The five U.S. federal agencies that are principally responsible for banking and financial market regulation in the United States (collectively, the Agencies)1 have approved a notice of proposed rulemaking (the NPR) that proposes significant revisions to the final rule (the Final Rule) implementing the Volcker Rule.2
The revisions would leave intact the core restrictions on proprietary trading and covered fund activities. However, the revisions would make certain significant changes to those restrictions. For example, the revisions to the proprietary trading restrictions would eliminate the first prong of the “trading account” definition, which addresses the intent of a banking entity when it purchases and sells financial instruments, and would add a new prong that addresses those financial instruments that are recorded by a banking entity at fair value under applicable accounting standards. The revisions to the compliance program requirements would eliminate almost all of the “enhanced minimum standards” set forth in Appendix B of the Final Rule. The revisions to the covered fund restrictions would be more limited, but the Agencies sought comment regarding many other aspects of those restrictions, including the base definition of “covered fund” (and certain express exclusions from that definition) and the definition of “ownership interest” (as it relates to debt securities issued by covered funds that are securitization issuers).
Recently passed legislation exempts community banks and other small banking organizations from the Volcker Rule and modifies the name-sharing restrictions of the Final Rule.3 Changes to the Final Rule required by that legislation are expected to be the subject of a separate rulemaking and are not dealt with in the NPR.
Comments in response to the NPR must be received by the Agencies within 60 days of its publication in the Federal Register.
Banking Entity Categories
The Final Rule, if revised in accordance with the NPR (the Revised Rule), would divide banking entities into three categories based on the level of their trading assets and liabilities. Those categories would be used to tailor the requirements in several sections of the Revised Rule, including the compliance program requirements. A banking entity’s category would be determined as of a given date by the average gross sum of its trading assets and liabilities (together with those of its subsidiaries and other affiliates) over the prior consecutive four quarters (measured as of the last day of each quarter). Obligations of the United States or any agency thereof would be excluded from the calculations. The categories and thresholds would be
- significant trading assets and liabilities: $10 billion or more
- moderate trading assets and liabilities: $1 billion or more
- limited trading assets and liabilities: less than $1 billion
Trading assets and liabilities would generally be measured on a worldwide basis. However, for purposes of determining whether a foreign banking organization (an FBO) has significant trading assets and liabilities, the FBO would measure only the trading assets and liabilities of the combined U.S. operations of the FBO’s top-tier entity (including all subsidiaries, affiliates, branches and agencies of the FBO operating, located or organized in the United States). But that limitation would not apply when the FBO determines whether it qualifies as having limited trading assets and liabilities. Thus, because of their worldwide trading operations, many FBOs with limited U.S. operations would likely be prevented from qualifying as having limited trading assets and liabilities.
Even if a banking entity does not exceed the threshold for a given category, the applicable Agency could assign the banking entity to that category if the Agency were to determine that the banking entity should be treated accordingly under the Revised Rule.
Proprietary Trading Restrictions
Definition of “Trading Account”
The NPR proposed significant changes to the definition of “trading account.” These changes are generally intended to make application of the definition to particular trades clearer and more objective. They would also likely reduce the compliance burden for some banking entities. However, the proposed changes would also likely expand the definition of trading account to reach trades that the definition does not currently cover.
Removal of the short-term intent prong and 60-day presumption. The NPR would remove the short-term intent prong of the definition of trading account. That prong requires banking entities to make subjective judgments about the purpose of each trade. The Agencies also proposed to remove the associated 60-day rebuttable presumption that the purchase or sale of a financial instrument is for the trading account if the banking entity holds the instrument for fewer than 60 days or substantially transfers the risk of the position within 60 days. Those changes would be meaningful because they would both narrow the scope of the trading account definition and reduce the subjectivity of its application.
Addition of accounting prong. The Agencies proposed to add a new prong to the definition of trading account, the so-called “accounting” prong. Under the new prong, the trading account of a banking entity would include any account used to purchase or sell financial instruments that the banking entity records at fair value on a recurring basis under applicable accounting standards. The Agencies noted that this would give banking entities greater certainty because they should know which instruments are recorded at fair value on their balance sheets. However, as the Agencies also acknowledged, the new prong would cover, among other things, transactions in derivatives, trading securities and available-for-sale securities. Some of these categories of financial instruments are quite broad and would likely result in transactions being assigned to a banking entity’s trading account even though the existing short-term intent prong of the definition does not cover these transactions. The Agencies appear to have recognized the potential breadth of this test, as they posed in the NPR a series of questions for public comment about the scope of the accounting prong, including whether available-for-sale securities should be included.
Trading desk rebuttable presumption of compliance. Under the proposed accounting prong, trading desks that remained below a certain quantitative threshold for trading activity would be presumed to be in compliance with the proprietary trading prohibition of the Volcker Rule. Such trading desks would remain subject to the prohibition, and the applicable Agency would be able to rebut the presumption; however, those trading desks would not be obligated to demonstrate on an ongoing basis that they were in compliance. The presumption would not be available for trading desks that are subject to the dealer or market risk capital prongs of the definition of trading account (discussed below).
To benefit from the presumption, a trading desk would be required to determine, on a daily basis, the absolute value of its net realized and unrealized gains and losses based on fair value. The trading desk could take advantage of the presumption on any date on which the sum of such daily absolute values for the preceding 90-day period did not exceed $25 million. In effect, the trading desk would need to renew its 90-day profit and loss calculation on a daily basis.
Given that trading desks remain subject to the proprietary trading prohibition and the presumption may be rebutted by the applicable Agency — and that trading desks could inadvertently exceed the $25 million threshold from time to time — trading desks would likely maintain, in practice, some version of a compliance program even if they were to qualify for the presumption as an initial matter.
Expansion of market risk capital prong to foreign banking organizations. The Agencies proposed to retain the dealer prong and the market risk capital rule prong of the trading account definition. However, FBOs should note the Agencies’ proposal to expand the market risk capital prong to cover non-U.S. banking entities that are subject to home-country capital requirements under a market risk framework that is consistent with the framework published by the Basel Committee on Banking Supervision. Under the Final Rule, the market risk capital prong applies only with respect to banking entities subject to the U.S. market risk capital rules.
Exclusions From Proprietary Trading
Liquidity management exclusion. The Final Rule limits the exclusion for liquidity management activities to designated purchases and sales of securities. In the NPR, the Agencies proposed to expand the financial instruments covered by the liquidity management exclusion. As expanded, the exclusion would be available for transactions involving foreign exchange forwards, foreign exchange swaps and physically settled cross-currency swaps (in addition to transactions involving securities). The use of such instruments must still meet the other conditions of the liquidity management exclusion in the Final Rule.
Error trades. The Agencies acknowledged in the NPR that on occasion banking entities erroneously purchase or sell financial instruments in the course of conducting otherwise permissible activities. The NPR proposed a new exclusion from the definition of proprietary trading for error trades and subsequent correcting transactions. The Agencies cautioned that the availability of this exclusion would depend on the facts and circumstances of the trades and that once recognized, financial instruments acquired in error should be transferred to a separately managed trade error account for resolution. This reflects the position of the Agencies that the error trade exclusion should be used only for bona fide errors and not as a means of evading the requirements of the rule.
Definition of “Trading Desk”
The definition of “trading desk” in the Final Rule remains unchanged in the NPR. However, the Agencies included significant commentary about the existing definition and posed questions regarding potential alternative definitions. In particular, the Agencies asked whether a definition of trading desk that more closely aligns with the manner in which banking entities structure trading desks for commercial purposes would be more appropriate in light of concerns that the existing definition is applied at too granular a level. The Agencies recognized that there is an interplay between any potential changes to the definition of trading desk and the proposed presumption of compliance for individual trading desks that have a 90-calendar-day absolute P&L that does not exceed $25 million. However, it is unclear whether the Agencies would adjust the dollar threshold related to the presumption if they were to change the definition of trading desk.
Underwriting and Market-Making Exemptions
The NPR proposed two sets of changes to each of the underwriting and market-making exemptions from the proprietary trading prohibition. One set of changes is designed to simplify the compliance burdens for banking entities relying on these exemptions; those changes relate to the level of a banking entity’s trading assets and liabilities. The other set of changes is designed to facilitate easier application of one of the conditions to relying on the exemptions; those changes relate to a banking entity’s reasonably expected near-term demands of clients, customers or counterparties of the banking entity (RENTD).
Reduced compliance burdens for certain banking entities. Banking entities with significant trading assets and liabilities generally would remain required under the Revised Rule to maintain, as a condition to reliance on the underwriting and market-making exemptions, compliance programs designed to satisfy the requirements of those exemptions as currently set forth in the Final Rule (but modified with respect to RENTD, as further discussed below). However, banking entities with either moderate or limited trading assets and liabilities would not be required to maintain such compliance programs as a condition to relying on those exemptions, although they would remain subject to the other conditions of those exemptions. In practice, it appears that some type of a compliance program would again be needed for banking entities to ensure that they are in fact complying with the other conditions, but the Agencies noted that their proposal should give a banking entity with moderate or limited trading assets and liabilities the option to tailor its compliance program in a manner appropriate for the banking entity.
RENTD replacement with internal risk limits. In the NPR, the Agencies proposed an alternative means by which a banking entity could satisfy the RENTD requirement. If a banking entity were to establish and enforce certain internal risk limits at each trading desk, the banking entity would be presumed to satisfy the RENTD requirement in connection with related underwriting and market making-related activities. The proposed internal risk limits would be required to address specific criteria (which differ to some extent for the underwriting and market-making exemptions) and would be subject to reporting requirements and Agency review. The presumption of compliance would be rebuttable by the applicable Agency depending on the facts and circumstances.
Risk-Mitigating Hedging Exemption
The Agencies acknowledged the difficulty and costs of implementing certain aspects of the Final Rule’s exemption for risk-mitigating hedging, and they proposed two changes in the NPR designed to address some of those challenges for all banking entities:
- Elimination of the correlation analysis requirement. Banking entities would not be required to complete a correlation analysis that demonstrates that the hedging activity demonstrably reduces or mitigates the specific risks being hedged.
- Elimination of the requirement that banking entities continually show that a hedge “demonstrably” reduces or otherwise significantly mitigates a particular risk. Hedges must nonetheless still be “designed” to reduce or otherwise significantly mitigate particular risks and be recalibrated on an ongoing basis.
The Agencies proposed additional changes whose applicability depends on the level of trading assets and liabilities. Thus, for banking entities that do not have significant trading assets and liabilities, the Agencies also proposed three additional changes:
- elimination of the requirement for a separate internal compliance program
- elimination of the restrictions on compensation arrangements for employees who perform risk-mitigating hedging activities
- elimination of the additional documentation requirements for hedging activities involving other trading desks or instruments or strategies not contemplated by the policies and procedures of the trading desk
For banking entities with significant trading assets and liabilities, the Agencies proposed to reduce, but not eliminate, the documentation requirements for hedging activities involving other trading desks or instruments or strategies not contemplated by the policies and procedures of the trading desk.
The Agencies also sought comments (but did not propose specific changes) regarding whether there should be a further exemption (presumably subject to fewer or no conditions) for hedging activity that is accounted for as hedging under applicable accounting rules.
Collectively, the proposed changes would likely reduce the costs and other burdens of compliance with the hedging exemption and therefore would likely encourage hedging activity that might not otherwise have been undertaken.
TOTUS: Trading Activity Outside the United States
The Final Rule provides an exemption for non-U.S. banking entities engaged in certain trading activity outside of the United States. It is sometimes referred to as the TOTUS exemption. In the NPR, the Agencies proposed to broaden its application by modifying one of its conditions and eliminating two other conditions.
- The NPR would modify the TOTUS condition requiring that personnel of the banking entity (or its affiliates) who arrange, negotiate or execute a given transaction not be located in the United States. That condition would be modified to address only “the decision to purchase or sell as principal,” thus permitting some involvement by U.S. personnel of the banking entity (or its affiliates) in the arrangement, negotiation and execution of trades.
- The NPR would eliminate the TOTUS condition requiring that no financing for a purchase or sale be provided by any U.S. branch or affiliate of the banking entity. However, the principal risk of the transaction would still be required to be booked and accounted for outside the United States.
- The NPR would eliminate the TOTUS condition prohibiting transactions from being conducted “with or through” any U.S. entity. Eliminating this condition would resolve complicated questions regarding application of the condition, particularly whether particular transactions with U.S. entities qualify for an exception to the prohibition.
Covered Fund Activities and Investments
Definition of “Covered Fund”
In the NPR, the Agencies did not propose specific changes either to the Final Rule’s base definition of “covered fund” or to the Final Rule’s express exclusions from that definition. However, the NPR discussed the base definition and the exclusions at length, and the detail of the related questions suggests that possible changes have already been the subject of significant interagency consideration.
Base definition of covered fund. In their first question related to the base definition of covered fund, the Agencies focused on the statute’s use of the terms “hedge fund” and “private equity fund.” The Agencies asked whether those terms should be defined and used in the Revised Rule. The Agencies also asked whether they “should provide exclusions from the covered fund base definition for an issuer that does not share certain characteristics commonly associated with a hedge fund or private equity fund.”4 In a related observation, the Agencies recalled an earlier statement, in the Final Rule Release, that the related statutory definition permits the Agencies “to tailor the scope of [their regulatory] definition to funds that engage in the investment activities contemplated by [the statute] (as opposed, for example, to vehicles that merely serve to facilitate corporate structures).”5
The Agencies’ questions and related observations thus suggest that the Agencies will be willing at least to consider changes that would result in the covered fund definition’s comporting better with the kinds of entities that are commonly understood to be hedge funds and private equity funds.
“Characteristics-based approach” and Form PF. The Agencies noted that, when the Final Rule was adopted, the Agencies had considered but rejected defining covered fund by reference to various fund characteristics, and that they chose instead to define the term by reference to Sections 3(c)(1) or 3(c)(7) under the Investment Company Act of 1940 (as the statutory definition does). Nonetheless, in the NPR the Agencies sought comment regarding whether they should revisit a “characteristics-based” approach to the definition.
In seeking that input, the Agencies discussed SEC’s Form PF, which uses a “characteristics-based approach to define different types of funds.”6 The Agencies queried whether the defined terms in Form PF7 might serve as guideposts for the Revised Rule’s covered fund definition. However, the Agencies’ questions point toward potential difficulties that they continue to see with respect to a characteristics-based definition.
Securitizations. Through a series of five questions, the Agencies sought comment regarding a number of issues that the Final Rule raised for the securitization markets. For example, in discussing the covered fund exclusion for “loan securitizations,” the Agencies asked whether issuing entities should be permitted to hold debt securities as a small (5 to 10 percent) proportion of their portfolios. This question relates to so-called “bond buckets,” which were, prior to the Volcker Rule, frequently included in the structure of collateralized loan obligation transactions.
The Agencies also sought comment regarding the definition of “ownership interest” as it applies to certain creditor rights. They asked whether the Revised Rule should make it clear that the ownership interest definition would not be trigged by a “right to participate in the removal of an investment manager for cause, or to nominate or vote on a nominated replacement manager upon an investment manager’s resignation or removal.”8
Foreign public funds. The Agencies posed multiple questions regarding the exclusion for “foreign public funds,” several of them focusing on the specific means by which the Final Rule identifies foreign funds that are similar to investment companies that are registered under the Investment Company Act of 1940 (RICs). The Agencies appear to be evaluating whether the prescriptive, but not always precise, manner that foreign public funds are identified in the Final Rule has served the purpose of excluding funds that are in fact similar to RICs (which are themselves excluded from the definition of covered fund).
Family wealth management vehicles. The Agencies sought comment regarding whether entities established by family wealth offices are covered by the base definition of covered fund under the Final Rule and, if so, whether such entities should be excluded under the Revised Rule. The Agencies asked commenters to identify the factors that would distinguish a family wealth management entity from a hedge fund or private equity fund. They also queried whether proposed changes to the Super 23A Restrictions (as defined and discussed below) would alleviate related concerns under the Final Rule.
Joint ventures. The Agencies sought comment regarding the exclusion of certain joint ventures from the covered fund definition. The Agencies noted that their staffs had published a response to a frequently asked question (FAQ) in 2015 to provide guidance regarding the exclusion. In large part, the related questions in the NPR address the issues addressed in the FAQ response.
Tender option bond issuers. The Agencies noted that banking entities have restructured how they participate in tender option bond (TOB) transactions because of the Final Rule. The Agencies sought comment regarding the roles that banking entities are now playing in those transactions and how the Final Rule has affected the TOB market generally. The Agencies also queried whether proposed changes to the Super 23A Restrictions would address challenges that banking entities have faced in relation to TOBs as a result of the Final Rule.
Underwriting, Market Making and Hedging Related to Covered Funds
As discussed above, the Final Rule includes, as exceptions to its general prohibition on proprietary trading, provisions that permit underwriting, market making and hedging. In addition, the Final Rule includes provisions that operate exclusively in connection with those activities as they relate to covered funds. The NPR proposes changes to those additional provisions.
Hedging. The NPR proposed a rule change that would permit banking entities to acquire covered fund interests “when acting as intermediary on behalf of a customer that is not itself a banking entity to facilitate the exposure by the customer to the profits and losses of the covered fund”; the NPR would require that any such hedge be for a “transaction conducted solely to accommodate a specific customer request with respect to the covered fund.”9
The Agencies noted that they had originally proposed, in 2011, to permit such hedging activity but that the Final Rule was adopted with a more limited hedging provision (limited to the hedging of employee compensation arrangements involving covered fund interests). If the Revised Rule were to permit hedging of the kind proposed in the NPR, banking entities would be able again to offer structured products that are linked to covered funds and to engage in other customer-oriented activities in which banking entities engaged before the Final Rule was adopted.
Underwriting and market making. The Final Rule imposes limitations on a banking entity when it acquires ownership interests in covered funds in the course of underwriting or making a market in such ownership interests. Some of the limitations apply only if the banking entity sponsors, advises or organizes and offers the covered fund in question; other limitations apply in the case of third-party covered funds as well. The latter limitations restrict a banking entity’s aggregate holdings of ownership interests and require certain related regulatory capital deductions.
The NPR would eliminate the latter limitations — related to aggregate holdings and regulatory capital deductions — where banking entities underwrite or make a market in ownership interest of third-party covered funds. The NPR would maintain those limitations for covered funds that a banking entity sponsors, advises or organizes and offers.
SOTUS: Covered Fund Activity Outside the United States
The Final Rule provides an exemption for non-U.S. banking entities to engage in certain covered fund activity outside of the United States. It is sometimes referred to as the SOTUS exemption. The NPR proposes two changes here: First, the NPR proposes to incorporate into the Revised Rule an FAQ response that the Agencies’ staffs published in 2015. That response clarified that the SOTUS “marketing restriction” — the requirement that covered fund ownership interests not be offered or sold to U.S. residents — applies only where the banking entity that wishes to rely on the SOTUS exemption participates in related offer and sale activity.10 Thus, a non-U.S. banking entity is permitted to invest in a U.S.-offered covered fund as long as the banking entity does not itself engage in marketing the covered fund (and other SOTUS conditions are met). The NPR, like the FAQ response, would deem a banking entity to participate in such offer and sale activity if it (or an affiliate) sponsors or serves, directly or indirectly, as the investment manager, investment adviser, commodity pool operator or commodity trading adviser to the respective covered fund.
Second, the NPR would eliminate the SOTUS condition that states that no financing for the banking entity’s ownership or sponsorship may be provided, directly or indirectly, by any branch or affiliate located in the United States or organized under the laws of the United States or of any state.
Super 23A Restrictions and Covered Funds
The Final Rule places restrictions on a banking entity’s ability to take certain kinds of exposure to covered funds for which the banking entity serves, directly or indirectly, as the investment manager, investment adviser, commodity trading adviser or sponsor, or that the banking entity otherwise organizes and offers. Those restrictions are referred to as Super 23A Restrictions because they are based on Section 23A of the Federal Reserve Act (which restricts the kinds of exposure that an FDIC-insured depository institution may take to its affiliates).
The NPR proposes only a single minor change to the Super 23A Restrictions (related to the timing of an officer certification for the prime brokerage exception to the restrictions, which is consistent with guidance that the Agencies’ staffs have previously provided). However, the Agencies address a much broader (and more important) subject by seeking comment regarding whether certain exceptions to restrictions under Section 23A under the Federal Reserve Act, which were not mirrored as exceptions to the Super 23A Restrictions, should be reconsidered. Specifically, the Agencies asked whether they should adopt an interpretation of the statutory provisions (different from the interpretation that they adopted in the Final Rule Release) that would permit the Revised Rule to reflect, for purposes of the Super 23A Restrictions, some or all of the exemptions in Section 23A of the Federal Reserve Act and the Board’s Regulation W. Those exemptions would permit, for example, (i) engaging in credit transactions with a covered fund, so long as the credit is secured by obligations of the United States, obligations guaranteed by the United States or cash held for that purpose in a segregated, earmarked deposit account and (ii) purchasing, at or below the current market price, assets for which there are readily identifiable and publicly available market quotations.
The Agencies also sought comment regarding related no-action relief that the CFTC provided to futures commission merchants (FCMs) that are banking entities. In its no-action letter, the CFTC provided relief for futures, options and swaps clearing services provided by a registered FCM to covered funds for which affiliates of the FCM are engaged in the services that trigger the Super 23A Restrictions. The NPR states that the other Agencies do not object to the CFTC’s no-action relief.
Compliance Program Requirements and Metrics Reporting
The NPR would simplify the compliance reporting requirements for all banking entities (including eliminating almost all of the “enhanced minimum standards” of the Final Rule’s Appendix B) and would make a number of detailed changes to the metrics reporting requirements (set forth in the Final Rule’s Appendix A) for the limited number of banking entities that must report those metrics.
Compliance Program Requirements
The three categories of banking entities that the NPR established (described above) would be subject to the following compliance program requirements.
Banking entities with significant trading assets and liabilities. Each such banking entity would be required to maintain a compliance program that satisfies (i) the “six-pillar” requirements of Section __.20(b) of the Final Rule,11 (ii) the covered fund documentation requirements of Section __20(e) of the Final Rule and (iii) the CEO attestation requirement of the Final Rule’s Appendix B. However, the balance of the “enhanced minimum standards” set forth in Appendix B — which elaborate on, and set minimum detailed requirements related to, the “six pillars” — would be eliminated. The Agencies explained:
The Agencies believe that the six-pillar compliance program requirements (currently in § __.20(b) of the 2013 final rule) can be appropriately tailored to the size and activities of each banking entity that is subject to these requirements. The proposed approach would afford banking entities flexibility to integrate the § __.20 compliance program requirements into other compliance programs of the banking entity, which may reduce complexity for banking entities currently subject to the enhanced compliance program requirements.12
Banking entities with moderate trading assets and liabilities. Each such banking entity would be required to establish a “simplified compliance program” in the manner prescribed currently by Section __20(f)(2) of the Final Rule; in addition, each such banking entity would be subject to the CEO attestation requirement described above (with respect to banking entities with significant trading assets and liabilities). Thus, a banking entity in this category would meet its compliance program requirements if it included in its existing compliance policies and procedures (i) references to the requirements of the Volcker Rule statutory provisions (Section 13 of the BHCA) and the implementing rules and (ii) the CEO attestation requirement.
Banking entities with limited trading assets and liabilities. Each such banking entity would be presumed to be in compliance with the Volcker Rule and would have no obligation to demonstrate compliance on an ongoing basis. The Agencies explained:
The Agencies would not expect a banking entity that meets the proposed criteria for the presumption of compliance to demonstrate compliance with the proposal in conjunction with the Agencies’ normal supervisory and examination processes. However, the appropriate Agency may exercise its authority to treat the banking entity as if it does not have limited trading assets and liabilities if, upon review of the banking entity’s activities, the relevant Agency determines that the banking entity has engaged in proprietary trading or covered fund activities that are otherwise prohibited under subpart B or subpart C.13
Section __.20(d) of the Final Rule requires the largest banking entities to report quantitative trading information in significant detail, as described in the Final Rule’s Appendix A. The NPR would retain Section __.20(d), but it would apply only to banking entities with significant trading assets and liabilities. In addition, the NPR would make significant changes to Appendix A with respect to the metrics that must be reported.