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From Securities Regulation Daily, December 10, 2013
By Jim Hamilton, J.D., LL.M.
The federal financial regulators have jointly adopted regulations to implement the Volcker Rule, Section 619 of the Dodd-Frank Act, which prohibits financial institutions from engaging in proprietary trading of securities, derivatives, and certain other financial instruments for the entity's own account. The Volcker Rule also prohibits financial institutions from owning, sponsoring, or having specified relationships with hedge funds or private equity funds. Thus, the two main prohibitions of the Volcker Rule are proprietary trading and sponsoring hedge funds.
The final Volcker Rule provides exemptions for market making, underwriting, hedging, trading in certain government obligations, and organizing and offering a hedge fund or private equity fund, among others. Like the Dodd-Frank Act, the final regulations limit these exemptions if they involve a material conflict of interest; a material exposure to high-risk assets or trading strategies; or a threat to the safety and soundness of the banking entity or to U.S. financial stability.
Implementation. The SEC and the Federal Reserve Board both addressed the complex implementation of the Volcker Rule. SEC Chair Mary Jo White said that, as with any regulatory initiative of this scope and complexity, the Volcker Rule demands close attention to the nature and pace of implementation. The final rule’s reporting and compliance program requirements will now focus both the regulatory agencies and firms on implementation. The staged implementation of the required reporting of quantitative trading data will allow the agencies and reporting firms to benefit from early experience to evaluate whether any modifications are warranted, and what they should be. Chair White also noted that regulators must be alert to both unintended impacts and regulatory loopholes. She believes that the collaborative relationships that have developed during the rulemaking process should carry forward and allow joint and coordinated guidance as necessary during the implementation of the Volcker Rule.
Federal Reserve Board Chair Ben Bernanke said that the Volcker Rule strikes a proper balance between prohibiting risky proprietary trading and allowing legitimate market making and risk-mitigating hedging activity. Chairman Bernanke expressed the consensus of the Board that regulators will have to closely monitor the implementation of the Volcker Rule so as to avoid unintended consequences. Fed Vice Chair, and Fed Chair nominee, Janet Yellen expressed strong support for the goal of the Volcker Rule to eliminate speculation at financial institutions that access the federal safety net, while at the same time providing important market making and hedging exemptions. In this regard, the Volcker Rule strikes right balance, she said, so long as the frontline regulators ensure that the Volcker Rule works as intended. Fed Governor Daniel Tarullo also agreed that implementation is key.
Proprietary trading. The finalized Volcker Rule clarifies which activities are not considered proprietary trading, provided certain requirements are met, including trading solely as an agent, broker, or custodian; through a deferred compensation or similar plan; to satisfy a debt previously contracted; under certain repurchase and securities lending agreements; for liquidity management in accordance with a documented liquidity plan; in connection with certain clearing activities; or to satisfy certain existing legal obligations.
Trading activity under the Volcker Rule generally includes any purchase or sale as principal of any security, derivative, commodity future, or option on any such instrument for the purpose of benefitting from short-term price movements or realizing short-term profits.
Hedge fund sponsoring. The Volcker Rule prohibits banking entities from owning and sponsoring hedge funds and private equity funds, referred to as covered funds. The definition of covered funds encompasses any issuer that would be an investment company under the Investment Company Act if it were not otherwise excluded by two provisions of that Act: Section 3(c)(1) or 3(c)(7). These exemptions are generally available to privately offered companies whose securities are beneficially owned by 100 or fewer persons or are owned exclusively by qualified purchasers.
Also included in the definition of covered funds are foreign funds and commodity pools, but they are defined in a more limited manner than under the proposal.
The Volcker Rule also excludes from the definition of covered funds entities with more general corporate purposes such as wholly owned subsidiaries, joint ventures, and acquisition vehicles, as well as SEC-registered investment companies and business development companies. Other exclusions are applied to foreign funds publicly offered abroad, loan securitizations, insurance company separate accounts, and small business investment company and public welfare investments. Also excluded from the definition of covered fund is any entity formed by, or on behalf of, the FDIC for the purpose of facilitating the disposal of assets acquired in the FDIC’s corporate, conservatorship, or receivership capacity.
Also exempt from the definition of a covered fund is any issuer of securities backed entirely by loans subject to certain asset restrictions. Accordingly, covered funds do not generally include securitizations such as residential mortgage-backed securities (RMBS) (including GSE exposures), commercial mortgage-backed securities (CMBS), auto securitizations, credit card securitizations, and commercial paper backed by conforming asset-backed commercial paper conduits.
As provided by the Dodd-Frank Act, the final regulations permit a banking entity, subject to appropriate conditions, to invest in or sponsor a covered fund in connection with: organizing and offering the covered fund; underwriting or market making-related activities; some types of risk-mitigating hedging activities; activities that occur solely outside of the United States; and insurance company activities.
In addition, provided certain requirements are met, a banking entity is not engaging in prohibited covered fund activities or investments when it acts on behalf of customers as an agent, broker, custodian, or trustee or similar fiduciary capacity; through a deferred compensation or similar plan; or in the ordinary course of collecting a debt previously contracted.
Collateralized loan obligations. Some collateralized loan obligations (CLO) structures have a limited amount of underlying exposure that consists of securities and/or other non-loan assets. These CLO structures could be covered funds if the non-loan exposures are impermissible assets as described in the final regulations. However, CLOs are allowed to divest of impermissible assets during the conformance period and thus avoid becoming a covered fund.
Underwriting exemption. The underwriting exemption requires that a banking entity act as an underwriter for a distribution of securities, including both public and private offerings, and that the trading desk’s underwriting position be related to that distribution. Consistent with the Dodd-Frank Act, the underwriting position must be designed not to exceed the reasonably expected near-term demands of customers.
Market making exemption. Under the market making exemption, a trading desk must routinely stand ready to purchase and sell one or more types of financial instruments. The trading desk’s inventory in these types of financial instruments must be designed not to exceed, on an ongoing basis, the reasonably expected near-term demands of customers. Under the final rules, determining customer demand will be based on such things as historical demand and consideration of market factors. A market-making desk may hedge the risks of its market-making activity under this exemption, provided it is acting in accordance with certain risk-management procedures required under the final rules.
Hedging exemption. The exemption for risk-mitigating hedging will apply to hedging activity that is designed to reduce, and demonstrably reduces or significantly mitigates, specific, identifiable risks of individual or aggregated positions of the banking entity. The banking entity will also be required to conduct an analysis (including correlation analysis) supporting its hedging strategy, and the effectiveness of hedges must be monitored and recalibrated as necessary on an ongoing basis. The final rules also require banking entities to document, contemporaneously with the transaction, the hedging rationale for certain transactions that present heightened compliance risks.
Government securities. A banking entity may still engage in proprietary trading in U.S. government, agency, state, and municipal obligations. The Volcker Rule also permits, in more limited circumstances, proprietary trading in the obligations of a foreign sovereign or its political subdivisions.
More specifically, the types of obligations that are exempt from the trading restrictions in the Volcker Rule include U.S. Treasuries, which are obligations of, or guaranteed by, the U.S Government and obligations, participations, or other instruments of, or issued by, the government sponsored enterprises, such as the Government National Mortgage Association, the Federal National Mortgage Association, the Federal Home Loan Mortgage Association, a Federal Home Loan Bank, the Federal Agricultural Mortgage Corporation, or a Farm Credit System institution. Also exempt is trading in the obligations of the FDIC, or any entity formed by, or on behalf of, the FDIC for the purpose of facilitating the disposal of assets acquired in the FDIC’s corporate, receiver, or conservator capacity. Trading in the municipal obligations of any state or of any political subdivision is also exempt.
Foreign banks. The final rules generally do not prohibit trading by foreign banking entities, provided the trading decisions and principal risks of the foreign banking entity occur and are held outside of the United States. Such transactions may involve U.S. entities only under certain circumstances. Specifically, an exempt transaction may occur with the foreign operations of U.S. entities; in cleared transactions with an unaffiliated market intermediary acting as principal; or in cleared transactions through an unaffiliated market intermediary acting as agent, conducted anonymously on an exchange or similar trading facility.
Fiduciary duty. The Volcker Rule exempts trading on behalf of a customer in a fiduciary capacity or in riskless principal trades and activities of an insurance company for its general or separate account, so long as certain conditions are met.
Compliance and attestation. The Volcker Rule requires banking entities to establish an internal compliance program reasonably designed to ensure and monitor compliance with the regulations. This is a scaled compliance program whose compliance requirements will vary based on the size of the banking entity and the amount of activities being conducted. The financial regulators believe that the scaled compliance regime will reduce the burden on smaller, less complex entities. Banking entities that do not engage in activities covered by the final rules will have no compliance program requirements.
Larger banking entities must establish a more detailed compliance program, including a required CEO attestation, while smaller entities engaged in modest activities will be subject to a simplified compliance regime. Banking entities that do not engage in any activity subject to the final rules, other than trading in exempt government and municipal obligations, will not be required to establish a compliance program.
The CEO of the banking entity must, annually, attest in writing that the firm has in place processes to establish, maintain, enforce, review, test, and modify the compliance program established under the Volcker Rule in a manner reasonably designed to achieve compliance. In the case of a U.S. branch or agency of a foreign banking entity, the attestation may be provided for the entire U.S. operations of the foreign banking entity by the senior management officer of the U.S. operations who is located in the United States.
The Volcker Rule requires banking entities to maintain documentation so that the federal financial regulators can monitor their activities for instances of evasion.
Corporate governance. The written compliance program must be approved by the board of directors, an appropriate committee of the board, or equivalent governance body, and senior management. In addition, the banking entity must establish and enforce a governance framework reasonably designed to achieve compliance that minimally provides for the designation of appropriate senior management or a committee of senior management with authority to carry out the management responsibilities of the banking entity for each trading desk and for each organizational unit engaged in covered fund activities.
The firm must also establish procedures for determining compensation arrangements for traders engaged in underwriting or market making-related activities or risk-mitigating hedging activities so that such compensation arrangements do not reward or incentivize prohibited proprietary trading and so that they appropriately balance risk and financial results in a manner that does not encourage employees to expose the banking entity to excessive or imprudent risk.
The Volcker Rule also provides that managers with responsibility for one or more trading desks of the banking entity are accountable for the effective implementation and enforcement of the compliance program with respect to the applicable trading desk.
In a tone-at-the-top provision, the Volcker Rule provides that the board of directors and senior management are responsible for setting and communicating an appropriate culture of compliance and ensuring that appropriate policies regarding the management of trading activities and covered fund activities or investments are adopted. The board of directors or a board committee must ensure that senior management is fully capable, qualified, and properly motivated to manage compliance. The board of directors must also ensure that senior management has established appropriate incentives and adequate resources to support compliance.
The Volcker Rule provides that, ultimately, senior management is responsible for implementing and enforcing the approved compliance program. Senior management must also ensure that effective corrective action is taken when compliance failures are identified.
Reporting. Banking entities with significant trading operations must report certain quantitative measurements designed to monitor trading activities. The reporting requirements will be phased in based on the type and size of the firm’s trading activities.
Effective dates. The Volcker Rule becomes effective April 1, 2014. The Federal Reserve Board has extended the conformance period until July 21, 2015. Beginning June 30, 2014, banking entities with $50 billion or more in consolidated trading assets and liabilities are required to report quantitative measurements. Banking entities with at least $25 billion, but less than $50 billion, in consolidated trading assets and liabilities will become subject to this requirement on April 30, 2016. Those with at least $10 billion, but less than $25 billion, in consolidated trading assets and liabilities will become subject to the requirement on December 31, 2016. The federal financial regulators will review the data collected prior to September 30, 2015, and revise the collection requirement as appropriate.
Community banks. Community banks — banking entities with less than $10 billion in total consolidated assets — receive special treatment under the Volcker Rule. This is because the federal financial regulators concluded that the vast majority of these community banks have little or no involvement in prohibited proprietary trading or investment activities in covered funds. Indeed, only a few community banks actually sponsor or invest in covered funds. Thus, they designed the Volcker Rule to place minimal burden on community banks given the nature of their activities.
Most community banks that engage in trading limit their activity to U.S. government, agency, and/or municipal obligations that are specifically exempted from the prohibition on proprietary trading. As such, community banks may continue these trading activities. Moreover, if a community bank’s existing policies and procedures already restrict its trading activities to these instruments, it will not need to revise its internal compliance programs.
Community banks that manage their liquidity through trading activities covered by the Volcker Rule may need to adopt an appropriate liquidity management plan. Many community banks already comply with the Volcker Rule, as their existing policies and procedures contain elements necessary to qualify them as bona fide liquidity management plans. Under the final Volcker Rule, a bona fide liquidity management plan specifically authorizes the particular securities; specifies securities are principally for the purpose of managing liquidity; requires securities to be highly liquid; does not give rise to other risks or appreciable profits as a result of short-term price movements; is limited to an amount that is consistent with near-term funding needs; and includes written policies and procedures, internal controls, analysis, and independent testing that are consistent with existing supervisory requirements, guidance, and expectations.
Many community banks already have policies and procedures restricting their fund investments to the types of securitizations exempt from the Volcker Rule, and therefore they will not need to take any steps to comply with the prohibition. However, if a community bank holds investments in asset-backed securities that do not meet all of the restrictions of the exemption, the bank will have to divest them in accordance with the conformance period in the Volcker Rule.
Similarly, only a small number of community banks own collateralized loan obligations or collateralized debt obligations, including CDOs backed by trust-preferred securities, that meet the definition of covered funds in the final Volcker Rule. If a community bank did not organize and offer the particular covered fund, for example act as the securitizer or asset manager, the bank will have to divest in accordance with the conformance period in the Volcker Rule
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