United States: Structured Thoughts: "Structured Products, Meet The Volcker Rule": The New Limitations On Proprietary Trading

Introduction

As readers of this publication know, the long-anticipated final Volcker Rule has been issued. The rule generally prohibits, among other things, any "banking entity" from engaging in "proprietary trading" with respect to a wide variety of financial instruments.

For our firm's more detailed discussion of the rule, please see our "User's Guide to the Volcker Rule" (the "User's Guide"), which may be found at: http://www.mofo.com/files/Uploads/Images/131223-A-Users-Guide-to-The-Volcker-Rule.pdf. 1 We will not repeat all of the information in that guide here. Instead, in this article, we discuss the principal expected impact of the rule on issuers and underwriters of structured products. In particular, we examine the rule's exemptions for market-making activities, underwriting and hedging activities. In addition to proprietary trading activities, we also will examine how the final rule's provisions relating to "covered funds" are likely to impact certain types of structured products.

Banking Entities – Affected Parties in the Structured Products Markets (Not Just Banks)

The final rules do not apply simply to "banks." Rather, the rule's prohibitions apply to a larger group of so-called "banking entities." These entities include:

  • insured depository institutions;
  • any company that controls an insured depository institution;
  • any foreign entity that is treated as a bank holding company for purposes of Section 8 of the International Banking Act of 1978 (i.e., because it has a U.S. branch or agency);2 and
  • any affiliate or subsidiary of any of those entities.

The broad final bullet above brings the broker-dealer affiliates of banks within the scope of the new rule. These entities, of course, are involved in a variety of features of the structured products market, including structuring, underwriting, trading and hedging. In contrast, broker-dealers that are not affiliated with banks, which sometimes act as key distributors of structured products, would be outside the scope of the new rules.

Broad Prohibition of Proprietary Trading

Definition. The final rule prohibits a banking entity from engaging in "proprietary trading." Proprietary trading is defined as "engaging as principal for the trading account of the banking entity in any purchase or sale of one or more financial instruments."

Exemptions. Because of the potentially broad reach of this prohibition, the rule contains detailed exemptions. These exemptions are intended to balance the need to reduce the risks relating to large financial institutions, while enabling these entities to continue many of their existing roles in the financial sector. In the area of structured products, the ones of principal importance are for market-making activities, underwriting and hedging, as discussed in more detail below.

The Backstop Provisions. However, even if otherwise permitted by the exemptions, proprietary trading activities by a banking entity are subject to additional provisions and restrictions under the final rule. These restrictions are described below in "The Backstop Provisions – Exceptions to the Exemptions." Structured products raise a variety of issues under the backstop provisions.

Transactions Within (and Outside) the Prohibition. The ban relates to trading for the banking entity's own account. As a result, a wide variety of transactions that occur in the structured products market are not affected. For example, transactions in which a financial institution acts on an agency basis for a client, or acts as a riskless principal for a non-affiliated entity, would not be prohibited by the new rules.

Note that the prohibition relates to "financial instruments," which are defined as:

  • securities (including options on securities);
  • derivatives (including options on derivatives); and
  • contracts of sale of a commodity for future delivery (or options on those contracts).

The majority of structured products issued today would fall into the first category, "securities." However, most structured certificates of deposit, which are intentionally structured not to be "securities," would appear to be exempt from the prohibition.3

Market-Making Exemption

General. The final rule is designed to permit a broad scope of market-making activities, while prohibiting impermissible proprietary trading that may pose significant risk to the financial system. The final rules provide flexibility for market-making activities generally, but also limit those activities through a mix of compliance requirements and risk controls. Banking entities will be permitted to determine the appropriate scope of their market-making activities based on the liquidity, maturity and depth of the relevant markets. Banking entities will need to analyze their activities in terms of the overall exposures and market-making inventory held by their different trading desks.

Scope of the Exemption. The rule permits "the purchase, sale, acquisition, or disposition" of financial instruments "in connection with market-making related activities, to the extent that such activities are designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties."

Criteria for Market-Making. Market-making activities are permitted for a particular "trading desk"4 if the trading desk satisfies six criteria:

  • It "routinely stands ready" and is "willing and available" to trade the relevant instruments.
    • This provision contemplates that the standards will differ somewhat among different asset classes and financial instruments. For example, a commodity-linked structured note does not have the same type of market as a share of Apple common stock. Even willingness to "trade by appointment" in an illiquid security can qualify under the rule. However, a trading desk would need to demonstrate a pattern of effecting transactions in response to demand from its customers. Broker-dealers may face a challenge of making this case in connection with illiquid types of structured products.
  • It has a "market-maker inventory" that is designed not to exceed the reasonably expected near-term demand of customers, clients and counterparties. o In the area of structured products, where the primary distribution of the instrument tends to exceed the distribution in the secondary market, the appropriate inventory may be relatively less than is the case for other types of instruments.
    • This inventory test will depend in part upon the liquidity, maturity and depth of the relevant market. It must be based on a "demonstrable analysis" of indicators of near-term customer demand that include (i) historical levels of demand, (ii) expectations based on market factors and (iii) current demand. For complex structured products, "demonstrable analysis" means that the trading desk needs to have "prior express interest" from customers in the "specific risk exposures" of the instrument prior to holding an instrument to engage in market-making activity.
    • In less mature markets, as is the case for many new structured products, it may be more difficult to predict near-term customer demand. In these cases, to determine near-term customer demand, the adopting release recommends that banking entities will use historical data from similar products, reasonably expected future demand that is determined based on customer relationships, or other relevant factors.
    • The final release states that a trading desk creating a structured product that is not based on any customer demand, and then soliciting customers to trade the instrument during or after its creation, would not satisfy this provision.

To read the full article, please click here.

Footnotes

1. See also our client alert, "The Volcker Rule and Capital Markets Offerings," which may be accessed at: http://www.mofo.com/files/Uploads/Images/131227-Volcker-Rule-Capital-Markets-Offerings.pdf.

2. For a discussion of the final rule's impact on certain off-shore transactions by non-U.S. entities, please see our client alert: "The Volcker Rule: Impact of the Final Rule on Foreign Banking Organizations," which may be accessed at http://www.mofo.com/files/Uploads/Images/131211-Volcker-Rule.pdf.

3. See the discussion in our "Frequently Asked Questions About Structured Certificates of Deposit," available at: http://www.mofo.com/files/Uploads/Images/Frequently-Asked-Questions-about-Structured-Certificates-of-Deposit.pdf.

4. A "trading desk" is "the smallest discrete unit of the organization of a banking entity that buys or sells financial instruments for the trading account of the banking entity or an affiliate thereof." The final rule contemplates that a trading desk will be managed and operated as an individual unit, and reflect the level at which the profit and loss of market-making traders will be attributed.

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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Authors
Bradley Berman
Peter Green
Jeremy C. Jennings-Mares
Daniel Nathan
Anna Pinedo
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