Letter concludes that a national bank may engage in customer-driven coal derivative transactions that settle in cash or by transitory title transfer and that are hedged on a portfolio basis with derivative and spot transactions that settle in cash or by transitory title transfer, provided the bank's examiner-in-charge is satisfied that the bank has adequate risk management and measurement systems and controls to conduct the activities on a safe and sound basis.

O

Comptroller of the Currency

Administrator of National Banks

Washington, DC 20219

April 26, 2006 Interpretive Letter #1060

May 2006

Subject: Portfolio-hedged Coal 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 engage in customer-

driven1 coal derivative transactions2 that settle in cash or by transitory title transfer and that are

hedged on a portfolio basis with derivative and spot transactions3 that settle in cash or by

transitory title transfer. Previously, the Bank received authority to enter into customer-driven,

cash-settled coal derivative transactions and simultaneously enter into perfectly matched

offsetting derivative transactions.4 Under its current proposal, rather than simultaneously

entering into a perfectly matched offsetting transaction, the Bank will hedge coal derivative

transactions on a portfolio basis with exchange-traded and over-the-counter (“OTC”) cash-settled

derivative transactions, in the same manner as the Bank currently hedges its crude oil, natural gas

and electricity derivatives.5 The Bank will also enter into transitory title transfers to settle and

hedge coal derivative transactions as permitted for the Bank in OCC Interpretive Letter No.

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 A coal derivative is a financial instrument used to manage the price exposure to the coal markets

ative transactions as permitted for the Bank in OCC Interpretive Letter No.

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 A coal derivative is a financial instrument used to manage the price exposure to the coal markets. The Bank is

currently authorized to engage in customer-driven, perfectly matched coal derivative transactions such as swaps,

options, forwards, caps, floors, collars and futures, where payments are based on coal prices and indices. OCC

Interpretive Letter No. 1039 (September 13, 2005).

3 A spot transaction is a cash sale for the immediate delivery of the commodities. See, e.g., OCC Handbook:

Foreign Exchange (March 1990).

4 OCC Interpretive Letter No. 1039, supra.

5 See, e.g., OCC Interpretive Letter No. 1025 (April 6, 2005).

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2

1025, in the context of electricity derivative transactions.6 For the reasons discussed below, we

conclude that the Bank may engage in the proposed transactions, 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.

I. Background

The Bank currently engages in a variety of financial intermediation transactions involving a wide

range of energy-related commodities. The Bank recently received authority to engage in

customer-driven,7 perfectly matched, cash-settled coal derivative transactions.8 The Bank now

wishes to engage in customer-driven, coal derivative transactions that settle in cash or by

transitory title transfer and hedge the transactions on a portfolio basis with derivative and spot

transactions that settle in cash or by transitory title transfer (coal-linked transactions)

ority to engage in

customer-driven,7 perfectly matched, cash-settled coal derivative transactions.8 The Bank now

wishes to engage in customer-driven, coal derivative transactions that settle in cash or by

transitory title transfer and hedge the transactions on a portfolio basis with derivative and spot

transactions that settle in cash or by transitory title transfer (coal-linked transactions).

Presently, the Bank enters into a coal derivative transaction and simultaneously enters into a

perfectly matched offsetting derivative transaction. Under the Bank’s proposal, it will enter into

coal derivative transactions and hedge the transactions, on a portfolio basis, with cash-settled,

exchange-traded and OTC coal derivative transactions and transitory title transfers, based on the

aggregate unmatched position in the portfolio. To the extent that the Bank determines that a

strong correlation exists between coal derivative contracts and other commodity derivatives or

the value of other commodities, the Bank may use such interrelated contracts and take transitory

title to such commodities in its overall portfolio management (i.e., cross-hedging). The Bank

may use only derivative contracts on commodities for cross-hedging purposes that the OCC

approved for hedging in OCC Interpretive Letter No. 1039 or other relevant OCC

precedent. Similarly, the Bank will use only those commodities for cross-hedging that the OCC

has approved for hedging by transitory title transfer in OCC precedent.9 As new derivative

transactions are added to the coal derivative transaction portfolios resulting in changes to the

unmatched position, the Bank will adjust its hedging position to manage its aggregate exposure

to market risk (i.e., the risk to earnings or capital arising from changes in the value of portfolios

of coal derivative transactions). The purpose of the proposed hedges, similar to the transactions

addressed in OCC Interpretive Letter No

erivative transaction portfolios resulting in changes to the

unmatched position, the Bank will adjust its hedging position to manage its aggregate exposure

to market risk (i.e., the risk to earnings or capital arising from changes in the value of portfolios

of coal derivative transactions). The purpose of the proposed hedges, similar to the transactions

addressed in OCC Interpretive Letter No. 1039, is to offset market risk from its coal derivative

transactions.

6 Id.

7 The Bank’s customers for this purpose include coal producers (e.g. mining companies), coal users (e.g. utilities and

other power generators) and other financial intermediaries.

8 Id.

9 See, e.g., OCC Interpretive Letter No. 1025, supra (transitory title transfer of electricity derivatives permitted for

hedging purposes).

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3

The Bank believes that the expansion of the Bank’s energy-related businesses to include the

proposed coal-linked transactions is a natural extension of the Bank’s existing financial

intermediation activities and will benefit customers as well as the Bank. The major difference

between the financial intermediation activities the OCC recently approved for the Bank

involving coal derivatives and the proposed activity, is that here the Bank will manage risks

arising from derivatives transactions on a portfolio basis rather than on a perfectly matched basis.

When transactions are perfectly matched, the primary risk to the Bank is counterparty credit risk

(i.e., the risk that a counterparty will not make payments according to the terms of the

transaction). In contrast, portfolio-hedging may expose the Bank to market and basis risk (i.e.,

the risk that the price fluctuations of the hedging instruments will not exactly match price

fluctuations of the underlying transactions), however, these risks will be subject to risk

management limits

t risk

(i.e., the risk that a counterparty will not make payments according to the terms of the

transaction). In contrast, portfolio-hedging may expose the Bank to market and basis risk (i.e.,

the risk that the price fluctuations of the hedging instruments will not exactly match price

fluctuations of the underlying transactions), however, these risks will be subject to risk

management limits. And, to the extent there is any legal risk in coal-linked transactions,

indemnification provisions in the relevant documentation discussed below will mitigate this risk.

The Bank represents that portfolio-hedging is a more cost effective means of managing risks

arising from permissible derivative activities than perfectly matching transactions because it

reduces transactional costs and operational risks (i.e., the risk of incurring financial loss due to

human or technical errors). Coal portfolios will naturally contain offsetting transactions. Thus,

the Bank need only hedge the net residual risk position in each portfolio when it engages in

portfolio-hedging. With perfectly matched transactions, the Bank must offset each coal

transaction that it enters into and pay the costs associated with executing each of these trades.

Because the Bank must execute a greater number of transactions to perfectly match transactions

than it would if it were portfolio-hedging, there is also greater opportunity for back office error

and reconcilement issues in perfectly matched trades.

Periodically the Bank may hedge coal derivative portfolios by using hedging instruments that

result in basis risk. Such mismatches, and thus the resulting basis risk, tend to become more

pronounced progressively during the life of the transactions, thus making accurate hedging

essential. In some instances, cash-settled transactions may provide less than completely accurate

hedges

des.

Periodically the Bank may hedge coal derivative portfolios by using hedging instruments that

result in basis risk. Such mismatches, and thus the resulting basis risk, tend to become more

pronounced progressively during the life of the transactions, thus making accurate hedging

essential. In some instances, cash-settled transactions may provide less than completely accurate

hedges. The Bank believes that the ability to engage in transitory title transfers involving coal

will enable the Bank to more accurately and precisely hedge its proposed coal derivative

transactions and substantially reduce its basis risk in portfolio-hedged coal derivative

transactions. For coal-linked transactions that involve transitory title transfer, the Bank

represents that it will execute an offsetting transaction for settlement at the same delivery point

on the same settlement day as the original transaction.10 Ownership and control of, and title to,

the coal will pass instantaneously from the Bank’s upstream counterparty through the Bank to its

downstream counterparty at the delivery point. The last buyer in the chain will provide the

transport vehicles to the delivery point, and the initial seller will load the vehicle. The Bank will

not be the initial seller or the end-buyer in the chain. The Bank represents that it will engage in

10 A time lag may exist between the original transaction and the offsetting transaction. The existence and duration

of that time lag will be a function of market conditions and customer interest. Notwithstanding any time lag, the

Bank represents that it will always have an offsetting transaction in place by the settlement date to make certain that

the Bank never will take physical possession of coal. The Bank will hedge market risk created by the time lag

through the futures or over-the-counter markets.

that time lag will be a function of market conditions and customer interest. Notwithstanding any time lag, the

Bank represents that it will always have an offsetting transaction in place by the settlement date to make certain that

the Bank never will take physical possession of coal. The Bank will hedge market risk created by the time lag

through the futures or over-the-counter markets.

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4

the proposed title transfer transactions solely for the accommodation of customers or for its own

risk management purposes.

The Bank plans to mitigate any potential legal risks from engaging in transitory title transfers of

coal by including indemnification provisions in its coal documentation, a customary industry

practice. Under the indemnification provisions, the Bank will be indemnified from legal claims

when it is the buyer and will be the indemnifying party for legal claims when it is the seller. Any

legal claim the Bank may face as a seller will be a claim that the Bank has as a buyer under the

matching indemnification provisions. Consequently, such legal claims should be resolved by the

initial seller and the ultimate buyer because the indemnification provisions effectively pass

claims up and down through the chain of intermediary titleholders to the initial seller and

ultimate buyer.11

The Bank states that its ability to engage in the proposed activities will enable the Bank to

compete more effectively with other intermediaries, meet customer demand, operate more

efficiently and profitably, and diversify its business risks. For example, the Bank represents that

expansion of its existing energy derivatives business will enable the Bank to compete with other

market intermediaries that can make coal products available to customers, particularly those

market intermediaries that give customers the option of engaging in coal-linked transactions that

settle by transitory title transfer

and diversify its business risks. For example, the Bank represents that

expansion of its existing energy derivatives business will enable the Bank to compete with other

market intermediaries that can make coal products available to customers, particularly those

market intermediaries that give customers the option of engaging in coal-linked transactions that

settle by transitory title transfer. Moreover, the Bank states that the ability to offer these

products will enable the Bank to meet the growing demand for these products by customers such

as mining companies and electricity generators. In addition, the Bank believes that by offering

customers a broader range of risk management products that more effectively address their

individual risk management needs, the Bank will have the ability to attract a broader customer

base. Finally, the Bank represents that by participating in a broader range of markets and

expanding its customer base, it may diversify and reduce credit and other risks arising from its

energy derivatives business. Accordingly, the Bank believes the proposed transactions will

enable it to meet customer demand and operate its energy derivatives business more

competitively, efficiently, and profitably.

In sum, the Bank contends that the proposed transactions pose risks similar in nature to those

inherent in perfectly matched, cash-settled coal derivative transactions and in its portfolio-

hedged oil, gas and electricity derivative transactions (e.g., credit, market and legal risks), which

it has demonstrated the ability to successfully manage and control. The Bank maintains that the

proposed transitory title transfers do not pose risks different from the transitory title activities the

11 The Bank will retain the right to have a representative present at the delivery point during the weighing, sampling

and analysis of the coal. The Bank represents that while most market participants retain this right, they do not

exercise this right

ontrol. The Bank maintains that the

proposed transitory title transfers do not pose risks different from the transitory title activities the

11 The Bank will retain the right to have a representative present at the delivery point during the weighing, sampling

and analysis of the coal. The Bank represents that while most market participants retain this right, they do not

exercise this right. If the Bank decides to exercise this right, the Bank will use consultants whom it has retained to

confirm the specifications of coal at the relevant delivery point. If the Bank does not exercise this right, such

representatives will not be able to confirm the specifications of the coal until after title has transferred and the seller

provides the analysis report, which will ultimately be provided to the end-buyers. If the coal does not meet the

required specifications, the end-buyer has the right to reject the coal, at which point title should revert back through

the chain instantaneously to the initial seller. The initial seller is then responsible for transporting the rejected coal

to another location and providing substitute coal at the buyer’s request. In most cases, the end-buyer will accept

non-conforming shipments with price adjustments rather than reject the coal.

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5

OCC addressed in OCC Interpretive Letter No. 1025 in the context of electricity derivative

transactions. Further, because the coal-linked transitory title transfer transactions will not entail

the physical possession of commodities, the Bank represents that these transactions will not

involve the customary activities relating to, or risks attendant to, commodity ownership (e.g.,

storage costs, insurance, and environmental protection)

o. 1025 in the context of electricity derivative

transactions. Further, because the coal-linked transitory title transfer transactions will not entail

the physical possession of commodities, the Bank represents that these transactions will not

involve the customary activities relating to, or risks attendant to, commodity ownership (e.g.,

storage costs, insurance, and environmental protection). The Bank maintains that while coal-

linked transitory title transfer transactions will require the Bank to perform obligations such as

sending loading instructions to the previous seller and analysis results to the next buyer12 as well

as making payment transfers, these functions are similar to those regularly performed by national

banks in their role as financial intermediaries.

The Bank states that its proposal to engage in coal-linked transactions does not envision the use

of special purpose entities (“SPEs”). However, should the Bank determine that the use of SPEs

may be appropriate in connection with coal-linked transactions, the Bank represents that the

transactions will undergo a thorough internal due diligence and review prior to execution. The

Bank further represents that such transactions would conform to the Bank’s SPE Policy.

The Bank commits that the proposed coal-linked transactions will be conducted in accordance

with all the risk management processes and procedures currently in place for the Bank’s energy-

related derivatives business.13

II. Discussion

For the reasons and subject to the conditions described below, the Bank may engage in customer-

driven coal derivative transactions that settle in cash and hedge these transactions on a portfolio

basis with cash-settled coal derivatives, and also may engage in transitory title transfers of coal

in connection with settling and hedging coal-linked transactions

es business.13

II. Discussion

For the reasons and subject to the conditions described below, the Bank may engage in customer-

driven coal derivative transactions that settle in cash and hedge these transactions on a portfolio

basis with cash-settled coal derivatives, and also may engage in transitory title transfers of coal

in connection with settling and hedging coal-linked transactions. These activities are permissible

for the Bank provided the Bank has established an appropriate risk measurement and

management process for these derivative and hedging activities that is satisfactory to the Bank’s

EIC. This process is necessary for the Bank to achieve its customer risk management objectives

12 The Bank represents that a seller is typically required to provide a shipping notice to the buyer within 48 hours of

loading the coal or prior to arrival of the vessel, barge, truck or train at the destination following loading of a

shipment (whichever comes first). The shipping notice includes the vessel’s name or train, barge or truck number,

source from which supplied, tonnage shipped, shipping date, destination, time loading commenced and finished, and

the results of a coal analysis showing that the coal meets the specifications set forth in the appropriate coal

documentation. The Bank states that the initial seller generally sends the shipping notice to the first buyer in the

chain. The buyer then has the obligation to send the results to the next buyer. The Bank represents that about 50%

of the time, the initial seller will agree to send the analysis results directly to the ultimate buyer; however, this

results only out of a courtesy agreement between parties. The shipping notice is tantamount to an instrument

evidencing title.

13 The Bank may execute coal hedging transactions with its unrated affiliate, JPMorgan Ventures Energy

Corporation, if the Bank decides that such a hedge is the most effective one available

e to send the analysis results directly to the ultimate buyer; however, this

results only out of a courtesy agreement between parties. The shipping notice is tantamount to an instrument

evidencing title.

13 The Bank may execute coal hedging transactions with its unrated affiliate, JPMorgan Ventures Energy

Corporation, if the Bank decides that such a hedge is the most effective one available. In such case, 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.

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6

in a safe and sound manner and thus must be established before the OCC can determine that the

proposed activities are permissible.

A. National Bank may engage in Customer-driven, Portfolio-hedged Coal-linked

Transactions.

The OCC has previously determined that the Bank may engage in perfectly matched cash-settled

coal derivatives as a financial intermediary under 12 U.S.C. § 24(Seventh).14 The Bank now

proposes to portfolio-hedge these derivatives with derivatives that settle in cash or by transitory

title transfer. The ability to engage in these transactions will increase the Bank’s hedging options

and its ability to control risks in its energy-related derivatives business. The difference between

the activities previously approved for the Bank and those for which approval is sought here is

that rather than simultaneously entering into coal-linked transactions with perfectly matched

offsetting transactions, the Bank will enter into coal derivative transactions with customers and

manage the transactions on a portfolio basis with exchange-traded and OTC cash-settled

derivative transactions, in the same manner as the Bank currently manages its crude oil, natural

gas and electricity derivatives

than simultaneously entering into coal-linked transactions with perfectly matched

offsetting transactions, the Bank will enter into coal derivative transactions with customers and

manage the transactions on a portfolio basis with exchange-traded and OTC cash-settled

derivative transactions, in the same manner as the Bank currently manages its crude oil, natural

gas and electricity derivatives. The Bank will also settle coal derivative transactions by

transitory title transfer and hedge these transactions with derivative transactions and spot

transactions that settle by transitory title transfer, in a manner previously addressed for the Bank

in OCC Interpretive Letter No. 1025 in the context of electricity derivative transactions.

The expansion of the Bank’s derivatives business to include the proposed transactions is a

natural extension of the Bank’s existing financial intermediation activities. The OCC has

previously addressed the permissibility of portfolio-hedging and transactions that settle in cash or

by transitory title where the bank takes title to the commodity in a “chain of title” and

relinquishes title instantaneously under Section 24(Seventh).15 Portfolio-hedging is a more cost

effective means of managing risks arising from permissible derivative activities than perfectly

matching transactions because it reduces transactional costs and operational risks. Portfolio-

hedging and transitory title transfer activities allow banks to compete more effectively, meet

customer demand, and operate more efficiently and profitably. Transitory title transfers also

enable banks to participate in markets using this form of settlement and provide customers a

broader range of sophisticated risk management tools to address their financial, risk

management, and liquidity needs

ing and transitory title transfer activities allow banks to compete more effectively, meet

customer demand, and operate more efficiently and profitably. Transitory title transfers also

enable banks to participate in markets using this form of settlement and provide customers a

broader range of sophisticated risk management tools to address their financial, risk

management, and liquidity needs. In conducting transitory title transfers in connection with a

permissible derivatives business, banks act as financial intermediaries, ultimately exchanging

payments between counterparties managing financial risks or otherwise meeting financial

needs.16 While a time lag may exist between the original transaction and the offsetting

transitory title transfer transaction, the Bank represents that it will always have an offsetting

transaction in place by the settlement date to make certain that the Bank never will take physical

14 OCC Interpretive Letter No. 1039, supra.

15 See OCC Interpretive Letter No. 1025, supra; OCC Interpretive Letter No. 962 (April 21, 2003); OCC Interpretive

Letter No. 632 (June 30, 1993); OCC Interpretive Letter (March 2, 1992).

16 See, e.g., OCC Interpretive Letter No. 1025, supra.

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7

possession of coal. Executing transactions and hedging in this manner is consistent with a

portfolio-hedged financial intermediation business.

The OCC finds the risks to which the Bank is exposed under this proposal are similar in nature to

other energy-related derivative transactions where the Bank has a demonstrated ability to manage

and control such risks

possession of coal. Executing transactions and hedging in this manner is consistent with a

portfolio-hedged financial intermediation business.

The OCC finds the risks to which the Bank is exposed under this proposal are similar in nature to

other energy-related derivative transactions where the Bank has a demonstrated ability to manage

and control such risks. Accordingly, the Bank may act as a financial intermediary in customer-

driven, portfolio-hedged coal derivative transactions that settle in cash or by transitory title

transfer, and hedge these transactions with coal derivative and spot transactions that settle in cash

or by transitory title transfer, subject to satisfying the safety and soundness factors discussed

below.

B. The Portfolio-hedged Coal-linked Transactions must be Conducted in a Safe and

Sound Manner.

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 Derivatives17 and Banking Circular 277,18 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

ivatives17 and Banking Circular 277,18 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.

In implementing these policies, procedures, and controls, the Bank shall commit to conducting a

full evaluation of: (i) pricing, hedging (including portfolio-hedging), processing, recordkeeping,

documentation, accounting, “back office” and risk management; (ii) the development of

adequate knowledge, staff, oversight management and technology (including contingency

planning) to accommodate the activity; (iii) the implementation of appropriate controls; (iv) the

establishment, implementation and monitoring of appropriate risk management limits with

respect to various types of risks —such as credit, market and basis risk —associated with coal

derivatives and transitory title transfers of coal; and (v) Compliance Department training of

personnel and development of a supervisory framework designed to ensure compliance with

policies and procedures, including trading practices. Risk Control, Operations, Accounting,

Legal, Compliance, Audit and Senior and Line Management will all be involved in assuring that

the risks undertaken by the Bank are comparable to, and are addressed in ways comparable to

those applicable to, the Bank's existing commodity derivative products and business.

17 OCC Handbook: Risk Management of Financial Derivatives (January 1997).

18 OCC Banking Circular No. 277 (October 27, 1993).

Compliance, Audit and Senior and Line Management will all be involved in assuring that

the risks undertaken by the Bank are comparable to, and are addressed in ways comparable to

those applicable to, the Bank's existing commodity derivative products and business.

17 OCC Handbook: Risk Management of Financial Derivatives (January 1997).

18 OCC Banking Circular No. 277 (October 27, 1993).

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8

In addition to a satisfactory risk management program, the Bank's process must include an

independent compliance monitoring program to ensure ongoing compliance with the specific

commitments made by the Bank in its proposal, including the commitment to continue to

conduct its financial intermediation activities involving coal derivatives as a customer-driven and

non-proprietary trading business. The compliance-monitoring program should also ensure that

the Bank has a supervisory framework that protects against manipulative practices of any kind.

An adequate and effective compliance-monitoring program will include policies, training,

independent surveillance and well-defined exception approval and reporting procedures.

Should the Bank determine that the use of SPEs is appropriate in connection with coal-linked

transactions, the Bank must satisfy its EIC of the adequacy of the Bank’s SPE policies for such

transactions prior to using SPEs.

III. 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. Our conclusions herein are specifically based

on the Bank’s representations and written submissions describing the facts and circumstances of

the subject transactions. Any change in the facts or circumstances could result in different

conclusions. If you have any questions please contact Tena M. Alexander, Special Counsel,

Securities and Corporate Practices Division, at (202) 874-5210

asis. Our conclusions herein are specifically based

on the Bank’s representations and written submissions describing the facts and circumstances of

the subject transactions. Any change in the facts or circumstances could result in different

conclusions. If you have any questions please contact Tena M. Alexander, Special Counsel,

Securities and Corporate Practices Division, at (202) 874-5210.

Sincerely,

Signed

Julie L. Williams

First Senior Deputy Comptroller

and Chief Counsel