Betting the Business

You like potato and I like potahto,

You like tomato and I like tomahto,

Potato, potahto, tomato, tomahto!

Let’s call the whole thing off!

            from Let’s Call the Whole Thing Off by George & Ira Gershwin

This past Tuesday was the closing date for Comment Letters to the CFTC on its proposed Volcker Rule, and this gives us a second batch of responses to consider. The letter submitted by Morgan Stanley (back in February) is interesting because in Attachment 2, the company focuses specifically on commodities and provides three Example Customer Transactions that Morgan Stanley alleges would be impaired by the proposed Rule. These examples help to make concrete the actual activities that the banks allege are uniquely provided by banks and that are endangered by the Volcker Rule.

For today, let’s focus on just one of Morgan Stanley’s three examples:

Example B, Helping a Major U.S. Airline Reduce Jet Fuel Related Costs.

As part of a Chapter 11 restructuring, a leading U.S. airline sought Morgan Stanley’s help to reduce its operating costs, working capital requirements, and balance sheet usage associated with its jet fuel supply. Prior to bankruptcy, the airline managed a large jet fuel supply operation in which it maintained up to a month’s inventory, creating significant operational overhead and a need for costly financing. To reduce these expenses, Morgan Stanley provided the airline a long-term contract for delivery of jet fuel, typically one day prior to the airline’s daily need to service its fleet. Morgan Stanley provided all logistical support and sold the airline jet fuel at a lower price than it was paying previously. This enabled the airline to reduce its operating expenses, reduce the size of its balance sheet and lower its overall interest expense.

I’m missing the part where Morgan Stanley explains how this is market making. They may call this market making, but I call it the jet fuel logistics business. The airline is subcontracting out a specialized function, one step in the air travel value chain. Lots of companies subcontract certain functions. This allows them to focus their managerial talent on the elements of the value chain on which they have a comparative advantage. My university has a contract with an electricity company to market the power our generator produces and to provide the balance of its fluctuating need for electric power on stable price terms. Hopefully we save money that way: the university has actively explored going into the wholesale electricity market on its own behalf, but rejected that option. The real estate company that owned and managed the downtown office building in which I worked subcontracted for janitorial services and for cafeteria services. Each of these subcontracted functions involves providing a real service quite distinct from making a market in financial securities. And Morgan Stanley’s jet fuel business provides a real service, too. It’s just not market making in financial securities. One can imagine that Morgan Stanley’s ability to offer jet fuel logistics services on favorable terms benefits from the banks expert analysis of volatile petroleum product prices, and also on its ability to trade in both the physical and financial petroleum and petroleum product markets. But none of that transforms the business into market making. There are plenty of non-banks that provide exactly this kind of logistics services in all kinds of commodities. Think Glencore, Cargill, etc. And all of these non-banks have had to master the markets in order to price their services competitively. Trading in financial securities may be useful to providing the logistics services, but it doesn’t turn it into market making.

Morgan Stanley, like several other banks, does some business in real commodities and related physical business. As we’ve pointed out elsewhere on this blog, many so-called end-users also conduct finance business underneath the same holding company–see here and here. Similarly, many banks provide non-financial services underneath the same holding company–see this post about Goldman Sachs. Just because a service is offered by a company best known as a non-financial company does not mean that service is a non-financial service, and just because a service is offered by a company best known as a financial company does not mean that service is a financial service. A lot of what commodity trading desks at the big banks do has nothing to do with market making

In an earlier post, I criticized a study by the consulting company IHS which was commissioned by Morgan Stanley. One of the key and faulty assumptions in that study is the claim that if the market making services can no longer be housed inside a bank, then the same service cannot be provided as readily or efficiently outside of a bank. Morgan Stanley’s jet fuel example helps to highlight what is so wrong about this assumption. Morgan Stanley currently faces direct competition from many non-banks on this front. And Morgan Stanley never provides any evidence or explanation to motivate understanding their jet fuel business as uniquely benefiting from being housed within a bank. If implementation of the Volcker Rule were to push Morgan Stanley out of the jet fuel business, that very same business unit could operate equally well without the Morgan Stanley name.