Flesh is starting to be put on the bones of the Volcker Rule, but that isn't making it any more attractive. As proposed, the regulations that would implement the Rule would require a massive effort by large banking institutions, both domestic and foreign, to implement policies, procedures, controls and reporting systems in order to continue conducting trading and private funds activities. Following is a summary of the proposed regulations and their implications, and some of the issues that financial institutions should surface with the regulatory agencies during the comment period.
Four financial regulatory agencies have issued proposed uniform regulations that would implement the Volcker Rule, which requires major financial institutions to cease engaging in proprietary trading and most hedge fund and private fund investment and management activities in July 2012. The Rule is at Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act and was enacted primarily at the urging of Paul Volcker, former Chairman of the Board of Governors of the Federal Reserve System. The proposed uniform regulations (herein, the "Proposal") were approved for issuance on October 12 and 13.1 The Proposal provides additional detail on the Rule's requirements and a very elaborate compliance regime that institutions with significant trading activities would have to adopt for purposes of monitoring permissible activities. The comment period ends on January 15, 2012.
The four agencies (collectively, the "Agencies") are the Federal Reserve, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation and Securities and Exchange Commission, with each agency's version applicable to the particular financial institutions under its jurisdiction. The Commodity Futures Trading Commission was expected to participate in the rulemaking — indeed was arguably required by statute to participate — but did not do so; news reports indicate that it will issue its own proposed version at a later time.
The general intent of the Volcker Rule is to prohibit US banking institutions from utilizing the benefits they obtain from deposit insurance and access to emergency lending facilities to make a profit from short-term trading and private fund investments that are unrelated to their customer business. An unstated intent is apparently to implement a belief of former Chairman Volcker that commercial banking is a relationship business, and that commercial banks should limit themselves to transactions that serve their customers, and not simply engage in trading and investing unrelated to customer needs.2
While this kernel of an idea is understandable, though debatable on a number of levels, the Proposal's expression of the idea and the mechanisms for explaining and enforcing it would provoke a vast compliance and recordkeeping structure unless it is significantly revised in its final form.
The Proposal continues to be reviewed by interested parties, and additional nuances reveal themselves on re-readings. Following is a summary of the salient parts of the Proposal and the issues that we believe deserve financial institutions' attention and on which they should provide commentary to the Agencies.
I. Who Has to Comply with the Rule?
Both the proprietary-trading and private-funds sections of the Proposal apply to "covered banking entities." This term refers to the specific types of "banking entities" to which an agency's version of the rule applies; for example, a registered broker-dealer or investment advisor would be a "covered banking entity" in the SEC's version of the regulation. "Banking entities" are defined, as they are in the statute, to include:
- Any insured depository institution and any company that controls such an institution;
- Any company treated as a bank holding company for purposes of Section 8 of the International Banking Act of 1978 ("IBA"), which applies to non-US banks with US banking operations; and
- Any affiliate or subsidiary of the above, with clarifying exceptions for certain private funds.
Insured depository institutions by definition are banking institutions chartered under US law the deposits of which are insured by the Federal Deposit Insurance Corporation ("FDIC"). This includes banks that are defined as "banks" for purposes of the Bank Holding Company Act of 1956, as amended ("BHCA"), but also other institutions such as FDIC-insured banking institutions that are not, such as industrial loan companies, thrift institutions and credit card banks. Thus, any company that controls an insured depository institution is subject to the Rule, which is in new Section 13 of the BHCA, even if the company is not subject to the other sections of the BHCA.3
Non-US banks that have a US branch or agency, or control a commercial lending company, are subject to most provisions of the BHCA through the IBA. Accordingly, such non-US banks are also "banking entities" and are subject to the Rule.
Affiliates and subsidiaries are defined by reference to BHCA definitions, which incorporate the concept of "control" by one company of another. "Control" is deemed to exist if one company owns or controls 25 percent or more of any class of voting stock of another company or controls in any way the election or selection of a majority of the other company's board of directors. The Federal Reserve also has standards for determining whether one company has a controlling influence over another even if the company owns or controls less than 25 percent of voting stock or does not control the board, but it is not clear whether those standards are incorporated here.4 The Proposal excludes from coverage a covered fund, as discussed in Section III below, that is controlled by a banking entity and any company controlled by such a fund. Apart from that exception, there is no exception for affiliates or subsidiaries, including those located outside the United States, and accordingly the Rule applies worldwide to all affiliates and subsidiaries of all "banking entities."
II. Proprietary Trading
A. In General
The Proposal's treatment of proprietary trading can be summarized through the following points:
- the definition of "proprietary trading,"
- the exemptions from the prohibition for certain proprietary trading activities, as well as exceptions to the exemptions, and
- the requirements that organizations must meet in order to conduct permitted trading activities, including the adoption of policies and procedures and of recordkeeping arrangements, including periodic reporting of the results of the recordkeeping to the Agencies.
B. Definition of "Proprietary Trading"
The Proposal adopts the Dodd-Frank Act's definition of "proprietary trading" and adds a host of additional definitions, many of which are packed with meaning. In outline form, showing the terms that need to be defined, the definition of "proprietary trading" is:
- "...engaging as principal
- for the trading account
- of the covered banking entity
- in any purchase or sale
- of one or more covered financial positions."5
"Engaging as principal" simply means engaging in transactions in one's own name and for one's own account, rather than acting as broker, agent or custodian.
The definition of "trading account" is any account that is used by a covered banking entity to:
- acquire covered financial positions (defined below) principally for the purpose of (a) short-term resale, (b) benefitting from actual or expected short-term price movements, (c) realizing short-term arbitrage profits or (d) hedging any of (a), (b) or (c);
- acquire or take covered financial positions that are "covered positions" (other than foreign exchange derivatives, commodity derivatives, or commodity futures contracts) for purposes of the banking agencies' market risk capital adequacy guidelines applicable to US entities; or
- acquire or take covered financial positions for any purpose if the banking entity is a registered (a) securities dealer, (b) Government securities dealer, (c) swap dealer, (d) securities swap dealer or (e) non-US entity engaged in such businesses, all to the extent of activities that cause the entity to be registered.
The second item — based on market risk capital rules — seems to apply by definition only to US institutions regulated by the US bank agencies; the theory seems to be that those institutions already know whether they have such an account because they would have had to characterize it as such in order to comply with capital guidelines. The first category is more general, but the Agencies state that it is substantially similar to the market risk definitions of the Basel Committee on Bank Supervision, on which the US market risk guidelines are based, and accordingly would cover both US and non-US banking entities. The third category reflects the Agencies' belief that any registered securities or swaps dealer should automatically be considered to be engaging in proprietary trading.
There is no definition of "short-term" for this purpose, but there is a rebuttable presumption that any position held for 60 days or less is a short-term position. Accordingly, any account that held such a position would generally be a trading account. The banking entity can rebut the presumption. Excluded from coverage are repurchase and reverse repurchase agreements for "assets" (not only securities), securities lending arrangements, and bona fide liquidity management programs pursuant to a written plan limiting the timing and types of instruments that may be purchased and sold.
The definition of "covered banking entity" is discussed above. The definition of "purchase or sale" tracks the definitions used in the Securities Exchange Act of 1934, as amended ("1934 Act") and incorporates such things as the execution, termination and conveyance of a derivative.
A "covered financial position" is defined as long, short, synthetic "or other" position in a (a) security, (b) derivative, or (c) contract of sale of commodity for future delivery or option, but does not include a position in a (d) loan, (e) commodity or (f) foreign exchange. "Security" and "commodity" are defined by reference to the terms used in the 1934 Act and Commodity Exchange Act ("CEA"). "Derivative" is defined by reference to the CEA and 1934 Act but incorporates definitions as adopted by the SEC and CFTC in the future. The term excludes consumer, commercial and other agreements that the CFTC and SEC find are not "swaps" and also excludes "identified banking products", which generally includes bank deposits and other short-term bank issuances.
In summary, a transaction taking place through any account on the books of a banking entity meeting the standards above is one that will be treated as proprietary trading. For this reason, the exemptions from the prohibition on proprietary trading become very important.
C. Exemptions from Prohibition on Proprietary Trading
There are two types of exemptions from the prohibition on proprietary trading. One is based on type of instrument, while the other is based on type of activity.
1. Type of Instrument
In general, US Government and agency obligations, obligations of the housing and agricultural agencies, and municipal obligations are exempt from the prohibition.6 The theory for this exemption seems to be that US banks, for at least a century, have dealt in US Government securities without restriction and that there was no reason to disrupt the practice, which also appears not to have caused any significant amount of loss to financial institutions. It appears that derivatives of such obligations are not exempt.
The Agencies have the authority to exempt additional classes of instruments but the Proposal does not do so.
2. Type of Activity
The Rule exempts several types of activities that would otherwise be prohibited as proprietary trading. It is these exemptions that led the Agencies to believe that the elaborate recordkeeping and reporting systems discussed below are necessary. The fear is that an activity that is claimed to be exempt is in fact disguised proprietary trading. Much of the burden of complying with the Proposal results from these exemptions.
a. Underwriting
Consistent with Chairman Volcker's idea that banking is a relationship business, the Rule allows banking entities to underwrite securities as a way to provide financing to a customer. The Proposal's definition of the term is relatively straightforward. It applies only to securities and requires that the underwriting entity have appropriate registration for the activity. It requires a "distribution," defined as an offering, whether or not registered under the Securities Act of 1933 ("1933 Act"), that is different from ordinary trading by "the magnitude of the offering and the presence of special selling efforts and special methods." This seems to recognize private placements and non-issuer secondary offerings as underwriting.
In addition, three restrictions appear intended to address specific concerns about evading the prohibition: (a) the underwriting must be designed not to exceed "reasonably expected near term demands" of customers, (b) the underwriting must be designed to generate revenues "primarily" from fees, commissions, spreads and other income not attributable to appreciation in value or hedging and (c) compensation arrangements for underwriting personnel must be designed "not to reward proprietary risk-taking."
Finally, the banking entity must have written policies and procedures, internal controls and independent testing to assure compliance with the Rule, as specified in detail in the regulation. This point is discussed below.
b. Market-making
The market-making exemption similarly is consistent with the idea that a bank should serve the needs of its customers, in this case by having securities and other instruments on hand to sell, and being willing to buy, in order to accommodate customer liquidity needs. However, unlike underwriting, market-making takes place in the secondary market, and accordingly is perceived as running a much greater danger of morphing into impermissible proprietary trading.
The requirements in the Proposal are much like those summarized above for underwriting, except that the exemption is not limited to market-making in securities. Hedging is authorized so long as the hedge reduces specific risks of the market-making positions, which may be on individual or aggregate positions, in the latter case as portfolio hedging. The requirements for policies and procedures, controls and monitoring are much more extensive than the ones for underwriting, discussed below.
c. Risk-mitigating Hedging
The Rule allows banking entities to enter into covered financial positions designed to reduce the specific risks of individual or aggregate positions or other contracts of the banking entity. The Proposal's requirements are much like those summarized above, with the addition that the hedge should not give rise at initiation to "significant exposures that were not already present" in the hedged position and must be monitored and managed to maintain a "reasonable level of correlation".
If a hedge is held in a legal entity different from the one holding the hedged position, the banking entity must document, at the time that the hedge is initiated, the risk-mitigating purpose of the hedge, the risks of the positions that the hedge is designed to reduce and the level of the organization establishing the hedge.
d. Trading on Behalf of Customers
Trading on behalf of customers is also an exemption consistent with the underlying premise that commercial banks may serve their customers. The Proposal limits this exemption to transactions (a) by an investment advisor, trustee or similar fiduciary for the account of the customer and for which the customer is beneficial owner, (b) as riskless principal and (c) by insurance companies for separate accounts.
e. Trading Outside the United States by Non-US Banking Entities
The statute recognizes that non-US banks subject to the Rule should be allowed the freedom to engage in trading activities outside of the United States. This exemption is consistent with the general approach of US banking regulation that non-US banks (organizations that are considered foreign banking organizations under the Federal Reserve's regulations under the BHCA) should not be significantly constrained by US law in their non-US operations and that any safety and soundness or related concerns are matters primarily for their home country supervisors.7 However, significant constraints are put on the exemption.
The exemption is available only to transactions that are (a) authorized by sections of the BHCA that, under Federal Reserve regulations, are performed by non-US entities primarily engaged in business outside of the United States and (b) occur "solely outside of the United States". The latter requirement is met only if (a) the entity is organized under non-US law, (b) no party to the transaction is a "resident of the United States," (c) no personnel involved in the transaction are physically located in the United States and (d) the transaction is executed "wholly outside of the United States." A "resident of the United States" does not clearly include a non-US subsidiary of a US entity, but does include a discretionary or non-discretionary account (other than an estate or trust) that is (a) held by a dealer or fiduciary for the benefit of a US resident or (b) is held by a US resident.
Footnotes
1 The Dodd-Frank Act is at Public Law No. 111-203, 124 Stat. 1376 (2010) and codified throughout the United States Code. The Proposal can be found on the Federal Reserve's website at www.federalreserve.gov/newsevents/press/bcreg/20111011a.htm . If you are interested in reading about the background of the Volcker Rule, you may wish to review our previous client memoranda: "The Leaked Staff Drafts: New Volcker Rule-Related Concerns for Non-US Banks" (October 10, 2011); "Dodd-Frank: The GAO Struggles with the Volcker Rule" (July 22, 2011); "FSOC Study on Implementing the Volcker Rule — A Series of Missed Opportunities and Some Surprises" (January 2011); "Financial Regulatory Reform Update: The Volcker Rule Continues to Garner Outsized Attention in the Wake of Passage of Financial Reform Legislation" (October 19, 2010).
2 He recently reiterated the point: "The justification for official support and protection of commercial banks is to assure maintenance of a flow of credit to business and individuals and to provide a stable, efficient payment system. Those are both matters entailed in continuing customer relations and necessarily imply an element of fiduciary responsibility. Imposing on those essential banking functions a system of highly rewarded – very highly rewarded – impersonal trading dismissive of client relationships presents cultural conflicts that are hard – I think really impossible – to successfully reconcile within a single institution." William Taylor Memorial Lecture at 10 (Sept. 23, 2011).
3 Insurance companies subject to the BHCA and derivatives clearing organizations that are banks or affiliates of banks are subject to these rules and have special exemptions, which are not discussed below.
4 Footnote 79 of the Proposal states that the concept of control incorporated into the Rule is as defined in the BHCA "and as implemented by the" Federal Reserve. This may be an indication that the drafters intended to include those policies into the Rule for purposes of determining subsidiary or affiliate status.
5 Proposal at Section ___.3(b)(1).
6 The housing and agricultural issuers are Government National Mortgage Association, Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, a Federal Home Loan Bank, Federal Agricultural Mortgage Corporation and any Farm Credit System institution. Both general and limited obligations (such as revenue bonds) are included.
7 The regulations governing foreign banking organizations are at the Federal Reserve's Regulation K, Subpart B, 12 C.F.R. Part 211, Subpart B (2011).
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