Introduction
As readers of this publication know, the long-anticipated final Volcker Rule has been issued. The rule generally prohibits, among other things, any “banking entity” from engaging in “proprietary trading” with respect to a wide variety of financial instruments.
For our firm’s more detailed discussion of the rule, please see our “User’s Guide to the Volcker Rule” (the “User’s Guide”), which may be found at: http://www.mofo.com/files/Uploads/Images/131223-A-Users-Guide-to-The-Volcker-Rule.pdf.1 We will not repeat all of the information in that guide here. Instead, in this article, we discuss the principal expected impact of the rule on issuers and underwriters of structured products. In particular, we examine the rule’s exemptions for market-making activities, underwriting and hedging activities. In addition to proprietary trading activities, we also will examine how the final rule’s provisions relating to “covered funds” are likely to impact certain types of structured products.
Banking Entities – Affected Parties in the Structured Products Markets (Not Just Banks)
- The final rules do not apply simply to “banks.” Rather, the rule’s prohibitions apply to a larger group of so-called “banking entities.” These entities include:
- insured depository institutions;
- any company that controls an insured depository institution;
- any foreign entity that is treated as a bank holding company for purposes of Section 8 of the International Banking Act of 1978 (i.e., because it has a U.S. branch or agency);2 and
- any affiliate or subsidiary of any of those entities.
The broad final bullet above brings the broker-dealer affiliates of banks within the scope of the new rule. These entities, of course, are involved in a variety of features of the structured products market, including structuring, underwriting, trading and hedging. In contrast, broker-dealers that are not affiliated with banks, which sometimes act as key distributors of structured products, would be outside the scope of the new rules.
Broad Prohibition of Proprietary Trading
Definition. The final rule prohibits a banking entity from engaging in “proprietary trading.” Proprietary trading is defined as “engaging as principal for the trading account of the banking entity in any purchase or sale of one or more financial instruments.”
Exemptions. Because of the potentially broad reach of this prohibition, the rule contains detailed exemptions. These exemptions are intended to balance the need to reduce the risks relating to large financial institutions, while enabling these entities to continue many of their existing roles in the financial sector. In the area of structured products, the ones of principal importance are for market-making activities, underwriting and hedging, as discussed in more detail below.
The Backstop Provisions. However, even if otherwise permitted by the exemptions, proprietary trading activities by a banking entity are subject to additional provisions and restrictions under the final rule. These restrictions are described below in “The Backstop Provisions – Exceptions to the Exemptions.” Structured products raise a variety of issues under the backstop provisions.
Transactions Within (and Outside) the Prohibition. The ban relates to trading for the banking entity’s own account. As a result, a wide variety of transactions that occur in the structured products market are not affected. For example, transactions in which a financial institution acts on an agency basis for a client, or acts as a riskless principal for a non- affiliated entity, would not be prohibited by the new rules.
Note that the prohibition relates to “financial instruments,” which are defined as:
- securities (including options on securities);
- derivatives (including options on derivatives); and
- contracts of sale of a commodity for future delivery (or options on those contracts).
The majority of structured products issued today would fall into the first category, “securities.” However, most structured certificates of deposit, which are intentionally structured not to be “securities,” would appear to be exempt from the prohibition.3
Market-Making Exemption
General. The final rule is designed to permit a broad scope of market-making activities, while prohibiting impermissible proprietary trading that may pose significant risk to the financial system. The final rules provide flexibility for market- making activities generally, but also limit those activities through a mix of compliance requirements and risk controls. Banking entities will be permitted to determine the appropriate scope of their market-making activities based on the liquidity, maturity and depth of the relevant markets. Banking entities will need to analyze their activities in terms of the overall exposures and market-making inventory held by their different trading desks.
Scope of the Exemption. The rule permits “the purchase, sale, acquisition, or disposition” of financial instruments “in connection with market-making related activities, to the extent that such activities are designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties.”
Criteria for Market-Making. Market-making activities are permitted for a particular “trading desk”4 if the trading desk satisfies six criteria:
- It “routinely stands ready” and is “willing and available” to trade the relevant instruments.
- This provision contemplates that the standards will differ somewhat among different asset classes and financial instruments. For example, a commodity-linked structured note does not have the same type of market as a share of Apple common stock. Even willingness to “trade by appointment” in an illiquid security can qualify under the rule. However, a trading desk would need to demonstrate a pattern of effecting transactions in response to demand from its customers. Broker-dealers may face a challenge of making this case in connection with illiquid types of structured products.
- It has a “market-maker inventory” that is designed not to exceed the reasonably expected near-term demand of customers, clients and counterparties.
- In the area of structured products, where the primary distribution of the instrument tends to exceed the distribution in the secondary market, the appropriate inventory may be relatively less than is the case for other types of instruments.
- This inventory test will depend in part upon the liquidity, maturity and depth of the relevant market. It must be based on a “demonstrable analysis” of indicators of near-term customer demand that include (i) historical levels of demand, (ii) expectations based on market factors and (iii) current demand. For complex structured products, “demonstrable analysis” means that the trading desk needs to have “prior express interest” from customers in the “specific risk exposures” of the instrument prior to holding an instrument to engage in market-making activity.
- In less mature markets, as is the case for many new structured products, it may be more difficult to predict near-term customer demand. In these cases, to determine near-term customer demand, the adopting release recommends that banking entities will use historical data from similar products, reasonably expected future demand that is determined based on customer relationships, or other relevant factors.
- The final release states that a trading desk creating a structured product that is not based on any customer demand, and then soliciting customers to trade the instrument during or after its creation, would not satisfy this provision.
- The banking entity must maintain an internal compliance program that includes “risk limits” on the trading desk's “market-maker inventory” and “financial exposure,” as discussed in the User’s Guide. We would note that the compliance program must identify how the banking entity hedges the risks associated with its market-making activities, for example, when the entity obtains additional exposures to different types of underlying assets as a result of its purchase of structured products in market-making transactions. These hedging activities related to its market-marking activities must comply with the market-making exemption, and not with the hedging exemption discussed below.
- If a risk limit is exceeded, the trading desk must promptly take action to restore adherence to the limits.
- In the case of structured notes, this may result at times in a broker-dealer requesting the affiliated or unaffiliated issuer of the note to repurchase and cancel the note at an agreed price.
- The banking entity must have compensation requirements for its traders that are not designed to reward or incentivize prohibited proprietary trading.
- The banking entity must be appropriately licensed or registered to engage in the market-making activity.
Underwriting Exemption
General. The final rule enables banking entities to structure their underwriting activities based on the nature of the relevant securities. The exemption includes a broad range of both registered and exempt offerings.
Scope of Exemption. Generally, a banking entity must meet five tests to satisfy the underwriting exemption:
- The banking entity must act as an underwriter for a distribution of securities, and the trading desk's underwriting position must be related to that distribution.
- The rule indicates that for purposes of this definition, a “selling group member” that is not in privity of contract with the issuer can be an “underwriter.”
- Participation in an exempt offering, such as a Rule 144A or bank note offering, can qualify as an “underwriting.”
- The rule is largely focused on traditional underwritings in connection with capital raising transactions. However, according to the adopting release and the rule’s definition of a distribution, an underwriter’s role in connection with a “reverse inquiry” transaction, such as those used for many structured note offerings, will typically qualify for the exemption, subject to the discussion below about the underwriter not purchasing more than it can expect to distribute in the near-term.
- According to the adopting release, a trading desk would not be able to use the underwriting exemption to purchase a financial instrument from a customer to enable the customer to buy securities in the distribution. This restriction suggests that, for example, a broker-dealer’s arrangement of a “pre-borrow” in a security may not be permitted, nor may the broker-dealer necessarily facilitate a hedge in a related security in advance of or in connection with a distribution. However, in some cases, another exemption may be available for these types of transactions, such as the market-making exemption. For example, the underwriter may be able to repurchase a security in which it makes a market in accordance with the new rules in order to enable a customer to purchase a security that is subject to the distribution.
- The composition of the securities in the underwriting position must be designed not to exceed the reasonably expected near-term customer demand, and reasonable efforts must be made to sell or reduce the position in a reasonable time (taking into consideration the liquidity, maturity, and depth of the market for the relevant type of security).
- This provision may have the effect of limiting a practice used at times in the structured products sector – an underwriter holding “inventory” to address future demand, particularly where there isn’t necessarily a historic interest in purchasing the relevant type of instrument from the underwriter’s inventory. The practice of holding a security in a “freezer” account (or an “investment account”) may be incompatible with the notion that the broker-dealer is attempting to continue the offering and to reduce the position.
- In contrast, the rule recognizes that an underwriter may at times hold an unsold allotment when market conditions make it impracticable to sell the entire allotment at a reasonable price at the time of the distribution, and that it may sell that position when it is practicable to do so.
- The provision may increase the likelihood that broker-dealers will size a structured note offering in accordance with the extent of actual orders, instead of adding an additional allotment to address potential orders after the pricing date.
- The banking entity must establish, implement, maintain and enforce an internal compliance program that identifies and addresses, among other items, position limits, internal controls, escalation procedures, and independent testing, as discussed in the User’s Guide.
- The compensation arrangements for employees on the trading desk must not incentivize impermissible proprietary trading.
- The banking entity must be appropriately licensed or registered to engage in underwriting activity, where required.
Risk-Mitigating Hedging Exemption
General. The final rule confirms that hedging transactions related to both individual or aggregated positions, including “dynamic hedging” and “anticipatory hedging,” are permitted. However, the final rule imposes enhanced documentation and compliance requirements upon banking entities that do so.
Scope of Exemption. The rule requires the establishment of an internal compliance program of policies and procedures to ensure compliance with the requirements of the hedging exemption, as discussed in the User’s Guide. These procedures will likely require input from a wide range of trading desks, to ensure that their activities fit within the scope of the banking entity’s policies. Structured products trading desks will seek to have a “seat at the table” to ensure that their needs are appropriately reflected.
For brokers hedging structured products, we note that the final rule expanded the hedging exception somewhat by removing a requirement in the proposed rule that an anticipatory hedge be established “slightly” before the banking entity becomes exposed to the specific, identifiable risk.
We anticipate that significant attention will be required among banking entities over the next several months to ensure the creation of policies and procedures that will comply with the rules.
The Backstop Provisions – The Exceptions to the Exemptions
Even if a transaction is permitted by the final rules under one of the exemptions described above, proprietary trading activities remain subject to the so-called “backstop provisions” of the Volcker rule. That is, otherwise permitted activities will be prohibited if they:
- Involve or result in a material conflict of interest between the banking entity and its clients, customers, or counterparties.
- Under the final rules, the mere fact that a buyer and seller (for example, an underwriter and an investor) are on opposite sides of a transaction and have differing economic interests would not be deemed a “material” conflict of interest. However, the existence of a material conflict of interest depends on the specific facts and circumstances, and the structured product area remains one that is rife with these types of conflicts.5
- Conflicts of interest can be mitigated under the final rules through either (a) timely and effective disclosure or (b) information barriers. The disclosures must permit a reasonable client, customer, or counterparty to understand the conflict in a meaningful way and substantially mitigate or negate any materially adverse effect created by the conflict.6 Disclosures must be provided sufficiently close in time to the customer’s investment decision to allow for meaningful understanding and mitigation action. In the case of structured products sold to retail investors, this will further the importance of providing an investor with robust disclosures, often in the relevant structured product offering documents, as to the relevant product and any embedded conflicts.
- If the banking entity addresses the conflict through information barriers, it must establish, maintain and enforce barriers reasonably designed to avoid a conflict's materially adverse effect, through written policies and procedures, physical separation, functional separation and limitations on types of activities conducted. These types of features are typically already in place in banking entities with affiliated broker- dealers. However, notwithstanding the establishment of information barriers, the banking entity may not rely on these information barriers if it knows or should reasonably know that a material conflict of interest may involve or result in a materially adverse effect on a client, customer, or counterparty. In these types of situations, the banking entity must address the conflict through the types of timely and effective disclosures described in the preceding bullet.
- Result in a material exposure by the banking entity to a high-risk asset or trading strategy.
- A high-risk asset or trading strategy is defined as an asset or trading strategy that would significantly increase the likelihood that the banking entity would incur a substantial financial loss or would pose a threat to the financial stability of the U.S. Accordingly, even though many structured products are “high risk” in the conventional sense, their individual or aggregate transaction amounts may not be deemed “high risk” for purposes of this test. For example, many “risky” structured products may be issued or hedged in amounts that are immaterial to the institutional as a whole. Of course, any particular transaction or series of transactions must be independently evaluated.
- Pose a threat to the banking entity’s safety and soundness or to the financial stability of the U.S.
Structured Products and Covered Funds
In addition to the new proprietary trading restrictions, market participants will also want to consider the second prong of the Volcker Rule – the prohibition on acquiring or retaining ownership interests in, or acting as sponsors to, “covered funds.”
Some issuers and their affiliated broker-dealers act from time to time as the sponsor or depositor of trust vehicles that are used to issue structured products or to “repackage” debt securities. These vehicles may be “covered funds.” The final rule provides for a number of specific exceptions from the definition of covered fund, such as the exceptions for traditional securitizations (as discussed in our client alert, “The Volcker Rule: Impact of the Final Rule on Securitization Investors and
Sponsors”7); however, there may not be an available exception for these types of structured product vehicles. As a result, issuers that are banking entities should consider whether any of their existing or planned vehicles would be impacted by the final rule.
Unless a special purpose entity fits within one of the exclusions from the covered fund definition, the issuer will be a “covered fund” if it:
- would be an investment company under the Investment Company Act of 1940, as amended (the “1940 Act”), but for the exemptions set forth in Section 3(c)(1) or 3(c)(7) of the 1940 Act;
- is a commodity pool for which the commodity pool operator (“CPO”) has claimed exempt status under the regulations of the Commodity Futures Trading Commission (“CFTC”) or that could qualify as such an exempt pool and that satisfies certain other criteria; or
- is a foreign issuer that is sponsored by, or which has an ownership interest held by, a U.S. banking entity or one of its affiliates, and that would be an investment company but for Section 3(c)(1) or 3(c)(7) of the 1940 Act if its securities were offered to U.S. residents (subject to certain exceptions).
Generally, most special purpose entities established to serve as repackaging vehicles or to issue structured products rely on the Section 3(c)(1) or 3(c)(7) exemption from the 1940 Act. If a special purpose vehicle relied on Section 3(c)(1) or 3(c)(7), it may not be a covered fund if another 1940 Act exemption is also available. Certain special purpose entities that were established after the enactment of the Dodd-Frank Act may be CPOs were it not for reliance on the de minimis exception. There are various exclusions available (i.e., there are exclusions for loan securitizations, qualifying ABCP conduits, qualifying covered bonds, and wholly owned subsidiaries); however, most of the exclusions would not be relevant to these types of special purpose entities. Generally, exclusions are not available for special purpose entities that hold securities and derivatives rather than loans.
Conclusion
Activities of participants in the structured products market will be affected in a variety of ways as a result of the Volcker rule’s implementation. At this stage, it is of vital importance that the trading desks of the relevant entities be involved in their institutions’ planning of their new operations, policies and procedures. They will need to ensure that, to the extent possible, their trading activities can be successfully fit into the institution’s overall compliance plans.
A variety of interpretative questions has already arisen, and will continue to arise prior to the effective dates of the new rules. Market participants will continue to monitor the interpretations and statements of the financial regulators, in order to help ensure their compliance with the new regime.