# O

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| ## Comptroller of the Currency                                        |
|                                                                       |
| > Administrator of National Banks                                     |
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Washington, DC 20219

September 13, 2005 **Interpretive Letter #1039**

##### September 2005

Subject: Customer-driven, Perfectly Matched, Cash-settled Derivative
Transactions

Dear **\[ \]**:

**\[ \]** ("Bank") is seeking confirmation from the Office of the
Comptroller of the Currency ("OCC") that it is permissible for the Bank
to enter into customer-driven, perfectly matched, cash-settled
derivative transactions on certain commodities and related indices. For
the reasons discussed below, we conclude that the Bank may engage in the
transactions it proposes, provided the Bank's examiner-in-charge ("EIC")
is satisfied that the Bank has adequate risk management and measurement
systems and controls to conduct the activities on a safe and sound
basis.

#### Background

The Bank proposes to act as a financial intermediary in
customer-driven,[^1] perfectly matched, cash-settled derivative
transactions with market participants and offsetting mirror transactions
with its unrated affiliate, **\[ \]** ("***OpSub***").[^2] The
commodities and indices that will serve as reference assets under the
Bank's request are: crude oil, natural gas, heating oil, natural
gasoline, gasoline, unleaded gas, gasoil, diesel, jet fuel,
jet-kerosene, residual fuel oil, naphtha, ethane, propane, butane,
isobutene, crack spreads, lightends, liquefied petroleum gases, natural
gas liquids, distillates, oil products, coal, emissions allowances,
benzene, dairy, cattle, wheat, corn, soybeans, soybean meal, soybean
oil, cocoa, coffee, cotton, orange juice, sugar, paper, rubber, steel,
aluminum, zinc, lead, nickel, tin, cobalt, iridium, rhodium, freight,
high density polyethylene (plastic), ethanol, methanol, newsprint, paper
(linerboard), pulp (kraft), and recovered paper (old newsprint).

The Bank proposes to enter into the transactions with **\[ *OpSub* \]**
in two contexts.[^3]  First, the Bank proposes to enter into these
transactions under a so-called "prime brokerage" agreement with **\[
*OpSub* \]** similar to prime brokerage agreements that the Bank has
executed with nonaffiliated third parties.   Under the agreement, **\[
*OpSub* \]** will negotiate transactions with Bank pre-approved
counterparties. If **\[ *OpSub* \]** and a third party agree on the
terms of the transaction, the Bank will execute the transaction with the
counterparty and concurrently enter into a perfectly matched transaction
with **\[ *OpSub* \]**.  \
\
The second context arises when the Bank identifies a transaction it
would like to enter into with a customer and decides that the best hedge
available would be a perfectly matched transaction with **\[ *OpSub*
\]**.   The Bank will negotiate the type, size and price of the
transaction with the customer, and if it reaches agreement with the
customer, the Bank concurrently will execute the offsetting, perfectly
matched transaction with **\[ *OpSub* \]**.

The Bank's transactions with **\[ *OpSub* \]** will match all the
economic terms of the transactions between the Bank and the market
participants (*e.g.,* commodity, amount and maturity). The arrangements
will be financial arrangements only. All of the transactions will settle
in cash. Neither the Bank, **\[ *OpSub* \]** nor the market participants
will at any time be required to take title to the commodities underlying
the derivative transactions. The Bank represents that the terms and
circumstances of all transactions between **\[ *OpSub* \]** and the Bank
will be at least as favorable to the Bank as those prevailing at the
time for comparable transactions between the Bank and similarly situated
counterparties or will be such that the Bank, in good faith, would offer
to, or that would apply to, such entities.

The Bank believes that by engaging in the proposed transactions it will
be exposed to credit risk with respect to **\[ *OpSub* \]** and the
other market participant counterparties. To manage the credit risk
arising from its transactions with **\[ *OpSub* \]**, an ISDA Master
Agreement and Credit Support Annex (\"CSA\") will govern each derivative
transaction executed between the Bank and **\[ *OpSub* \]**. The terms
of the CSA with **\[ *OpSub* \]** will be as stringent on **\[ *OpSub*
\]** as CSAs the Bank enters into with comparable third parties. The
Bank will either have or obtain standard ISDA Master Agreements and CSAs
with its other counterparties.

The Bank will be compensated for its credit risk in the pricing on all
of the proposed transactions, the terms of which it represents will be
consistent with arms-length terms and based upon market conditions at
the time of each transaction. The Bank will also provide operational and
administrative services to **\[ *OpSub* \]**, paid for by **\[ *OpSub*
\]** under the terms of an agency agreement between the parties. The
**\[ *OpSub* \]** service agreement will be at least as favorable to the
Bank as its service agreements with its other comparable third parties.

The Bank represents that it will comply with the requirements of section
23A and 23B of the Federal Reserve Act, the Federal Reserve Board's
Regulation W and the Bank's section 23A and 23B and Regulation W policy.

#### Discussion

The proposed activities are consistent with OCC precedent finding
national banks may engage in customer-driven commodity derivative
transactions as financial intermediaries under 12 U.S.C. §
24(Seventh).[^4] National banks may enter into derivative transactions
and may hedge risks arising from these permissible banking activities as
part of the business of banking.[^5] In assuming an offsetting
derivative or hedge, a bank protects itself against risks arising from
an established permissible banking activity and acts as a financial
intermediary by interposing itself between customers providing
offsetting cash flows or returns. Permissible financial intermediation
transactions include cash-settled options, forwards, and swaps.[^6]

In OCC No-Objection Letter 87-5,[^7] the OCC recognized that a national
bank could engage in perfectly matched, cash-settled, derivative
contracts based on the rise or fall in the price of designated price
indices (specifically, swaps based on oil price indices).[^8] The bank
entered into these transactions only on a matched basis, such that the
bank would be matched as to index, amount, and maturity on each side of
the transaction. Because the transactions were matched, the only risk to
the bank was its credit risk with respect to the counterparties to these
transactions, as is the case here.

The difference between the activities in OCC No-Objection Letter 87-5
and the Bank\'s proposal is the use of an affiliate for one leg of the
transaction and the expansion of the list of commodities and related
indices that the Bank may use as reference assets in these transactions.
Based on the facts presented, these differences do not alter the nature
of the proposed activities as financial intermediation. Indeed, the OCC
has recognized that national banks may enter into derivatives
transactions with affiliates that mirror the affiliates\' transactions
with customers, and may hedge resulting risks, in the banks\' role as
financial intermediaries.[^9] Further, the OCC has already determined
national banks may engage in derivative transactions on any commodity
where the use of the commodity will not result in any substantive change
in the type or nature of the financial intermediation activity but only
in its underlying basis (*i.e.,* the particular commodity or related
index used as the reference asset).[^10] Accordingly, the Bank may act
as a financial intermediary in customer-driven, perfectly matched,
cash-settled, derivative transactions on the listed commodities and
related indices where its EIC is satisfied the Bank has adequate risk
management systems and controls to conduct the activities on a safe and
sound basis.

**Safety and Soundness Requirements and EIC No Objection**

For the Bank to permissibly engage in the proposed activities, the
Bank\'s risk measurement and management capabilities must be of
appropriate sophistication to ensure that the activity can be conducted
in a safe and sound manner and in accordance with applicable law.
Consequently, in order for the OCC to conclude that this activity is
permissible for the Bank, the Bank must demonstrate to the satisfaction
of its EIC, that the Bank has established an appropriate risk
measurement and management process for its proposed activity. As
detailed further in the *OCC Handbook: Risk Management of Financial
Derivatives* [^11] and Banking Circular 277,[^12] an effective risk
measurement and management process includes board supervision,
managerial and staff expertise, comprehensive policies and operating
procedures, risk identification and measurement, and management
information systems, as well as an effective risk control function that
oversees and ensures the appropriateness of the risk management process.
The Bank's risk control processes should include the Bank's compliance
with accounting and reporting as stipulated by the instructions for the
Consolidated Reports of Condition and Income and generally accepted
accounting principles.

The Bank may not commence the proposed activity unless and until its EIC
concludes that the foregoing standards are met and expresses no
supervisory objection. Provided these standards are met, the Bank may
commence the proposed activities on the commodities and related indices
addressed by the EIC.

**Conclusion**

We conclude that the Bank may engage in the transactions it proposes,
provided the Bank's EIC is satisfied that the Bank has adequate risk
management and measurement systems and controls to conduct the
activities on a safe and sound basis. Any change in this information
could lead to

a different conclusion. If you have any questions concerning this
letter, please contact Tena M. Alexander, Special Counsel, Securities
and Corporate Practices Division, at (202) 874-5210.

Sincerely,

/s/

Julie L. Williams

First Senior Deputy Comptroller

and Chief Counsel

[^1]: A "customer-driven" transaction is one entered into for a
    customer's valid and independent business purpose. *See* OCC
    Interpretive Letter No. 892 (September 13, 2000).

[^2]: **\[ *OpSub* \]** is an indirect subsidiary of the bank's holding
    company, **\[ *BHC* \]**. The Bank represents that **\[ *OpSub* \]**
    is subject to the Federal Reserve Board's Regulation Y, 12 C.F.R.
    Part 225, and will engage only in activities authorized by that
    regulation. **\[ *OpSub* \]** is not rated by any credit rating
    agency. The Bank states that **\[ *OpSub* \]**'s business strategy
    is to enter into commodity and commodity derivatives transactions,
    including cash-settled, over-the-counter derivative transactions.
    The Bank represents that this strategy has been approved within **\[
    *BHC* \]** and is permissible under Regulation Y.

[^3]: The Bank also proposes to act as financial intermediary in
    customer-driven, perfectly matched derivative transactions where
    **\[ *OpSub* \]** is not a counterparty.

[^4]: OCC Interpretive Letter No. 1018 (February 10, 2005); OCC
    Interpretive Letter No. 937 (June 27, 2002); OCC No-Objection Letter
    No. 87-5 (July 20, 1987).

[^5]: OCC Interpretive Letter No. 892, *supra*.

[^6]: ^?^ OCC Interpretive Letter No. 937 (June 27, 2002).

[^7]: OCC No-Objection Letter No. 87-5, *supra.*

[^8]: *Id.*

[^9]: OCC Interpretive Letter No. 1018, s*upra*; OCC Interpretive Letter
    No. 892, *supra.*

[^10]: OCC Interpretive Letter 937 (June 27, 2002).

[^11]: OCC Handbook: *Risk Management of Financial Derivatives* (January
    1997).

[^12]: OCC Banking Circular No. 277 (October 27, 1993).