Yesterday, the Federal Deposit Insurance Corporation, the Federal Reserve Board, and the Office of the Comptroller of the Currency each issued a joint Notice of Proposed Rulemaking to implement the Volcker Rule (the “Notice”), which the Securities and Exchange Commission (“SEC”) also issued today.1
The Volcker Rule is part of the Dodd-Frank Act and restricts the proprietary trading and private investment fund activities of U.S. banks and bank affiliates, as well as foreign banks with banking operations in the United States and their affiliates (collectively, “banking entities”). While the Notice provides far more detail than was contained in the Dodd-Frank Act, many aspects of how the Volcker Rule will be implemented are still open to interpretation. Moreover, in addition to soliciting general comments, the Notice poses nearly 400 explicit questions for consideration. Once the regulation is finalized, banking entities will have until July 21, 2014 to conform their activities, with the Federal Reserve Board empowered to grant a banking entity up to three one-year extensions (with an additional five-year extension potentially available for investments in illiquid funds).
Interested parties will have until Jan. 13, 2012 to submit comments. The Notice is available at: http://www.federalreserve.gov/newsevents/press/bcreg/20111011a.htm.
This Alert summarizes the proposed regulation as it would affect a banking entity’s ability to engage in “proprietary trading.”2 In this regard, the proposed regulation would generally prohibit any activity where a banking entity is acting as principal in the purchase or sale of a “covered financial position” for its own “trading account.” The proposed regulation also establishes exemptions from the general prohibition for certain underwriting, market making, hedging and other specified activity, as discussed below.
GENERAL PROHIBITION ON PROPRIETARY TRADING
“Covered Financial Position”
A “covered financial position” is defined as any position, including any long, short, synthetic or other position, in any:
- Commodity futures contract; or
- Option on any of the above.
A “covered financial position” does not include any:
- Commodity; and
- Foreign exchange or currency.
- Regulatory guidance makes clear that the exclusion on loans, commodities and foreign exchange is intended to capture only the purchase and sale of these instruments themselves, and any derivative based off of these instruments is included in the definition of covered financial position and therefore subject to the prohibition on proprietary trading.
A “trading account” is defined to include any account that is:
Used to hold covered financial positions principally for the purpose of (i) short-term resale, (ii) benefiting from actual or expected short-term price movements, (iii) realizing short-term arbitrage profits, or (iv) hedging one or more such positions;
- Any account used to hold a covered financial position for 60 days or less is presumed to be a trading account. This presumption may be rebutted, if the banking entity can demonstrate that the position was not acquired principally for short-term trading purposes.
- Used by a banking entity that is subject to the Market Risk Capital Rules3 to acquire or take one or more covered financial positions that are subject to those rules, other than certain foreign exchange or commodities positions; or
- Used by a banking entity that is: (i) an SEC-registered securities or municipal securities dealer; (ii) a government securities dealer that registered, or that has filed notice, with an appropriate regulator; (iii) a CFTC-registered swap dealer; (iv) an SEC-registered security-based dealer, in each case to acquire or take covered financial positions in connection with its dealing activities; or (v) engaged in the business of a dealer, swap dealer, or security-based swap dealer outside of the United States if the position is acquired or taken in connection with the activities of such business.
- Used to hold covered financial positions principally for the purpose of (i) short-term resale, (ii) benefiting from actual or expected short-term price movements, (iii) realizing short-term arbitrage profits, or (iv) hedging one or more such positions;
An account will not be deemed a “trading account” if it is used solely for positions arising under:
- Repurchase or reverse repurchase agreements;
- Securities lending transactions;
Bona fide liquidity management, in accordance with a documented liquidity management plan that supports such characterization; or
- Such documented liquidity plan must:
- Specifically contemplate and authorize the particular instrument to be used;
- Require that any transaction contemplated and authorized by the plan be principally for the purpose of managing the liquidity of the banking entity;
- Require that any position be highly liquid and not susceptible to appreciable profits or losses based on short-term price movements;
- Contain limitations on the amounts consistent with the banking entity’s near-term funding needs; and
- Be consistent with the regulatory guidelines related to liquidity management.
- A banking entity’s position as a derivatives clearing organization registered under Section 5b of the Commodity Exchange Act or a clearing agency registered under Section 17A of the Securities Exchange Act of 1934.
EXCEPTIONS TO GENERAL PROHIBITION ON PROPRIETARY TRADING
Permitted Underwriting Activities
The purchase or sale of a covered financial position by a banking entity made in connection with its underwriting activities is exempt as long as:
- An internal compliance program is established;
- The covered financial position is a security;
The transaction is effected solely in connection with a distribution of securities for which the banking entity is acting as an underwriter;
- The definitions of “distribution” and “underwriter” are taken from, and generally the same as, the definitions provided in the SEC’s Regulation M. However, “underwriter,” as it is defined here, also includes a person who has an agreement with another underwriter to engage in a distribution of securities for or on behalf of an issuer or selling security holder.
- The banking entity is (i) appropriately registered as a dealer (ii) exempt from registration as a dealer, (iii) excluded from regulation as a dealer, or (vi) engaged in the business of a dealer outside of the United States and subject to substantive non-U.S. regulation of such business;
- The activity is designed not to exceed the reasonably expected near-term demands of clients, customers and counterparties;
- The activity is designed to generate revenues primarily from fees, commissions and underwriting spreads, and not from appreciation in the value of the covered financial positions it holds related to such activity; and
The compensation of persons performing the activity is designed not to encourage proprietary risk taking.
- This includes a prohibition on a compensation incentive structure that rewards appreciation of the market value of securities underwritten.
- The banking entity should provide compensation incentives that primarily reward client revenues and effective client service.
Permitted Market-Making-Related Activities
The purchase or sale of a covered financial position by a banking entity made in connection with its market-making-related activities is exempt as long as:
- An internal compliance program is established;
The unit within the banking entity conducting the activity holds itself out as being willing to both buy and sell the covered financial position for its own account on a regular or continuous basis;
- In the context of relatively liquid positions, this would generally include:
- Making continuous two sided quotes;
- A pattern of trading that includes both purchases and sales in roughly comparable amounts to provide liquidity;
- Making continuous quotes that are at or near the market on both sides; and
- Providing widely accessible and broadly disseminated quotes.
- In the context of less liquid positions, this would generally include:
- Holding oneself out as willing and available to provide liquidity by providing quotes on a regular (but not necessarily continuous) basis;
- With respect to securities, regularly purchasing covered financial positions from, or selling the positions to, clients, customers, or counterparties in the secondary market; and
- Transaction volumes and risk proportionate to historical customer liquidity and investment needs.
The activity is not designed to exceed the reasonably expected near-term demands of clients, customers and counterparties;
- Regulators judge compliance with this requirement based on all available facts and circumstances, including:
- An evaluation of the extent to which a trading unit’s transactions are (i) with customers versus non-customers, and (ii) the frequency with which the trading unit’s retained principal positions and risks turn over; and
- A comparison of the above figures to:
- The trading unit’s prior results with respect to similar positions and market situations, and
- The results of other banking entities’ trading units with respect to similar positions.
- Absent satisfactory explanatory facts and circumstances, a trading activity will be considered prohibited proprietary trading if it is not transacted through a trading system that interacts with orders of others or primarily with customers of the banking entity’s market-making desk to provide liquidity services.
- Possible explanatory facts and circumstances include (i) sudden market disruptions, (ii) substantial intermediary trading, and (iii) documented and reasonable expectations for temporary increases in customer demand in the near term.
- The banking entity is (i) appropriately registered as a dealer, (ii) exempt from registration as a dealer, (iii) excluded from regulation as a dealer, or (vi) engaged in the business of a dealer outside of the United States and subject to substantive non-U.S. regulation of such business;
- The activity is designed to generate revenues primarily from fees, and not from appreciation in the value of the covered financial positions held related to such activity;
The compensation of persons performing the activity must be designed not to encourage proprietary risk taking; and
The activity must be consistent with the other guidelines and regulatory commentary provided in the rule aimed at distinguishing permitted activities from proprietary trading.
- Regulators will base a general determination of whether a trading unit retains risk in excess of the size and type required for market-making-related purposes on all available facts and circumstances, including a comparison of retained principal risk to:
- The amount of risk that is generally required to execute a particular market-making function;
- Hedging options that are available in the market and permissible under the banking entity’s hedging policy at the time the particular trading activity occurred;
- The trading unit’s prior levels of retained risk and its hedging practices with respect to similar positions; and
- The levels of retained risk and the hedging practices of other trading units with respect to similar positions.
- This commentary suggests that bona fide market-making activity will generally involve either:
-With respect to securities trading on an organized trading facility or exchange, the passive provision of liquidity by the submission of resting orders that interact with the orders of others on an organized trading facility or exchange and acting as a registered market maker where applicable, or
- With respect to less liquid positions, the provision of an intermediation service to its customers by assuming the role of a counterparty that stands ready to either buy or sell a position from a customer.
- Regulatory guidance also states that the following situations, in addition to the failure to adhere to the explicit requirements for permissible market-making-related activity, would be demonstrative of prohibited proprietary trading:
- Trading that exhibits any of the following characteristics:
- Generates only very small or very large amounts of revenue per unit of risk taken;
- Does not demonstrate consistent profitability; or
- Demonstrates high earnings volatility; or
- Trading that routinely results in the payment of fees rather than receipt of fees, commissions, or spreads.
The proposed rule contemplates that certain hedging activities will qualify as permissible market-making-related activities. To qualify, the activity must:
- Be conducted in order to reduce the specific risks to the banking entity in connection with the holdings held pursuant to the market-making-related exemption, and
- Meet the criteria for the general exemption on risk-mitigating hedging activities.
Permitted Risk-Mitigating Hedging Activities
The purchase or sale of a covered financial position by a banking entity made in connection with and related to its individual or aggregated positions, contracts, or other holdings and designed to reduce the specific risks of these holdings will be exempt as long as:
- An internal compliance program is established;
- Relevant trading activities are made in accordance with such internal compliance program;
The transaction hedges actual risks arising in connection with and related to positions, contracts, or other holdings of the banking entity, either on an individual, or aggregate (i.e., portfolio) basis;
- Anticipatory hedging will be permitted where the hedge is established slightly before the banking entity is exposed to the underlying risk if such anticipatory hedging:
- Is consistent with the internal compliance program;
- Meets the other requirements of the hedging exemption; and
- Does not involve the potential for speculative profit.
- A banking entity relying on this exemption should be prepared to identify the specific position or portfolio of positions that is being hedged and demonstrate that the hedging transaction is risk-reducing in the aggregate, as measured by the appropriate risk management tools.
The transaction is reasonably correlated, based upon the facts and circumstances of the underlying hedging positions and the risks of the liquidity of those positions, to the risk or risks the transaction is intended to hedge or otherwise mitigate;
- Regulatory commentary suggests that if the predicted performance of a hedge position during the period that the hedge position and the related position are held would result in a banking entity earning appreciably more profits on the hedge position than it stood to lose on the related position, the hedge would appear likely to be a prohibited proprietary trade.
- The hedging transaction does not give rise, at the inception of the hedge, to significant exposures that are not themselves hedged in a contemporaneous transaction;
- The transaction is subject to continuing review, monitoring and management after it is initiated; and
- The compensation of persons performing the risk-mitigating hedging activities are designed not to reward proprietary risk-taking.
- A special documentation requirement, mostly calling for contemporaneous and detailed transaction logs, is imposed where a banking entity conducts a hedging transaction established at a level of organization that is different than the level of organization establishing the positions, contracts or other holdings the risks of which the hedging transaction is designed to reduce.
Other Permitted Proprietary Trading Activities
Trading in Government Obligations
The prohibition on proprietary trading does not apply to the purchase or sale by a banking entity of a covered financial position that is:
- An obligation of the United States or any agency thereof;
- An obligation, participation, or other instrument of, or issued by, (i) the Government National Mortgage Association, (ii) the Federal National Mortgage Association, (iii) the Federal Home Loan Mortgage Corporation, (iv) a Federal Home Loan Bank, (v) the Federal Agricultural Mortgage Corporation, or (vi) a Farm Credit System institution chartered under and subject to the provisions of the Farm Credit Act of 1971; or
- An obligation of any state or any political subdivision thereof.
- The prohibition on proprietary trading does not apply to the purchase or sale by a banking entity of a covered financial position that is:
Trading “On Behalf of Customers”
- The prohibition on proprietary trading does not apply to the purchase or sale of a covered financial position by a banking entity “on behalf of customers.”
A purchase or sale of a covered financial position will be deemed to be “on behalf of customers” if it is:
- Conducted by a banking entity acting as (i) investment adviser, (ii) commodity trading adviser, (iii) trustee, or (iv) an adviser in a similar fiduciary capacity solely for a customer and for the account of, and positions beneficially owned by, that customer;
- Made with the banking entity acting as riskless principal; or
- Made solely for the separate account of insurance policyholders by a banking entity that is a regulated insurance company.
Trading by a Regulated Insurance Company
- The prohibition on proprietary trading does not apply to (i) a banking entity’s purchase or sale of a covered financial position if the banking entity is a regulated insurance company acting for its general account, or (ii) an affiliate of an insurance company acting for the insurance company’s general account.
Permitted Trading Outside of the United States
The prohibition on proprietary trading does not apply to the purchase or sale of a covered financial position by a banking entity organized in a non-U.S. jurisdiction, if:
- The banking entity in question is not directly or indirectly controlled by a banking entity that is organized in a U.S. jurisdiction;
- The purchase or sale is conducted pursuant to paragraph (9) or (13) of Section 4(c) of the BCA Act meaning either of the following; and
- The prohibition on proprietary trading does not apply to the purchase or sale of a covered financial position by a banking entity organized in a non-U.S. jurisdiction, if:
- If the entity is a “foreign banking organization” under the Federal Reserve Board’s Regulation K, it must be a “qualifying foreign banking organization” and comply with subpart B thereunder.4
- If the entity is not a “foreign banking organization” under Regulation K, it must meet at least two of the following:
- Its total non-U.S. assets exceed its total U.S. assets;
- Its total non-U.S. revenues exceed its total U.S. revenues; or
- Its total non-U.S. net income exceeds its total U.S. net income.
- The purchase or sale occurs “solely outside of the United States.”
- In addition to the banking entity being organized in a non-U.S. jurisdiction, the following requirements must be met in order for a transaction to be characterized as occurring “solely outside the United States”:
- No party to the transaction is a resident of the United States;
- No personnel of the banking entity who is directly involved in the transaction is physically located in the United States; and
- The transaction is executed wholly outside the United States.
Limitations on Permitted Proprietary Trading
No transaction, class of transactions, or activity will be deemed permissible, even if compatible with other specified requirements for permitted proprietary trading, if such transaction, class of transactions or activity would:
- Involve or result in a material conflict of interest between the banking entity and its clients, customers or counterparties;
- Materially expose the banking entity, directly or indirectly, to a high-risk asset or high risk trading strategy; or
- Pose a threat to the safety and soundness to the banking entity or to the financial stability of the United States.
- These are necessarily subjective analyses that a banking entity will have to undertake, but that will ultimately be judged by its primary federal regulator.