.
clarifies when a bank's physical commodity hedging transactions constitute a nominal percentage of the bank's risk management activities.
clarifies the OCC's expectation that a bank, before engaging in physical commodity hedging activities, will submit to the OCC a detailed plan for such activities and receive a written OCC supervisory nonobjection.

Background

BC-277 provides guidance on risk management practices to banks engaging in financial derivatives activities. The guidelines in BC-277 represent prudent practices that enable banks to conduct financial derivatives activities in a safe and sound manner.

As described in BC-277, a bank that satisfies certain conditions may engage in physical commodity transactions (for example, by buying or selling title to a commodity via a warehouse receipt or bill of lading) to manage the risks of commodity derivatives. One condition is that the physical commodity transactions constitute a nominal percentage of the bank's risk management activities. BC-277 does not, however, detail what percentage of risk management activities is "nominal," nor does it provide a calculation methodology for this condition.²

A bank's physical hedges are a nominal percentage of its risk management activities only if, for each commodity, the value of the position in that commodity (long or short) is no more than 5 percent of the notional value of derivatives contracts in that commodity that allow for settlement through physical delivery within 30 days. More specifically, for each physical commodity³ "C" that underlies a commodity derivative transaction (including a future, forward, or option) to which the bank is a party, the bank's physical commodity transactions in C are nominal only when

where

"value of physical C" is the carrying value of the bank's physical holdings of C, measured at the end of the business day,⁴ and
"value of contracts for C" is the gross notional value (i.e., the sum of the absolute value of notionals) of the bank's contracts for C that allow for settlement through physical delivery of C⁵ within the next 30 days, measured at the end of the business day.

This limit applies to each commodity that underlies any of the bank's commodity derivatives. C refers to a particular commodity specified in a derivative that contemplates physical delivery within 30 days, including (as applicable) the commodity's delivery point, purity, grade, chemical composition, weight, and size. This limit ensures that the bank keeps physical inventory of a particular commodity to levels commensurate with its need to make or take physical delivery of that commodity.

The OCC continues to expect banks to present a detailed plan to the OCC, and to obtain prior written nonobjection of the OCC's supervisory staff, before engaging in physical commodity hedging activities. The plans should address the supervisory expectations discussed in BC-277 and relevant OCC precedent.⁶ Banks should submit a detailed plan for each commodity for which they plan to make or take physical delivery.

Further Information

Please contact Kurt Wilhelm, Director, Financial Markets Group, at (202) 649-6416.

Jennifer C. Kelly
Senior Deputy Comptroller and Chief National Bank Examiner

¹ The OCC has not issued any legal interpretation that federal savings associations may make or take delivery of physical commodities to hedge commodity derivatives.

² In OCC Interpretive Letter 684 (August 4, 1995), the requesting bank represented that no more than 5 percent of its commodity hedges would involve actual physical delivery.

³ Financial instruments, intangible assets or rights, and indices are not physical commodities.

⁴ A physical commodity that the bank acquired and then immediately sold by transitory title transfer would not be included in the bank's physical inventory of that commodity.

⁵ Contracts that allow physical settlement include futures, forwards, options, some swaps, and combinations of these contracts.

⁶ Refer to, for example, OCC Interpretive Letter 684.