Earlier this week, the Federal Reserve Board and other federal regulatory agencies (the "Agencies") responsible for implementing the Volcker Rule agreed to seek public comment on proposed changes (the "Proposed Rule") to the regulations implementing the Volcker Rule, one of the hallmark provisions of the landmark 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. Consistent with prior rulemaking regarding the Volcker Rule, this proposal to streamline the Volcker Rule is lengthy, running to 373 pages with 342 specific questions posed for comment. The feedback received in response to these comments has the potential to make any revisions to the final rule more far-reaching than the specific changes in the Proposed Rule.

The changes set forth in the Proposed Rule appear to be intended to streamline compliance burdens under the Volcker Rule rather than to bring about significant changes to actual trading and other banking activity. Senior agency officials noted that the proposed changes reflect several years of regulators' experience implementing the Volcker Rule, as opposed to a political effort by recent appointees under the Trump administration. The following provisions are among the more significant changes in the Proposed Rule:

  • replacing the intent prong of the trading account definition and its 60-day "trading account" presumption with an accounting-based prong and a limited rebuttable presumption that trading desks subject only to the accounting prong that fall within a $25 million profit and loss threshold comply with the Volcker Rule;
  • expanding the market risk capital prong of the trading account definition to encompass foreign banks that are subject to Basel market risk capital requirements under their home country rules;
  • adding a rebuttable presumption of compliance with the current RENTD requirements for the market-making and underwriting exemptions when a banking entity establishes specified internal risk limits, so long as such risk limits are appropriate;
  • eliminating the correlation analysis requirement for using the hedging exemption;
  • liberalizing the so-called TOTUS exemption for proprietary trading outside the United States by foreign banks by eliminating the "funding" restriction, permitting trades to be conducted with or through a U.S. entity, and permitting U.S.-based personnel to be involved in arranging and negotiating (but not executing) transactions;
  • for covered funds that a banking entity does not organize or offer, removing the requirement that the banking entity include in its aggregate fund limit and capital deduction the value of any ownership interests in covered funds acquired or retained under the underwriting or market-making exemptions;
  • dividing banks into three tiers for compliance purposes, and basing compliance obligations on the amount of a banking entity's trading assets and liabilities, with the most stringent requirements applying only to the 18 banking organizations with over $10 billion in trading assets and liabilities (not counting trading assets and liabilities involving obligations of or guaranteed by the United States or any agency of the United States); and
  • removing the CEO attestation requirement regarding compliance with the Volcker Rule for banks with the lowest trading activity and presuming that such banks are in compliance with the Volcker Rule (based on this rebuttable presumption of compliance, such banks would not be required to establish or maintain a separate Volcker Rule compliance program, unless directed to do so by the appropriate Agency).

The Proposed Rule also refrains from specific proposals regarding certain difficult issues that have arisen under the Volcker Rule and instead requests further comment on those matters. These include the following:

  • the definition of "covered fund" is left unchanged, although comment is requested on various aspects of the definition;
  • the "Super 23A" provisions of the Volcker Rule remain in place, although comment is sought on whether to apply the exemptions of Section 23A of the Federal Reserve Act to the prohibition of Super 23A; and
  • the treatment of foreign private funds as banking entities remains unresolved, although comment is requested and the no-action relief granted in July 2017 will be extended until July 21, 2019.

These and other highlights of the proposed revisions are described in more detail below. Changes to the statutory provisions of the Volcker Rule made by legislation enacted on May 24, 2018, will be implemented through a separate rulemaking, though the Agencies have indicated that they will not enforce the Volcker Rule in a manner inconsistent with the statutory amendments.1 In addition to the Federal Reserve Board, the other Agencies responsible for administering the Volcker Rule are the Federal Deposit Insurance Corporation (the "FDIC"), the Office of the Comptroller of the Currency (the "OCC"), the Securities and Exchange Commission (the "SEC") and the Commodity Futures Trading Commission. Comments on the Proposed Rule are due within 60 days after publication in the Federal Register.

While certain changes to the Volcker Rule require Congressional action, the proposed revisions appear to offer significant relief to the financial industry, especially with respect to compliance burdens under the Volcker Rule. Moreover, recent legislation also accomplished certain changes that reduce the compliance burdens of the Volcker Rule. As a result, the Volcker Rule of 2019 is likely to look significantly different from the Volcker Rule of 2017. Nevertheless, the changes are not of a type that should result in significant changes to the activities of trading desks at banking organizations, much less the return of true proprietary trading desks at large banking organizations.

Volcker Rule 2.0 in Context

The Volcker Rule applies to banking entities, which is a broadly defined term. It covers not only FDIC-insured banks and thrifts, but also their affiliates, which include companies that control such a bank or thrift. Foreign banks and their affiliates are also covered under the provision that encompasses any company that is treated as a bank holding company for purposes of Section 8 of the International Banking Act of 1978, e.g., foreign banks that operate a branch or agency office in the United States.

From the time they were originally proposed in 2011 and adopted in 2013, the Volcker Rule regulations have been recognized as exceedingly complex, ambiguous, and requiring extensive compliance efforts.2 Unsurprisingly, calls for reform have come from various sectors. In October 2017, the U.S. Department of the Treasury issued a report (the "Treasury Report") in response to an executive order issued by President Trump soon after he took office calling for a study of financial services regulation in the United States. In addition, the OCC solicited public comment on potential reforms to the Volcker Rule regulations in the summer of 2017. Prominent criticisms of the Volcker Rule have focused on its general complexity, the compliance burden imposed on banking entities, especially those with limited trading or covered funds activities, the extent to which exemptions intended to provide relief to foreign banks operating outside the United States (as well as other exemptions) have been unworkable as a practical matter, and inadvertent capture of foreign private funds as banking entities that are subject to the Volcker Rule. The combination of new senior leadership at the regulatory agencies, together with several years of experience in implementing the Volcker Rule, have now resulted in a concrete proposal for regulatory change. The proposed changes to the Volcker Rule regulations are generally in line with the proposals included in the Treasury Report. Absent statutory changes to the Volcker Rule, there are limits on how much the Agencies can change the regulations. For example, Congress recently passed a bill that exempted banks with limited trading activity and less than $10 billion in total consolidated assets from the Volcker Rule, a change that would be beyond the regulatory authority of the Agencies. Nevertheless, the proposed changes appear to offer significant simplification and relief with respect to some aspects of the Volcker Rule, and the Agencies have posed numerous questions for specific comment that indicate more significant changes may be made in the final regulation if public comments in response to these questions provide substantive support for more wide-ranging changes.

Highlights of the Proposed Revisions

Proprietary Trading

The Volcker Rule prohibits banking entities from engaging in proprietary trading of financial instruments, which is generally defined as trading as principal for short-term gain as well as trading undertaken by dealers and trading subject to the market risk capital rule. These prohibitions are subject to various exceptions and exemptions.

Definition of Trading Account—Elimination of the 60-Day Presumption

The Volcker Rule currently includes a three-prong definition of trading account. The first two prongs are based on trading activity that is subject to the market risk capital rule and to trading activity conducted by a registered dealer. The third prong is an intent-based prong relating to trading for short-term profit and includes a rebuttable presumption that the purchase and sale of a financial instrument within 60 days constitutes proprietary trading. Moreover, there is no presumption that holding an instrument for longer than 60 days (or any other minimum period) does not constitute proprietary trading.

The Proposed Rule eliminates the 60-day presumption and replaces the intent-based test with an accounting-based test that looks to whether the account is used to trade financial instruments whose value is recorded at fair value on a recurring basis under applicable accounting standards. Moreover, the Proposed Rule would establish an optional rebuttable presumption of compliance with the Volcker Rule for trading desks that are subject only to the accounting prong (i.e., where the desks are not part of a registered dealer and where the positions are not subject to the market risk capital rule), based on certain conditions, including a $25 million limit on the absolute value of the daily gain and loss figures for the preceding 90-calendar-day period measured at the trading desk level.

Market Making and Underwriting Exemptions—Presumption of Meeting RENTD

The Volcker Rule includes exemptions for underwriting and market-making activities. However, those exemptions rely in part on the banking entity demonstrating that its positions are designed not to exceed the reasonably expected near-term demand of clients, customers or counterparties (RENTD). Demonstrating such demand can be a challenge, especially for certain financial instruments.

The Proposed Rule includes a rebuttable presumption that a banking entity meets the RENTD requirement if the banking entity establishes and enforces internal risk limits on its underwriting and market-making positions, and contemplates that those risk limits could change to reflect customer demand. Those risk limits are subject to supervisory review and oversight, but the Proposed Rule essentially changes the operation of the Volcker Rule from a need-to-prove compliance to a presumption of compliance. The compliance program requirements for market making and underwriting also are tailored under the Proposed Rule so that banking entities with significant trading assets and liabilities would continue to be required to have a comprehensive internal compliance program as a condition for relying on these exemptions; however, banking entities with moderate or limited trading assets and liabilities would not have specific compliance program requirements. The release also explores whether the exemptions should be expanded for swaps entered into with borrowers in connection with lending activity.

Liquidity Management

The Volcker Rule permits banking entities to purchase and sell securities for liquidity management purposes, subject to certain requirements. A difficulty with this exemption from the proprietary trading ban is that banking entities also trade other instruments (that are not securities) for liquidity management purposes. The trading of nonsecurities does not qualify for the exemption.

The Proposed Rule would expand the liquidity management exemption to permit the use of deliverable foreign exchange forwards and swaps, and physically settled cross-currency swaps for liquidity management purposes. Cash settled swaps (including non-deliverable FX forwards) would not be covered by the liquidity management exemption.

Trading Errors

The Proposed Rule would include an exemption from the proprietary trading prohibition for trading undertaken to correct a trading error made in connection with customer-driven or other permissible transactions.

Hedging Exemption—Eliminating the Correlation Analysis Requirement

The Volcker Rule exempts trading undertaken for certain risk-mitigating hedging purposes. However, the exemption requires a banking entity to show that a hedging activity demonstrably reduces or mitigates specific risks.

The Proposed Rule would eliminate the correlation analysis requirement as well as the "demonstrably" reduces or otherwise significantly mitigates specific risk requirement from the exemption. Furthermore, for banking entities without significant trading assets and liabilities, the Proposed Rule would eliminate the requirement for a separate internal compliance program for risk-mitigating hedging and other requirements. Even for banking entities with significant trading assets and liabilities, the Proposed Rule would eliminate the enhanced documentation requirements for certain commonly used hedging instruments whose use is pre-approved by the banking entity.

Foreign Banks—Seeking to Make the TOTUS Exemption Workable

The Volcker Rule intended generally to permit foreign banks to trade solely outside the United States (the so-called TOTUS exemption) without being subject to the Volcker Rule's prohibitions. However, it has been difficult for foreign banks to comply with the terms of the exemption. One of the major challenges is that no funding for proprietary trading may come from the foreign bank's U.S. operations, and yet money is fungible and so proving an absence of funding in relation to a particular transaction can be very challenging, and trading may not take place with or through a U.S. entity.

The Proposed Rule would remove both of those restrictions. Moreover, the Proposed Rule would relax a restriction on personnel in the United States having virtually any involvement in a transaction. In particular, it appears that personnel located in the United States would be able to be involved in arranging or negotiating transactions, but not executing or otherwise being responsible for the foreign banking entity's decision to enter into a transaction.

Hedge Funds and Private Equity Funds

The Volcker Rule also prohibits banking entities from acquiring ownership interests in, sponsoring, and having certain other relationships with, hedge funds and private equity funds, referred to in the Volcker Rule regulations as "covered funds." The proposed revisions address several provisions regarding covered funds.

Ownership of Covered Funds in an Underwriting or Market-Making Capacity

The Volcker Rule currently permits banking entities to acquire ownership interests in covered funds only under limited circumstances. In addition, the Volcker Rule imposes various ownership caps on such investments. One of the caps limits a banking entity's ownership interests in covered funds held under the asset management exemption and the underwriting and market making exemptions to 3% of the banking entity's tier 1 capital. Such holdings are also subject to a capital deduction requirement.

The Proposed Rule relaxes these limits. In particular, ownership interests in covered funds that a banking entity does not organize and offer (i.e., under the asset management exemption) but acquires under the underwriting and market-making exemptions would not count toward the banking entity's aggregate 3% of capital fund limit and capital deduction.

The Definition of Covered Fund is Unchanged, but Comment is Requested

Although the Proposed Rule would not amend the definition of covered fund, the Proposed Rule seeks comment on this definition, including whether the Agencies should adopt characteristics-based exclusions to the definition of covered fund, such as by excluding funds that do not meet the definition of either hedge fund or private equity fund in the SEC's Form PF. The Proposed Rule also requests comment on all aspects of the Volcker Rule regulations regarding securitizations, including provisions that classify an ownership interest as one that gives the holder the right to participate in the selection or removal of a general partner or person acting in a similar capacity. Industry commenters have argued that that this provision limits participation by banking entities in the market for debt instruments issued by CLOs.

Super 23A Prohibitions—Comment Requested on Adding Exemptions to Super 23A

The so-called Super 23A provisions of the Volcker Rule generally apply the restrictions of Section 23A of the Federal Reserve Act on "covered transactions" between a member bank and its affiliates (e.g., purchase of assets from, extension of credit to, derivative transaction with) as flat prohibitions on such transactions between a covered fund and a banking entity (and the affiliates of such banking entity) that sponsors or advises or organizes and offers such fund. The rule prohibits covered transactions as if the fund were an "affiliate" and the banking entity were a member bank for purposes of Section 23A. The result is that a banking entity and its affiliates may not, for example, lend money to a covered fund that the banking entity sponsors or advises. Nor may the banking entity purchase assets from such covered fund or engage in other covered transactions with such fund.

Section 23A itself has various exemptions from its restrictions (e.g., purchasing certain liquid assets), but Super 23A does not incorporate those exemptions. The Proposed Rule seeks comment on whether to make available the Section 23A exemptions in the Super 23A context. Doing so would permit banking entities that sponsor or advise or organize and offer covered funds to engage to a limited extent in covered transactions with the covered funds they sponsor or advise or organize and offer.

Risk-Mitigating Hedging Involving Covered Funds

The Volcker Rule permits banking entities to acquire ownership interests in covered funds to hedge employee compensation arrangements. This is an exemption to the general prohibition on acquiring ownership interests in covered funds.

The Proposed Rule would expand this exemption to permit a banking entity to acquire ownership interests in a covered fund when the banking entity is acting as an intermediary on behalf of a customer that is not itself a banking entity to facilitate the exposure by the customer to the profits and losses of the covered fund, subject to various conditions, including an internal compliance program reasonably designed to ensure compliance with the requirements of the exemption.

The SOTUS Exemption—Covered Fund Activities Conducted by Foreign Banking Entities Outside the United States

The Volcker Rule purports to permit foreign banks to sponsor or acquire ownership interests in covered funds outside the United States. However, the regulatory provisions implementing that exemption (the SOTUS exemption) include a marketing restriction that makes the exemption unavailable if ownership interests are sold pursuant to an offering that targets residents of the United States.

The Agencies issued FAQ 13 to clarify that the marketing restriction applies only to offerings in which the banking entity claiming to rely on the exemption participates. The Proposed Rule basically incorporates FAQ 13 into the language of the SOTUS exemption.

However, FAQ 13 and the Proposed Rule further provide that any banking entity that acts directly or indirectly as sponsor, investment adviser or in a similar capacity to a covered fund is deemed to participate in any offer or sale of an interest in such covered fund. The practical impact appears to be that the SOTUS exemption permits foreign banking entities to invest in funds sponsored or advised by third parties, even if interests in the fund are sold to residents of the United States, so long as the foreign banking entity does not participate in such offers or sales.

Foreign Excluded Funds—Status as Banking Entities

The Volcker Rule generally does not treat covered funds as banking entities. Instead, a banking entity's relationship with a covered fund is governed by the Volcker Rule's various limitations and prohibitions, but a covered fund associated with a banking entity may, for example, engage in proprietary trading.

One of the apparent unintended consequences of the Volcker Rule regulations is that a foreign private fund that is not offered to residents of the United States and therefore does not rely on exemptions under Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 is not itself a covered fund. However, if the foreign banking entity that sponsors such a fund controls the fund through governance arrangements or otherwise, the fund itself will be treated as a banking entity that is subject to the Volcker Rule.

The Agencies recognize this quandary and the relevant Agencies provided no-action relief in July 2017 for one year. The Proposed Rule would extend the no-action relief until July 21, 2019, and requests comment on how this issue should be addressed.

Compliance Program Obligations

The Volcker Rule requires banking entities to adopt policies and procedures to address compliance with the requirements of the Volcker Rule.

The Proposed Rule classifies banking entities into three categories and imposes more stringent requirements on those banking entities with the highest level of trading activity (i.e., with trading assets and liabilities of $10 billion or more, not counting trading assets and liabilities involving obligations of or guaranteed by the United States or any agency of the United States). Those banking entities with the lowest level of trading activity, by contrast, are, in effect, exempt from establishing or maintaining a separate Volcker Rule compliance program. The accompanying chart shows the basic categories and compliance obligations.

Significant Trading Assets and Liabilities3 ≥ $10 billion Six-pillar compliance program,4 metrics reporting, underwriting and market-making compliance program, covered fund documentation requirement Yes
Moderate Trading Assets and Liabilities5 < $10 billion, ≥ $1 billion Simplified compliance program. Yes
Limited Trading Assets and Liabilities6 < $1 billion Presumed to be in compliance with the Volcker Rule. No compliance program required unless directed, then a simplified compliance program. No

With respect to foreign banks, those with less than $1 billion in worldwide trading assets and liabilities will be considered to have limited trading assets and liabilities, and therefore exempt from establishing a specific Volcker Rule compliance program. Only those foreign banks with trading assets and liabilities of $10 billion or more in their combined U.S. operations would be considered to have significant trading assets and liabilities.

The Proposed Rule also eliminates the prescriptive Enhanced Minimum Standards for Compliance Programs (Enhanced Compliance Program; Appendix B to the Volcker Rule). These standards apply to banking entities with total consolidated assets exceeding $50 billion (total U.S. assets in the case of a foreign banking entity). Under the Proposed Rule, the Enhanced Compliance Program would be eliminated, but banking entities with significant or moderate trading assets and liabilities would remain subject to a CEO attestation requirement (which is part of Appendix B).

Metrics Reporting Requirements

The Agencies have proposed several changes to metrics reporting requirements in the Proposed Rule. Reporting and recordkeeping requirements are tailored to the banking entity's size and level of trading activity, with some metrics completely eliminated and some new metrics added. Timelines for reporting metrics are extended for certain firms. The Agencies have also requested comment on whether metrics reporting should be centralized into a single collection point.

Proposed changes to metrics reporting requirements include adding qualitative information schedules, removing certain metrics, such as inventory aging for derivatives and stressed value-at-risk for risk mitigating hedging desks, and switching reporting of metrics to a standard XML file format. Under paragraph III.b to the Appendix to the Proposed Rule, the Agencies would collect descriptive information for each trading desk in order to better evaluate quantitative metrics. Seven categories of qualitative data are proposed: trading desk name and trading desk identifier, type of covered trading activity, trading desk description, types of financial instruments and other products, legal entities the trading desk uses, legal entity type identification, trading day indicator, and currency reported/currency conversion rate. The Proposed Rule would also double the allowable metrics reporting time, from 10 to 20 days, for the largest firms (those with $50 billion or more in trading assets and liabilities).

Recent Statutory Changes

As noted above, Congress recently passed legislation that completely exempts smaller banks with limited trading activity from the Volcker Rule.

In addition, the recent legislation amends the Volcker Rule by removing covered fund naming restrictions in certain instances in which a banking entity organizes and offers a covered fund. The naming restriction generally prohibits such a fund from sharing a name with the banking entity that sponsors it or with an affiliate of such banking entity, but the new statute permits name-sharing subject to certain limits. The Agencies intend to issue a separate rule to address these legislative changes, but in the interim will enforce the Volcker Rule in a manner consistent with the statutory changes.

Other Provisions

This note provides a brief summary of the Proposed Rule. As noted above, the Proposed Rule sets out 342 specific questions for comment, and requests general comment on the proposed revisions to the Volcker Rule. It appears that comments submitted in response to these questions may have an important bearing on the nature of the final rule that the Agencies ultimately adopt.


1  For an overview of The Economic Growth, Regulatory Relief, and Consumer Protection Act, you may wish to refer our client publication "First Major Dodd-Frank Reform Bill Signed Into Law'", available at: https://www.shearman.com/perspectives/2018/05/first-major-dodd-frank-reform-bill.

2  Since the Volcker Rule regulations were published, the Agencies have issued 21 FAQs explaining the application of various provisions of the regulation. The FAQs are available at: The Fed - Frequently Asked Questions.

3  Proposed Rule §_.2(t).

4  A six-pillar compliance program must include written policies and procedures, internal controls, a management framework, independent testing and audit, training for relevant personnel, and recordkeeping requirements. Volcker Rule Regulations §_.20(b).

5  Proposed Rule §_.2(v).

6  Proposed Rule §_.2(ff).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.