Morgan Stanley Focuses on Smaller, Smarter Trades

Nancy King, global head of commodities trading at Morgan Stanley (MS), has spent the last few years remodeling what used to be one of the most profitable units on Wall Street, by downsizing and focusing on smaller, smart trades for customers instead of the big, risky bets it used to make on its own account.

The shift in strategy, which has cut the size of Morgan Stanley's commodities business by roughly two thirds, was largely forced on the bank by post-financial crisis regulations that banned banks from using their own money on potentially risky speculation, and increased capital requirements.

The bank is "sticking their toe back into the market," said Robert Pease, senior counsel at law firm Bracewell and a former commodity and energy market regulator.

Morgan Stanley's former crown jewel - built up from the 1990s into a swaggering unit specializing in big bets - has been hemmed in by regulations that have eaten into profits.

Long-dated derivatives pegged to energy prices that once delivered fat margins now fall under onerous capital requirements.

The Federal Reserve no longer wants banks transporting natural gas or stockpiling sheets of aluminum. And the Volcker Rule, part of the 2010 Dodd-Frank Act designed to prevent another crisis, prohibits lenders from proprietary trading, precluding speculative bets on oil and other volatile commodities.

As a result, Morgan Stanley sold big chunks of the business that ran afoul of such rules, losing roughly two-thirds of commodities staff in the process. Its exposure to physical commodities has dropped to $179 million, down from $9.7 billion in 2011.

Before the financial crisis, the business was one of Morgan Stanley's most lucrative operations, generating annual revenue of as much as $3 billion with about 400 employees. It now produces around $1 billion in revenue with 150 employees.

Commodities trading is no longer a unit unto itself. King and her business now report to Sam Kellie-Smith, who heads fixed-income trading. Previously, the business answered to the head of the larger institutional division that included trading and investment banking.

LEARNING CURVE
King, a 30-year veteran of Morgan Stanley who started in 1986 as an oil trader, was named the sole global head of commodities in June after global co-head Peter Sherk resigned.

She declined to speak publicly to Reuters about her plans.

With the backing of Kellie-Smith, King is urging staff across the bank to generate more commodities revenue from customers - as opposed to making its own bets - according to people familiar with the strategy.

Earlier this year, the commodities group moved from its suburban campus in Purchase, New York, to Morgan Stanley's Times Square headquarters in New York City, some 30 miles (48 km) south.

Some commodities traders are now seated near fixed-income staff to improve the flow of information. The metals team sits near the foreign exchange desk, for example, as the two have an overlapping client base. That way, salespeople can offer gold hedges to a client, alongside currencies, to protect against inflation.

Metals traders can now also use risk management tools and technology from the fixed income desk to help with pricing, and make better use of its electronic trading business.

The commodities group is also holding 'teach-ins' with colleagues in other parts of the firm, such as investment banking and capital markets, to encourage them to pitch commodity-related products to clients.

The aim is to win business from existing Morgan Stanley investor clients who have not typically included commodities in their portfolios, as well as new corporate clients the bank may have dismissed earlier as the opportunity was seen as too small.

For example, Morgan Stanley is helping plastics businesses hedge the raw materials used to produce bottles. It is also working with industrial companies to hedge exposure to the cost of polyethylene and polypropylene used in their packaging.

While Morgan Stanley has worked with mining companies in the past to help them lock in their future gold or ore production at set prices, it is looking at new ways for these businesses to think about hedging, such as energy usage.

"It's more small wins and focusing on areas and clients that in the past haven't been as profitable," said Craig Pirrong, a finance professor at the University of Houston who specializes in commodities. "Businesses that didn't look as lucrative for banks before are looking better now."

BARRIERS TO SUCCESS
However, bankers, traders and industry experts said Morgan Stanley still has challenges.

First, the bank faces stiff competition in commodities markets. Not just from rival banks that want to do the same kind of business, like Goldman Sachs Group Inc and Citigroup Inc, but also from non-bank trading firms such as Mercuria Energy Group, Vitol SA, Glencore Plc (GLNCY) and Trafigura Group Pte, that do not face the tough regulations lenders do.

Second, if President-elect Donald Trump makes good on his campaign promise to dismantle the Dodd-Frank Act, and does away with the Volcker rule, proprietary trading may make a comeback, which might force Morgan Stanley into another rethink.

In the meantime, if the Federal Reserve becomes more lenient on capital rules and physical commodities, Morgan Stanley may also be at a disadvantage for cutting back on businesses that its chief rival, Goldman, has kept.

"If in fact the clock can be turned back, there may be some aspects of what Morgan Stanley used to do that they might want to explore, but cultures have changed," said Guy Moszkowski, a banking analyst with Autonomous Research. "It's very hard to rebuild."

Morgan Stanley had planned to make a big push into inventory financing, where it would lend to buyers of natural resources, using physical inventory as collateral, people familiar with the strategy told Reuters.

But that plan is no longer a priority, the people said, after the Federal Reserve's September move to propose new requirements for banks to hold billions of dollars of extra capital in their commodities business, which would depress returns in inventory financing and other businesses.

Bruce Bullock, director of the Maguire Energy Institute at Southern Methodist University's Cox School of Business, said Morgan Stanley can still make its reduced and redesigned commodities unit work.

"The bank's job is to know their clients backwards and forwards and to manage their risks better than the average trading house," he said. "If banks can maintain this deep view of the business, they'll win."

Reporting by Olivia Oran, Jessica Resnick-Ault and Catherine Ngai