On October 11, 2011, federal banking and securities regulators released the proposed Volcker Rule to implement requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), which became effective on July 21, 2010. The Volcker Rule is named after Paul A. Volker, the former chairman of the Federal Reserve, a staunch advocate of curbing exotic activities and excessive risk-taking by banks and other financial institutions. Section 619 of Dodd-Frank, which will become effective July 21, 2012, prohibits banking entities from engaging in “proprietary trading” and from entering into certain relationships with hedge funds or private equity funds. Congress mandated that federal regulators adopt rules to implement Section 619. The proposed rule is also to become final on July 21, 2012, however, conformance periods provided in the rule for banking entities engaged in covered activities extend the actual compliance date at least two years, and in some situations up to five years. Banking entities subject to the proposed rule include insured depository institutions, bank holding companies and their subsidiaries or affiliates (including affiliated broker-dealers).
Comments on the proposed Volcker Rule are due by January 13, 2012. As a testament to the magnitude of the proposed rule in operation, in the 298-page proposing Release, regulators posed nearly 400 unanswered questions on which comments are solicited.
Rule would curtail short-term trading by banking entities
Under Dodd-Frank, a banking entity may not engage in short-term trading of any security, derivative and certain other instruments for its own account. The proposed rule implements this prohibition by imposing limitations on activities by banking entities seen as having significantly contributed to the 2008 financial crisis. The stated goal, however, is not to unduly constrain the ability of a banking entity to continue to structure its businesses and manage its risks in a safe and sound manner, and to effectively deliver to clients the types of financial services that are important to the U.S. financial markets and the participants in those markets.
The core prohibition on proprietary trading, for example, focuses on trading activity in which positions are taken by a banking entity principally for the purpose of short-term resale, to benefit from actual or expected short-term price movements, to realize short-term arbitrage profits, or to hedge other trading account positions, all of which turn on short-term trading intent. Exemptions, however, are included for underwriting and market-making activities provided certain requirements designed to ensure that the trading activity is consistent with bona fide underwriting and market-making. Risk-mitigating hedging also is permitted, but again, subject to requirements ensuring that the activity be truly risk-mitigating hedging in its purpose and effect. Nevertheless, a paramount concern is the ability to distinguish between prohibited proprietary trading and such other permitted activities.
Conflicts of interest, risky strategies targeted
Overarching all permitted activity, however, is the general prohibition of any transaction by a banking entity that involves or would result in a material conflict of interest with a client, customer or counterparty. Additionally, banking entities may not engage in transactions or activity that would result, directly or indirectly, in a material exposure to a high-risk asset or high-risk trading strategy; or which would pose a threat to the safety and soundness of the covered banking entity or to the financial stability of the United States.
Private equity and hedge fund participation is severely limited
Dodd-Frank generally prohibits banking entities from investing in or retaining interest in hedge funds or private equity funds. The proposed Volcker Rule implements the Dodd-Frank prohibition by prohibiting a banking entity from directly or indirectly acquiring and retaining an ownership interest in, or having certain relationships with, a “covered fund,” which as defined, includes hedge funds, private equity funds and commodity pools. The rule does allow a banking entity to sponsor a covered fund, subject to conditions that ensure the activity is related to bona fide trust, fiduciary, investment advisory or commodity trading advisory services. Also, a banking entity may acquire and retain ownership in a covered fund that it or any of its affiliates sponsor for the purpose of providing sufficient initial equity to the fund to permit the fund to attract unaffiliated investors, provided it takes only a de minimis interest, not exceeding 3 percent of the total outstanding interests in the fund. Other requirements, including an aggregate investment limitation, also apply.
Other provisions of the rule would permit banking entities to acquire and maintain ownership interests in a joint venture that is an qualified operating company, and to have ownership interests in qualifying small business investment companies. There are other permitted activities and investments which are not of the type and scope seen as undermining the safety and soundness of banking entities. As with all parts of the proposed rule, there are many unanswered questions yet to be addressed through the comment process.
Concerns raised about compliance costs, vagueness
As an overarching consideration, the proposed Volcker rule mandates the establishment and implementation of an extensive compliance program. Banking entities have cited the major burdens and costs of compliance, and the absence of bright lines on many questions that will make it difficult to put the mandated compliance program into place. A call for clarity concerning exceptions in the proposed rule for permissible activities upon which a compliance program may be based is being made. Consumer advocates have also urged that the final Volcker Rule should spell out precisely what banking entities can and cannot do.
There are other concerns. In the wake of the release of the proposed rule, market participants have expressed serious reservations over the potential negative impact on market liquidity and concerns that it will discourage investment, limit credit availability and increase the cost of capital for companies. Private equity and hedge funds will see a fundamental change their investor base, as a banking entity’s ability to maintain its investment position in a fund will depend upon the size of that position in relation to the size of the fund, and the aggregate amount of similar investments by that entity. It is thus certain that the road to a final Volcker Rule has more twists and turns. Dodd-Frank makes the destination clear, however, and fundamental changes are now simply a matter of time and the effective input of those directly impacted into the final drafting process.