A Many-Headed Hydra


The notorious regulation technically took effect on April 1. Covered entities must now pay closer attention to how they structure their trading activities, and their investments in fund-type vehicles.

Perhaps not surprisingly, a rule crafted by five regulators that purports to stop banking entities engaging in risky activities – while also attempting to permit activities necessary to well-functioning markets – poses enormous challenges. In December 2013, over two years since the release of the proposed rule, the Federal Reserve, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, Securities and Exchange Commission, and the Commodity Futures Trading Commission adopted the final Volcker Rule. Subject to exceptions, this prohibits banking entities – a broad term that includes banks, bank holding companies, foreign banks treated as bank holding companies (FBOs) and their respective affiliates – from engaging in proprietary trading and acquiring or retaining ownership interests in, or acting as sponsors to, certain hedge funds and private equity funds (Covered Funds). Broker-dealers not affiliated with banks are not subject to the rule. By statute, the rule took effect two years following adoption of the Dodd-Frank Act in July 2012 with a two-year conformance period that originally ended July 2014. The agencies have extended the conformance period by one year to July 2015 (and by three years to July 2017 for investments in certain pre-existing collateralised loan obligations). Setting aside its sheer heft (about 80 pages of rule text accompanied by approximately 900 pages of preamble or explanatory notes), the rule’s complexity assures that we will be struggling to grapple with its provisions far beyond 2015.

Proprietary trading -

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. A ‘financial instrument’ includes a security, derivative, and contract of sale of a commodity for future delivery (or an option on the same). It excludes loans, a commodity that is not an ‘excluded commodity’, derivative or a commodity future, and foreign exchange or currency. A trading account is one that satisfies either the purpose test, market risk capital test, or status test. The purpose test addresses trading for short-term resale or to benefit from shortterm price movements. The market risk capital test applies to a US bank or thrift, or a US bank or thrift holding company subject to the US banking agencies’ market risk capital rules. For such entities, a trading account includes one used to trade in financial instruments that are both market risk capital rule covered positions and trading positions. The status test addresses – for a banking entity that is a securities dealer, swap dealer or securities-based swap dealer – trades that would require them to be licensed as such. All such trades are deemed to occur in a trading account. Given the breadth of these definitions, and the presumption established by the rule that the purchase or sale of a financial instrument held in a trading account for less than 60 days constitutes proprietary trading, many necessary or benign activities are prohibited.

Please see full alert below for more information.

Originally published in International Financial Law Review - May 2014.

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DISCLAIMER: 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.

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