Despite a winter snowstorm that shut down the US Government in Washington DC, five federal agencies issued rules today (December 10) to implement the so-called Volcker Rule under the Dodd Frank law enacted in 2010. These rules generally prohibit banks and their affiliates trading on a short-term proprietary basis for their own account certain securities, derivatives, futures and options on these instruments. Subject to certain exemptions, the rules also articulate strict limits on banking entities acquiring or maintaining an ownership interest in, sponsoring, or having certain relationships with hedge or private equity funds.
The five agencies are the Board of Governors of the Federal Reserve System, the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Securities and Exchange Commission.
Notwithstanding, the rules grant exemptions for certain proprietary activities, including (1) trading in US government and certain non-US sovereign (or their political subdivisions') obligations, (2) market making, (3) underwriting, (4) risk mitigating hedging, and (5) organizing and offering hedge or private equity funds. Acting as an agent, broker or custodian is also permitted. Similarly trading on behalf of customers in a fiduciary or riskless principal basis, as well as activities of an insurance company, are also permitted under certain circumstances. These exemptions are limited if they involve a material conflict of interest, a material exposure to "high-risk" trading strategies or assets, or a threat to the safety and soundness of the banking entity or to overall US financial stability.
Express requirements are imposed by the rules for each banking entity engaged in authorized trading activities or investments. These include (1) establishing a compliance program; (2) limiting positions, inventory and risk exposure to ensure activities "do not exceed the reasonably expected near term demands of clients, customers or counterparties;" (3) limiting the duration of holdings and positions; (4) defining escalation procedures to modify or exceed previously approved limits; (5) ensuring senior management accountability; and (6) limiting incentive compensation.
Compliance programs must be reasonably designed "to ensure and monitor compliance with the prohibitions and restrictions on covered trading activities and covered fund activities and investments." Chief Executive Officers of larger banking entities will have to attest that the banking entity has in place a program reasonably designed to achieve compliance with the Volcker Rule.
The rules potentially impact foreign banking entities located in the United States. Trading by these entities is permitted outside the U.S. but only provided that the risk as principal, the decision-making and the accounting occur outside the U.S. too.
Under the rules, certain entities also will have to file monthly or quarterly reports (depending on their size) regarding their trading activities. Metrics covered by the reporting include (1) risk and position limits and usage; (2) risk factor sensitivities; (3) value at risk and stress VaR; (4) profit and loss attribution; (5) inventory turnover; (6) inventory aging; and (7) customer facing trade ratio.
Overlapping jurisdiction by federal regulators in connection with the rules will be inevitable as each agency has oversight over a banking entity for which it is the primary financial regulatory agency. The US Commodity Futures Trading Commission, for example, will have first line jurisdiction over swaps dealers, future commission merchants, commodity trading advisors and commodity pool operators even if such entities or their parent companies or affiliates are regulated by other agencies.
Among other things, the rules limits risk mitigating hedging to hedging that "is designed to reduce, and demonstrably reduces or significantly mitigates, specific, identifiable risks or individual or aggregated positions of the banking entity." This would be supported by banking entities' contemporaneously documenting a hedge's rationale, and an analysis, including a correlation analysis, of the effectiveness of its hedging strategy on an ongoing basis. General portfolio hedging not based on specific correlations will not be permitted. According to CFTC Chairman Gary Gensler, in his statement related to the new rules,
"The final Volcker Rule also permits hedging to reduce identified, specific risks from the banking entity's individual or aggregated positions. Permitted hedging activity will be required to (1) be designed to and (2) demonstrably reduce or otherwise significantly mitigate one or more specific, identifiable risks. The final rule's preamble further states that this activity is not intended to be hedging of generalized risks based on non-position specific modeling or other considerations. Hedging of the general assets and liabilities of the banking entity or a guess as to the direction of the economy will no longer be permitted."
The CFTC vote in approving these rules was 3-1 with Commissioner O'Malia dissenting. In voting to approve these rules, Commissioner Chilton, likened proprietary trading by banking entities to the high roller's room in casinos:
"If you've ever been to a casino, many of them have a high roller's room. There's usually a sign about a $1000 minimum bet. Many have ornate gaming tables and heavy draperies. If you walk around, you can catch a glimpse inside. But other than betting a lot of money, I'm not sure what goes on in there… But, what if what the high rollers did in that room impacted all of us? What if it impacted consumers, our economy and our country? What if what the high rollers did in that room cost us $417 billion dollars (in a big bank bailout) because the games they were playing were tanking the economy? That's why we need a strong Volcker Rule. We should never again be put in a circumstance where too big to fail high rollers play games of chance with our nation."
On the other hand, Commissioner O'Malia vehemently objected to the "abuse of process" around the passage of the new rules. He argued that provisions of both the Administrative Procedure Act and the Commodity Exchange Act were violated in the process that led to passage of the new rules:
"I believe the Commission must get back to the basics of good government and proper rulemaking. I cannot vote for a final rule that is hardly the product of meaningful consideration by the full Commission, but instead was negotiated exclusively by the Chairman. In addition, I cannot vote for a final rule where the Commission has not devoted enough attention to providing sufficient clarity and due process in the enforcement of new and untested regulatory authority, but still imposes significant obligations upon market participants at an unknown—but surely considerable—cost."
The SEC voted 3-2 to approve these rules, with Commissioners Daniel Gallagher and Michael Piwowar dissenting. In his dissent, Commissioner Piwowar, as did Commissioner O'Malia of the CFTC, argued that the SEC did not meet regulatory obligations in connection with promulgating new rules:
"The Rulemaking Agencies have not complied with legal obligations that apply to any rulemaking. In particular, the proposal of the Volcker Rule that preceded today's action did not provide sufficient notice to the public of the contents of the rule adopted today. As the United States Court of Appeals for the District of Columbia Circuit ("D.C. Circuit") has noted concerning what constitutes adequate notice, '[i]t is not consonant with the purpose of a rule-making proceeding to promulgate rules on the basis of inadequate data, or on data that, to a critical degree, is known only to the agency.' The Volcker Rule adopted today is not based on data sufficient to meet this standard."
SEC Chair Mary Jo White, however, praised adoption of the final rules:
"To carry out the mandate ...of the Dodd Frank Act, the final rule seeks to focus U.S. banks and their affiliates on customer-directed activities, and to prevent the risks to U.S. taxpayers that can flow from proprietary trading and investments in private funds. The final rule has been written to carry out these objectives while maintaining the strength and flexibility of the U.S. capital markets by allowing both domestic and foreign financial firms to continue to participate meaningfully in those markets where they are permitted to do so."
Although the final rules are effective April 1, 2014, banking entities are permitted until July 21, 2015 to comply with the rules' restrictions. Reporting obligations will commence as of June 30, 2014, however, for the largest banking entities while other banking entities will not be required to commence reporting, depending on their size, until one of two dates in 2016.
For more information, see:
Volcker Rule Fact Sheet:
Volcker Rule Final Rules (CFTC):
Volcker Rule Final Rules (Common Rules):
The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of December 10, 2013, but no representation or warranty is made regarding the accuracy of any statement. To ensure compliance with requirements imposed by U.S. Treasury Regulations, Gary DeWaal and Associates LLC informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Gary DeWaal and Associates may represent one or more entities mentioned in this article.
Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office.
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