On July 17, the five main federal financial regulatory bodies — the Board of Governors of the Federal Reserve System (the Fed), the Securities and Exchange Commission, the Federal Deposit Insurance Corp., the Commodities Futures Trading Commission and the Office of the Comptroller of the Currency — published a proposed rule to simplify and tailor the so-called Volcker Rule, a provision under the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act that generally prohibits banking entities (including so-called nonbank systemically important financial institutions, or SIFIs) from engaging in proprietary trading and from owning or controlling “covered funds.” (Covered funds are entities, such as hedge funds or private equity funds, relying on certain specified exemptions from the Investment Company Act of 1940.)
The original Volcker Rule was codified in Section 619 of Dodd-Frank and formally implemented by federal regulation in December 2013 by the five bodies. In announcing the proposed rulemaking this past spring, the Fed indicated that the “proposed changes are intended to streamline the rule by eliminating or modifying requirements that are not necessary to effectively implement the statute, without diminishing the safety and soundness of banking entities.” The proposal is open for public comment until Sept. 17.
Key changes contemplated by the proposal include those summarized below.
- With respect to the prohibition on “proprietary trading” by banking entities:
- The definition of “trading account” — the entity on which the prohibition is actually imposed — is narrowed. Currently, a trading account is any account used for purchasing financial instruments primarily for the purpose of short-term resale or trading. Under the proposal, only financial instruments subject to capital requirements or certain accounting requirements would result in the account’s being deemed a trading account.
- Similarly, a presumption in the current rule that certain types of short-term trades make an account a trading account would be removed. In its place, a presumptive safe harbor would be granted for a trading desk that does not purchase or sell financial instruments for a trading account. Such a desk may calculate the net gain or net loss on its portfolio of financial instruments each business day, and if the sum of the absolute values of the daily net gain and loss figures for a rolling 90-calendar-day period does not exceed $25 million, the trading desk is presumed to be in compliance with the proprietary trading prohibition. If it exceeds such amounts, it must report such fact to the relevant federal regulatory body.
- An exemption from the definition of trading account, for certain accounts using liquidity management techniques, has been widened to permit the purchase of not only securities but also foreign exchange derivatives (e.g., currency swaps).
- An exemption to the proprietary trading prohibition has been added for trades made in error or trades needed to correct an error.
- In the rule’s existing exemptions for underwriting and market-making activities, a requirement that the bank enforce certain internal limits in order to qualify for the exemption has been narrowed to apply only to banking entities having “significant trading assets and liabilities” (generally, trading assets and liabilities, other than U.S. government-backed instruments in the case of a U.S. entity, the average gross sum of which over the previous consecutive four quarter-ends equals or exceeds $10 billion), and a presumptive safe harbor is granted to other types of banking entities that do maintain and enforce the specified internal limits.
- The conditions necessary to qualify for the safe harbor for “risk-mitigating hedging activities” have been relaxed, with some conditions being applied only to banking entities having “significant trading assets and liabilities.”
- The conditions necessary to qualify for the safe harbor for trading activities of foreign banking entities have been relaxed, with certain prongs of the existing rule eliminated under the proposal.
- With respect to covered funds:
- In order to qualify for the exemption for underwriting or market-making activities, under the proposal it would no longer be necessary that the banking entity not guaranty or assume the covered fund’s obligation.
- The ability to engage in “risk-mitigating hedging activities” without violating the covered fund prohibitions has been broadened to:
- No longer require a “demonstrable” showing of risk mitigation
- Include transactions that accommodate a customer’s specific request with respect to the fund
- Permit transactions in which the bank is acting as an intermediary on behalf of a customer
- With respect to permitted activities outside the United States:
- One of the conditions in the current rule to qualify for this exemption is that no ownership interest in the covered fund is offered to a resident of the U.S. The proposal would specify that an ownership interest in a covered fund is deemed “not offered for sale or sold to a resident of the U.S.” only if it is not sold “pursuant to an offering that targets residents” of the U.S. “in which the banking entity or any affiliate of the banking entity participates.”
- Another existing condition is that “no financing for the banking entity’s purchase or sale is provided, directly or indirectly, by any branch or affiliate that is located in the U.S. or organized under the laws of the U.S. or any state.” The proposal would delete this condition.
- With respect to reporting requirements:
- Banking entities with “limited trading assets and liabilities” (generally, trading assets and liabilities, other than U.S. government-backed instruments, the average gross sum of which over the previous consecutive four quarter-ends is less than $1 billion) are exempted from having a program to demonstrate compliance with the Volcker Rule.
Other specific prongs of a required compliance program would be applicable only to banking entities having “significant trading assets and liabilities.”