United States: A User’s Guide To The Volcker Rule


The legislation known as the Volcker Rule was enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act and codified in Section 13 of the Bank Holding Company Act ("BHC Act").1 The Volcker Rule generally prohibits, subject to exceptions, a banking entity from engaging in proprietary trading and from acquiring or retaining an ownership interest in or sponsoring a hedge fund or private equity fund. Certain trading and fund activity is expressly permitted – notably, underwriting activities, market making-related activities, and risk-mitigating hedging activities.

The Volcker Rule legislation covered the area with a broad brush, leaving many significant issues open to regulatory interpretation. In December 2013, five federal financial regulatory agencies (collectively, the "Agencies"),2 adopted a final rule (the "Final Rule") construing the Volcker Rule.3 The Final Rule also sets out a compliance and reporting regime for banking entities engaged in proprietary trading or fund sponsorship or investment. The determinations made by the Agencies in the Final Rule reflect two years of comment and debate following the issuance of a Proposed Rule (the "Proposed Rule") in November 2011.

Under the Final Rule, larger banks and bank affiliates (based on total assets) that are engaged in proprietary trading permitted by the Final Rule will be subject to a compliance regime to ensure compliance with the Final Rule. In addition, larger banks and bank affiliates (in terms of the amount of their trading assets and liabilities) that are engaged in proprietary trading permitted by the Final Rule will be required to report a highly technical set of quantitative measures. Banking entities with only a "modest" level of trading and fund investment activities will be subject to a much less comprehensive set of compliance requirements. The compliance requirements are discussed in more detail below.

The Final Rule is complex in scope and has already elicited significant commentary and questions from the banking industry and the public at large. The purpose of this guide is to discuss the requirements of the Final Rule at a practical level. While the relevant components of the Final Rule are addressed here, financial institutions should consider all of the Final Rule's "fine print" – the many detailed definitions and conditions that comprise the Final Rule (as well as the extensive commentary contained in Attachment B to the Final Rule) – before making any decisions regarding compliance.

The Volcker Rule, as construed by the Final Rule, has special application to foreign banking organizations that have U.S. bank subsidiaries or operate branches, agencies or commercial lending company subsidiaries in the United States ("FBOs"). Please refer to our Client Alert dated December 11, 2013 for a more complete explanation of the impact of the Final Rule on FBOs. The Client Alert may be found at http://www.mofo.com/files/Uploads/Images/131211-Volcker-Rule.pdf.

The Conformance Period

The Final Rule is effective April 1, 2014, but the compliance period during which banking entities must conform their activities to the Volcker Rule has been extended for one year until July 21, 2015. Nonetheless, effective June 30, 2014, the largest banking entities (those with $50 billion or more in consolidated trading assets and liabilities, as discussed further below) are required to report quantitative measurements to regulators.

The FRB emphasized in its order approving the extension of the conformance period that each banking entity is expected to engage in good-faith efforts, appropriate for its activities and investments, that will result in conformance with the Volcker Rule not later than the end of the conformance period. Moreover, banking entities should not expand activities or make investments during the conformance period with an expectation that additional time to conform those activities or investments will be granted, and banking entities with stand-alone proprietary trading operations are expected to promptly terminate or divest such operations.

Banking Entities

The Volcker Rule applies to "banking entities." A "banking entity" includes:

  1. any insured depository institution;
  2. any company that controls an insured depository institution (in other words, any bank holding company or savings and loan holding company);
  3. any FBO; and
  4. any affiliate of the foregoing. The term "affiliate" is used as defined in the BHC Act and thus includes any company controlled by a banking entity.

Notwithstanding the breadth of the definition of a "banking entity," there are certain specific exceptions. For example, a "banking entity" does not include a covered fund that is not itself a bank holding company or an FBO. This is an important exception. A bank holding company that serves as the general partner of a fund would be deemed to control that fund. But for this exception, the "covered fund" would itself be a "banking entity" subject to the Volcker Rule.

In addition, a "banking entity" does not include a portfolio company held by a bank holding company or an FBO under the so-called BHC Act's merchant banking authority,4 a company controlled by an insurance company affiliate of a bank holding company,5 or any portfolio concern that is controlled by a small business investment company, as defined in Section 103(3) of the Small Business Investment Act of 1958, as long as the portfolio company or portfolio concern is not itself an insured depository institution, a bank holding company or savings and loan holding company, or an FBO.


The Volcker Rule prohibits a banking entity from engaging in proprietary trading, subject to certain exceptions discussed below. Proprietary trading is defined as engaging as principal for the trading account of the banking entity in the purchase or sale of a financial instrument. Thus, compliance with the Rule by a banking entity depends on whether the account for which the trade is placed satisfies the definition of "trading account" and whether the trade involves a "financial instrument."


Trading Account. The Final Rule provides a functional definition of "trading account," which means an account that satisfies any one of three criteria: a "purpose test," a "market risk capital rule test," or a "status test."

The Purpose Test.A trading account includes any account used by a banking entity to buy or sell a financial instrument principally for the purpose of short-term resale, benefitting from actual or expected short-term price movements, realizing short-term arbitrage profits, or hedging a position resulting from any of the foregoing trading activities.

Market Risk Capital Rule Test. If the banking entity or any affiliate is an insured depository institution, bank holding company, or savings and loan holding company and calculates risk-based capital ratios under the market risk capital rule, a trading account includes accounts used to buy or sell one or more financial instruments that are both market risk capital rule covered positions and trading positions (or hedges of other market risk capital rule covered positions).

Status Test. If the banking entity is licensed or registered to engage in the business of a securities dealer, swap dealer or security-based swap dealer, a trading account includes any account used by a banking entity to purchase or sell financial instruments for any purpose to the extent the financial instruments are purchased or sold in connection with activities that require the banking entity to be so licensed or registered.

Trades are presumed to be for the trading account of a banking entity if the banking entity holds the position for fewer than sixty days, unless the banking entity can demonstrate that it did not make the trade for any of the purposes described in the preceding paragraph.

As the definition of a trading account is broad, the Rule excludes the following types of trading from the definition of proprietary trading:

  • Trades pursuant to purchase or reverse repurchase agreements;
  • Trades that arise under a transaction in which the banking entity lends or borrows securities temporarily under an agreement pursuant to which the lender retains the economic interest in the securities, and has the right to recall the loaned securities;
  • Trades for the purpose of liquidity management in accordance with a documented liquidity management plan that meets specific requirements of the Final Rule;7
  • Trades by a derivatives clearing organization or clearing agency;
  • Any "excluded clearing activities"8 by a banking entity that is a member of a clearing agency, a member of a derivatives clearing organization or a member of a designated financial market utility;
  • Trades to satisfy an existing delivery obligation, including to prevent or close out a failure to deliver, in connection with delivery, clearing or settlement activity;
  • Trades to satisfy an obligation in connection with a judicial, administrative or SRO or arbitration proceeding;
  • Trades where the banking entity is acting solely as agent, broker or custodian;
  • Trades through a deferred compensation, stock-bonus, profit-sharing or pension plan of the banking entity; and
  • Trades made in the ordinary course of collecting a debt previously contracted ("DPC") in good faith, provided that the banking entity divests the financial instrument as soon as practicable.

Trades between affiliates are not specifically excluded from the definition of proprietary trading and therefore must rely on a stated exception.

Financial Instrument. A "financial instrument" includes:

  • a security (including an option on a security);
  • a derivative (including an option on a derivative); and
  • a contract of sale of a commodity for future delivery (or an option on the same).

Specifically excluded from the definition of "financial instrument" are:

  • loans;
  • a commodity that is not (i) an "excluded commodity"9 (other than foreign exchange or currency), (ii) a derivative, or (iii) a commodity future; and
  • foreign exchange or currency.

Permitted underwriting and market making-related activities

The prohibition against proprietary trading does not apply to underwriting activities and market making-related activities. Significant comment was provided to the Agencies after the publication of Proposed Rule regarding how best to distinguish these permitted activities from prohibited proprietary trading. The Final Rule enumerates detailed conditions for qualifying as permitted underwriting or market-making. The long commentary published with the Final Rule in Attachment B provides useful insights into the view of the Agencies regarding the distinctive features of these permitted activities. This guide is intended as a summary only.

To engage in either permitted activity, a banking entity must comply with three overall conditions:

  • the banking entity must maintain an internal compliance program required by Subpart D (and discussed below) to ensure that the banking entity complies with the conditions permitting the activity;
  • the compensation arrangements of people involved in these activities must not be designed to reward or incentivize prohibited proprietary trading; and
  • the banking entity must be licensed or registered to engage in the permitted activity.

In addition, the following specific conditions apply.

Underwriting. Underwriting activities are permitted only if the trading desk's10 underwriting position is related to a "distribution" of securities for which the banking entity is acting as underwriter.11 The amount and type of the securities in the underwriting position cannot exceed the reasonably expected near term demands of clients, customers or counterparties, and the trading desk must make reasonable efforts to reduce the underwriting position within a reasonable period.

The Final Rule defines "distribution" to include offerings of securities made pursuant to a registration statement under the Securities Act of 1933 (the "1933 Act"), as well as offerings whether or not pursuant to the 1933 Act that involve special selling efforts and selling methods.12

The Final Rule defines "underwriter" broadly as well, to include a person who has agreed to purchase securities from an issuer or selling security holder for distribution, or engage in or manage a distribution of securities for or on behalf of the issuer or selling security holder, as well as a person who has agreed to participate or is participating in a distribution of securities on behalf of the issuer or selling security holder.

Market-making. Market making-related activities are permitted only if the relevant trading desk13 routinely stands ready to purchase and sell one or more types of financial instruments related to its financial exposure and is willing and available to quote, purchase or sell those types of financial instruments for its own account in commercially reasonable amounts and throughout market cycles on a basis appropriate for the liquidity, maturity and depth of the market for the relevant types of financial instruments.14 In addition, the amount, types and risks of the financial instruments in the trading desk's market-maker inventory must be designed not to exceed the reasonably expected near-term demands of clients, customers, or counterparties, based on:

  • the liquidity, maturity, and depth of the market for the relevant types of financial instruments; and
  • demonstrable analysis of historical customer demand, current inventory of financial instruments, and market and other factors regarding the amount, types, and risks, of or associated with financial instruments in which the trading desk makes a market, including through block trades.

The Final Rule establishes a rebuttable presumption that the trading desk of another banking entity with trading assets and liabilities exceeding $50 billion is not a "client, customer, or counterparty" for the purposes of considering whether trading with that desk is permitted market making. In Attachment B, the Agencies recognize, however, that allowing a trading desk to engage in customer-related interdealer trading is appropriate because it can help a trading desk appropriately manage its inventory and risk levels and can effectively allow clients, customers, or counterparties to access a larger pool of liquidity. However, regulators will scrutinize interdealer trading to ensure it reflects market-making activities and not impermissible proprietary trading.

Permitted risk-mitigating hedging activities: The prohibition on proprietary trading does not apply to certain risk-mitigating hedging activities. Section __.5(a) of the Final Rule permits, subject to numerous conditions, hedging activities that are "in connection with and related to individual or aggregated positions, contracts or other holdings" and "designed to reduce the specific risks to the banking entity" that are "related to such positions, contracts or other holdings."

The Compliance Program detailed below is a condition for any risk-mitigating hedging activity to be permissible. Such Compliance Program is required to include, among other things:

  • written policies and procedures regarding positions, techniques and strategies that may be used for hedging;
  • documentation indicating what positions, contracts or other holdings a particular trading desk may use in its hedging activities;
  • position and aging limits; and
  • internal controls and authorization procedures (including relevant escalation procedures) and analysis, including correlation analysis, and independent testing designed to ensure that the positions, techniques and strategies that may be used for hedging may reasonably be expected to demonstrably reduce or otherwise significantly mitigate the specific, identifiable risks being hedged, and the

correlation analysis demonstrates that the hedging activity demonstrably reduces or otherwise significantly mitigates the specific, identifiable risks being hedged.

Risk-mitigating hedging activities must not give rise, at the inception of a hedge, to any significant new or additional risk that is not itself hedged contemporaneously, and continuing review, monitoring and management of hedging activity, and ongoing recalibration of the hedging activity, is required. The Final Rule imposes additional documentation requirements with respect to risk-mitigating hedging activities established by a trading desk other than the desk responsible for the underlying positions and with respect to hedges of aggregated positions across trading desks.

Other permitted proprietary trading activities

The prohibition on proprietary trading does not apply to the following:

  • trading in U.S. government or government agency securities;
  • trading in municipal bonds;
  • trading by a foreign bank subsidiary of a U.S. banking entity of debt of a foreign government (or of any agency or political subdivision of that foreign government) issued by the foreign country in which the foreign bank affiliate is organized;
  • trading on behalf of a customer in a fiduciary capacity or as riskless principal; and
  • trading by a banking entity that is a regulated insurance company (including a foreign insurance company), whether for the insurance company's general account or for a separate account.

Exemptions for FBOs

The Final Rule establishes an exemption for proprietary trading by an FBO to the extent the trading is conducted solely outside the United States. In addition, U.S. affiliates of FBOs are permitted to engage in proprietary trading of debt of the foreign country (or its agencies or political subdivisions) under which the FBO is organized. These two exemptions are discussed at greater length in our Client Alert available at http://www.mofo.com/files/Uploads/Images/131211-Volcker-Rule.pdf.

Prudential Backstops

The permitted proprietary trading activities referenced above are not permissible under the Rule if (i) they would involve or result in a material conflict of interest between the banking entity and its clients, customers or counterparties; (ii) they would result in a material exposure by the banking entity to a high-risk asset15 or a high-risk trading strategy;16 or (iii) they pose a threat to the safety and soundness of the banking entity or to the financial stability of the United States.

A material conflict of interest is deemed to exist if the banking entity engages in transactions that would involve or result in the banking entity's interests being materially adverse to the interests of its client, customer or counterparty with respect to such transactions, and prior to engaging in such transactions, the banking entity has not made appropriate disclosures to address the conflict of interest or, in appropriate circumstances, established information barriers memorialized in written policies and procedures, such as physical separation of personnel or functions or other measures designed to prevent such conflict of interest.

Failure to comply with these prudential backstops can take away the availability of what otherwise appears to be a clearly available trading exemption. This is worrisome in that there are no clear guidelines regarding the measures a banking entity is required to take with respect to any given activity to assure compliance. In particular, it will be difficult for banking entities to know what would constitute adequate disclosure to deal with a potential conflict of interest, and what kind of information barriers would be appropriate in particular circumstances. In addition, the incurrence of a substantial financial loss in a permitted trading activity, regardless of the compliance framework in which the activity is conducted, bears the risk, in hindsight, that the activity will be characterized as "high risk," with the consequence of losing the exemption relied on for the activity.

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1 Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat.1376 (July 21, 2010) ("Dodd-Frank" or the "Act"); Section 13 of the Bank Holding Company Act ("BHC Act"), 12 U.S.C. § 1851.

2 The Federal Deposit Insurance Corporation ("FDIC"), the Federal Reserve Board ("FRB"), the Office of the Comptroller of the Currency ("OCC"), the Securities and Exchange Commission ("SEC"), and the Commodity Futures Trading Commission ("CFTC").

3 The Final Rule may be found at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20131210a1.pdf. The Final Rule was accompanied by a long explanatory commentary ("Attachment B"). Attachment B may be found at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20131210a2.pdf.

4 12 U.S.C.§ 1843(k)(4)(H).

5 12 U.S.C. § 1843(k)(4)(I).

6 The Volcker Rule is 71 pages long and consists of Subparts A through D and Appendices A and B. Subpart A is titled "Authority and Definitions," and is not discussed directly here.

7 The liquidity management plan should:

(i) specifically contemplate and authorize the particular securities to be used for liquidity management purposes, the amount, types, and risks of these securities that are consistent with liquidity management, and the circumstances in which the securities may be used;

(ii) require that any transaction in securities under the plan be principally for the purpose of liquidity management and not for short-term price movements, resale, profits or arbitrage;

(iii) require that any securities purchased or sold for liquidity management purposes be highly liquid and limited to securities the risks of which the banking entity does not reasonably expect to give rise to appreciable profits or losses in the short term;

(iv) limit any securities and other instruments purchased or sold for liquidity management purposes to an amount consistent with the banking entity's near-term funding needs;

(v) includes written policies and procedures, internal controls, analysis and independent testing to ensure that transactions in securities other than domestic or foreign government obligations are for the purpose of liquidity management; and

(vi) be consistent with the relevant Agency's supervisory requirements regarding liquidity management.

8 Final Rule, §___.3(e)(7).

9 An "excluded commodity" is as defined in Section 1a(19) of the Commodity Exchange Act, 7 U.S.C. 1a(19). "The term "excluded commodity" means—

(i) an interest rate, exchange rate, currency, security, security index, credit risk or measure, debt or equity instrument, index or measure of inflation, or other macroeconomic index or measure;

(ii) any other rate, differential, index, or measure of economic or commercial risk, return, or value that is—

(I) not based in substantial part on the value of a narrow group of commodities not described in clause (i); or

(II) based solely on one or more commodities that have no cash market;

(iii) any economic or commercial index based on prices, rates, values, or levels that are not within the control of any party to the relevant contract, agreement, or transaction; or

(iv) an occurrence, extent of an occurrence, or contingency (other than a change in the price, rate, value, or level of a commodity not described in clause (i)) that is—

(I) beyond the control of the parties to the relevant contract, agreement, or transaction; and

(II) associated with a financial, commercial, or economic consequence."

10 A "trading desk" is the smallest discrete unit of organization of a banking entity that purchases or sells financial instruments for the trading account of the banking entity. Final Rule, §___.3(e)(13).

11 Final Rule, § __.4(a).

12The definition of "distribution" tracks in some respects the definition provided in Regulation M under the Securities Exchange Act of 1934, 17 CFR § 242.100 to105 but excludes the need to consider the "magnitude" of the offering. Thus, permitted underwriting activities include activities related to 1933 Act registered offerings as well as private placements, Rule 144A offerings, commercial paper offerings, and syndicate and stabilizing activities. Attachment B provides a useful discussion of the types of offerings, as well as the types of syndicate and related stabilizing activities, which are intended to be included.

13 See note 10 supra.

14 Final Rule, § __.4(b).

15 An asset that would, if held by a banking entity, significantly increase the likelihood that the banking entity would incur a substantial financial loss or would pose a threat to the financial stability of the United States. Final Rule, § ___.7(c)(1). See also note 31 infra.

16 A trading strategy that would, if engaged in by a banking entity, significantly increase the likelihood that the banking entity would incur a substantial financial loss or would pose a threat to the financial stability of the United States. Final Rule, § ___.7(c)(2). See also note 31 infra.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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