While the battle over proprietary trading and new derivatives regulations has taken place largely in public view since the 2008 financial crisis, the fight by JPMorgan Chase, Morgan Stanley and Goldman Sachs to retain or expand their prized physical commodity operations - most acquired in only the past six years - has remained hidden.

The debate is nearing an inflection point: Within 18 months, the Fed will likely either allow banks more freedom to invest in the physical commodity world than ever; or force them to sell off the assets that many banks are counting on to buttress their trading books at a time when they are already vulnerable because of intensifying competition and new trading curbs.

The banks are now locked in deep debate with the Fed, multiple sources involved in the discussions told Reuters. Goldman and Morgan Stanley argue the right to own such assets is 'grandfathered' in from their lightly-regulated investment banking days, or that at least they should be allowed to retain them as "merchant banking" investments, kept segregated from the trading desks.

But regulators and lawmakers may not be in the mood to give way. Banks are under pressure to reduce risk on their balance sheet; as commodity prices rise again, they may face more allegations that they could use these assets to drive prices higher or lower, squeezing them for trading profits.

"The Fed's not going to be terribly accommodating," said Oliver Ireland, a former associate counsel to the U.S. Federal Reserve and a partner with law firm Morrison Foerster in Washington, D.C. "There doesn't seem to be a lot of sentiment in this town for people doing new things and taking new risk."

Should these banks lose the debate, the result may be the biggest shake-up in commodity markets since the early 1980s, when Wall Street first discovered the potential profits to be made by wading deep into the murky world of crude oil cargoes, copper stockpiles and power plants.

"Adding large-scale, complex commodity market activities to "too-big-to-fail" bank portfolios, with dangerous potential ramifications to the real economy - as demonstrated in California by Enron - is not comforting," says John Fullerton, who ran JPMorgan's commodity business in the 1990s, and is now a markets activist at the Capital Institute in Connecticut.

The loss of their coveted assets would be a blow for the banks at the worst possible moment, with their proprietary trading desks shut down, commodity merchants trying to poach their top traders and new Basel III capital regulations requiring them to further build capital reserves.

Morgan Stanley's commodity trading revenues have fallen by some 60 percent over the past three years. Goldman Sachs' commodities business revenues fell from $4.6 billion in 2009 to $1.6 billion in each of the past two years.

The Fed declined to discuss specific companies directly or the likely final outcome of the talks. Spokespeople for Morgan Stanley, Goldman Sachs and JPMorgan declined to comment on detailed questions put to them by Reuters.

A CHANGE OF HEART

To a degree, it is a story that has been hiding in plain sight. In last year's second-quarter Securities and Exchange Commission filing, Morgan Stanley added the following new text to its lengthy Supervision and Regulation disclaimer:

"The company is engaged in discussions with the Federal Reserve regarding its commodities activities. If the Federal Reserve were to determine that any of the company's commodities activities did not qualify for the BHC (Bank Holding Company) Act grandfather exemption, then the company would likely be required to divest any such activities."

That disclosure was made at about the same time the bank began to have second thoughts about a new $430 million storage tank investment undertaken by its publicly listed oil transport and logistics subsidiary TransMontaigne, according to two people familiar with the transaction. In October, TransMontaigne reduced its stake in the project to 50 percent; it sold the rest in January.

The bank's abrupt change of stance last year is the clearest sign yet that the Federal Reserve may be taking a harder line.

Yet it may be JPMorgan, which has eclipsed long-time market leaders Goldman and Morgan under commodities chief Blythe Masters, that will be first to feel its effects.

The bank has begun sounding out possible buyers for its small operation trading metal concentrates, according to one source who examined the business late last year. It acquired that business when it bought most of RBS Sempra in mid-2010, but because metal concentrates aren't traded on any exchange they were not covered by a 2008 Federal Reserve order that allowed RBS to begin trading physical commodities.

More importantly, the sale has also raised questions about JPMorgan's ownership of its global metals warehousing business Henry Bath, which had also been excluded from the RBS waiver. The Fed's rules give banks a two-year grace period in which to divest any non-compliant businesses they acquire; sources say it's not clear why JPMorgan would be exempt from this rule.

Goldman too faces scrutiny of its ownership of Detroit-based metal warehousing firm Metro International. Goldman has come under fierce criticism from companies such as Coca-Cola, which has accused it of inflating metal prices.

Since buying the privately held firm in early 2010, the bank has taken great pains to avoid any direct involvement in its business to minimize regulatory scrutiny, according to two industry sources. But questions remain.

The warehouses are lucrative on their own: As surplus metal stocks accumulated during the recession, profits at the UK-based Henry Bath surged to more than $110 million in 2009 and near $80 million in 2010, about $1 million per employee per year, according to annual reports filed to UK Companies House in November. These units could, in theory, be run as "merchant banking" investments, as with Metro, but that requires they be kept at arm's length and divested within 10 years.

But for trading firms, that's only half the benefit.

"The truth of it is that having access to the physical markets is about optimization and knowledge - it gives you the visibility of the market to make far more successful proprietary trading decisions in both physical and financial markets," said Jason Schenker, President and Chief Economist at Prestige Economics in Austin, Texas.

"That's why for many years the most successful traders had access to both markets, and why we've seen little sign they're moving quickly to divest these assets now. It's trading with material non-public information - the difference compared with equity markets is that it's perfectly legal."

Based on past precedent, financial holding companies would still be allowed to be involved in trading physical commodities like oil or metals, even if they are not allowed to outright own the physical infrastructure which supports their operations.

Between 2003 and 2008, the Federal Reserve granted permission for nearly a dozen banks to engage in such trading, which it deemed "complementary" to financial operations within certain limits. Citigroup was the first in, seeking approval on behalf of its aggressive trading unit Phibro.

But there are signs that the Fed may be reassessing. The permit to form RBS Sempra in March 2008 is one of the last it has granted, according to the Fed's quarterly bulletins. That took eight months to negotiate, and covered a range of activities including third-party refining that the Fed had not previously approved.

In 2009, Bank of America told the Fed of its plans to trade a broad range of commodities following its acquisition of Merrill Lynch, which had not been subject to Fed regulations, a source familiar with the discussion said. BoA secured its own approval from the Fed to engage in physical trading in 2007, but Merrill's operation was much larger -- although still within the scope of what the Fed had approved for other banks such as RBS.

That request is still pending, the source said, even though BoA has not sought permission to own or operate physical assets.

"Beginning in 2009, we have been working with regulators to ensure that we will continue to service our clients in the physical commodity market with products and services on which they have relied," a BoA spokeswoman told Reuters in response to questions.

On the other hand, if the Fed allows Goldman, Morgan Stanley and JPMorgan to retain all their assets, it may open up a Pandora's Box. Rivals are already up in arms about the potential for a competitive disadvantage.

"It's a space we'd love to be in, but have had to limit our investments to Europe and Asia due to the Financial Holding Company regulations," one lawyer with a rival European bank said.

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Banks' commodity revenues: link.reuters.com/xam86s

Morgan Stanley's revenues: link.reuters.com/kyb86s

Henry Bath profits: link.reuters.com/reb86s

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BANKS UNDER PRESSURE

It wasn't supposed to be like this.

After Goldman Sachs and Morgan Stanley converted to Bank Holding Companies at the peak of the financial crisis to gain emergency access to discounted Fed funds, many bankers confidently predicted that they would be able to carry on trading in much the same way as before.

Despite the Fed's longstanding stance that its regulated banks should not own commercial enterprises to avoid distorting the real economy or opening them up to untold environmental, operational or legal risks, Wall Street's giants felt sure they were protected by a key passage in the Gramm-Leach-Bliley Act of 1999.

That law - which effectively scrapped part of the 1933 Glass-Steagall law separating commercial and investment banks - says that any investment bank that converted to holding company status after 1999 could continue to trade or own physical assets if it had done so prior to September 30, 1997.

But the passage was extraordinarily vague. If they were trading physical commodities in 1997, as both Goldman and Morgan were, would they be allowed to buy hard assets later? If they traded gasoline, could they also buy shipping fuel?

The debate over how broadly or narrowly to interpret that clause has already consumed two-thirds of the five-year grace period that they were automatically granted when they became BHCs. Morgan Stanley says it has already secured two of three possible one-year extensions on the initial two-year waiver; the deadline looms in November 2013.

Banks may be hoping that this year's U.S. presidential election ushers in a more banking-friendly political environment, says Shannon Burchett, who was previously an energy trader with commodity firm Phibro when it was part of Salomon Brothers, and is now chief executive of Risk Ltd. in Dallas, Texas.

"It's a political wildcard right now," he says. "The leading Republican candidates have indicated that while they might not repeal Dodd-Frank, they might certainly reduce it."

Meanwhile, rivals are not standing still. On Friday, Russia-backed global oil trader Gunvor said it would buy insolvent Petroplus' refinery in Antwerp, Belgium.

KING OF THE ARB

In the early 1990s, Morgan Stanley oil trader Olav Refvik earned the moniker 'King of New York Harbor' by securing a host of leases on storage tanks at the key import hub, giving the company an enviable position in the market. Refvik left Morgan in 2008 and now works for commodity trader Noble.

Morgan Stanley bought terminal and logistics firm TransMontaigne and tanker operator Heidmar in 2006. Heidmar would grow to ship almost 750 million barrels of oil last year, the equivalent of roughly 8 days of global demand.

Last year, using TransMontaigne's own tanker truck fleet to haul oil, Morgan was one of the only traders able to take advantage of an unprecedented $25 a barrel gap between oil prices at the U.S. storage hub at Cushing, Oklahoma, and prices 500 miles south on the Gulf coast. Many other traders failed to find transport firms willing to lease them trucks.

In 2010, TransMontaigne joined a $430 million project to build a 6.6-million-barrel oil terminal on the Houston Shipping canal supplying black oil and residual fuel for ships, power plants and industrial operations.

But in mid-2011, the Morgan Stanley began to get cold feet over the venture, the Battlefield Oil Specialty Terminal (BOSTCO), concerned that it could be a red flag to regulators, according to a person familiar with the project.

"This issue really didn't rise to the fore until the middle of last year," said the person, who declined to be named.

In October, TransMontaigne sold half its stake in the project to Kinder Morgan Energy Partners because of "the uncertain regulatory environment relating to Morgan Stanley's status as a financial holding company". Chief executive Chuck Dunlap said Morgan Stanley would no longer approve any "significant" acquisition or investment by his firm.

In January, TransMontaigne sold the rest of its share to Kinder Morgan, but with an option for TransMontaigne to buy back a 50-percent share at any point before January 2013 - a twist that gave the firm a way back in if the regulatory pressure eased.

In 2008 Morgan Stanley sold 49 percent of Heidmar to Shipping Pool Investors Inc. and 2 percent to Heidmar's own management, reducing Morgan's share to a 49-percent minority.

Morgan Stanley says in its filings that it does not believe any possible forced divestment would have a "material adverse impact" on its overall earnings.

Tim Brennan, Chief Executive of Heidmar, told Reuters he had not discussed any possible divestment with Morgan Stanley: "Morgan Stanley have really left us to get on with running the business," he said. "I don't think there's any reason to be concerned."

JPMORGAN RALLIES

JPMorgan was already regulated as a financial holding company in 2008, and therefore can't claim any grandfathering exemption. But two big acquisitions have brought it deep into the debate.

As a result of its hastily arranged takeover of investment bank Bear Stearns early in the financial crisis in March 2008, JPMorgan inherited a firm called Arroyo Energy, which owns several power plants in the Southeast. The Fed gave JPMorgan some latitude at the time, but it is not clear whether the bank will be able to keep the assets beyond five years.

In July 2010, Masters closed a $1.7 billion deal to buy the global metal and energy trading units of RBS Sempra, a crowning achievement that expanded the bank's physical footprint to 25 locations with more than 130 storage and warehousing facilities.

But there was a catch.

When UK-based Royal Bank of Scotland bought into Sempra Commodities in 2008, the Fed said the unit would have to sell off the U.S. assets of the Henry Bath warehousing company, according to three sources familiar with the deal.

That left open whether JPMorgan would be allowed to continue owning the same operations that RBS had been asked to divest. Fed regulations require a financial holding company to divest any disallowed activities within two years of a transaction, although the board can apply to extend that deadline if it chooses. The two-year anniversary is July 1.

Unlike Goldman Sachs, JPMorgan does not appear to be distancing itself from the warehousing unit.

Henry Bath named Michael Camacho, JPMorgan's newly appointed metals division head, as one of its two directors, according to a February 1 UK filing; he assumed a role that had been filled by Peter Sellars, who ran the unit for most of the past decade when he headed metals trading at Sempra, then JPMorgan.

Asked about the operations, a JPMorgan official said only: "JPMorgan is authorized to undertake all of the businesses it is engaged in."

GOLDMAN'S METRO

Goldman has taken a more tactical approach to asset deals ever since its 1981 purchase of J. Aron, a major precious metals and coffee trader. The unit expanded into oil in the 1980s, becoming one of the "Wall Street refiners" that helped kick-start the oil derivatives market. It later began to accumulate assets, building a modest condensate refinery in Rotterdam and buying natural gas fields in Canada.

Goldman bought a fleet of power plants at bargain prices in the aftermath of the Enron meltdown; it sold many of them in 2007, though its Cogentrix unit still has 17 plants with 1,437 megawatts of capacity, according to IIR Energy. That's enough to power the city of San Diego. Its private equity unit bought into the Coffeyville oil refinery in Kansas in 2005 - a deal swiftly followed by an exclusive crude oil supply pact with J Aron. It has since sold that stake.

Its biggest gambit came quietly in early 2010, when commodities chief Isabelle Ealet outbid rival merchants to buy Metro from its two founders and private equity firm Monitor Clipper Partners. Trade sources say Goldman paid around $550 million for the firm.

The bank has stressed from the start that Metro would continue to run independently, though a Goldman source said the firm is owned by the bank's commodity trading arm.

The top three executives at Metro remain the same as prior to the takeover. The board of directors is comprised almost wholly of Goldman executives who are unrelated to the commodities division, a person familiar with the board said; one of them is Philip Holzer, who heads up its German business, according to the December 2010 edition of the bank's German-language shareholder magazine KnowHow. The bank's metals traders have almost no interaction with the unit, market sources say.

Even so, Nick Madden, vice president and chief procurement officer at Novelis, the world's largest manufacturers of rolled-aluminum for drink cans, has said Goldman has purposively made it difficult for firms to get their metal out when they most need it, as the bank benefits from high rental fees.

"The banks and metal producers are both benefiting from this, but the people who are paying the price are in the real economy who can't get their metal out in a timely fashion," Madden said in an interview in February.

In a sentiment that may resonate in Washington, he added: "The last thing we want is to see is manufacturing jobs threatened by artificial market shortages and price squeezes resulting from short-term trading plays by the investment banks."

(Additional reporting by Jonathan Spicer, Jeanine Prezioso, Janet McGurty and Scott DiSavino; Editing by Martin Howell and Alden Bentley)

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