After several years and 18,000 comments, yesterday regulators braved a “snow covered” Washington and voted to approve a final rule to prohibit banks from engaging in proprietary trading, known as the Volcker rule. As industry had feared, the Volcker rule will likely increase compliance burdens and complexity and, as a practical matter, narrow the scope of trading revenue generating activities for covered institutions. Given the phased implementation schedule for the new requirements, the impacts will not be fully felt until 2017.

Changes from the Proposed Rule

As with the proposed rule, the final Volcker rule generally prohibits banking entities from engaging in short-term proprietary trading of securities and derivatives (including swaps, commodity futures, and options) for their own account and bars them from having certain relationships with hedge funds or private equity funds. However, there are numerous exemptions to this standard, including for market making, underwriting, hedging, trading in government obligations, and organizing and offering a hedge or private equity fund.

In response to numerous comments and industry pressure, the final rule grants broader exemptions for banks’ market-making activities. While the proposed rule outlined seven standards that banks must satisfy to meet the definition, the final rule provides that banks’ trading desks need to be “routinely” ready to both “purchase and sell one or more types of financial instruments” in order to qualify as “market making.” Furthermore, the rule states that trades qualifying for the market-making exemption, like those qualifying for the underwriting exemption, will not be allowed to surpass the “reasonably expected near-term demands of clients” which would be assessed through historical demand and consideration of market factors. The new rule mandates certain risk management activities and procedures for permissible hedging activities of market-making desks.

The final rule delineates the scope of certain foreign funds and commodity pools covered by the fund investment and sponsorship restrictions in a more limited manner than under the proposed rule. The final rule does not restrict investments in or sponsorship of certain entities like wholly-owned subsidiaries, joint ventures, and acquisition vehicles. The final rule excludes mutual funds and other registered investment companies, business development companies, certain publicly offered foreign pooled investment vehicles, loan securitizations, insurance company separate accounts, small business investment companies, and public welfare investments.

While the market-making exemption and private fund activity restrictions may have been softened, much of the final rule builds on the proposed, imposing new and stronger requirements on banks.

Among the strengthened provisions are risk-mitigating hedging provisions that require banks to analyze, test, and demonstrate to regulators that a hedge “demonstrably reduces or otherwise significantly mitigates one or more specific, identifiable risks of individual or aggregated positions of the banking entity.” Banking entities will be required to support claims of exempt hedging with analysis, including detailed correlation analysis, to monitor and recalibrate as necessary hedging strategies on an ongoing basis and to document, contemporaneously with the transaction, the hedging rationale for certain transactions that present heightened risks. Based on public comments from regulators, it appears the hedging language was tightened partly in response to a $6.2 billion JPMorgan trading loss by the rogue trader known as the “London Whale.”

Among the most vocal in their concerns with the proposed rule was the small and community banking industry, which feared that the compliance requirements associated with the rule would push them out of the market in favor of the large banks and financial institutions with greater capacity to handle the increased compliance costs associated with conforming to the Volcker rule’s standards. The response to these concerns was to allow smaller institutions additional time to comply with select requirements. Regulators created a phased compliance schedule in the final rule. The originally proposed effective date of April 1, 2014 was extended until July 21, 2015. The rule also requires a number of quantitative measurements, knows as “value-at-risk” calculations. The final rule offers a phased approach for reporting estimates of risk, position limits, profits, losses, and estimates of capacity for loss per day. Beginning June 20, 2014, entities with over $50 billion in consolidated trading assets and liabilities will be required to report quantitative measurements. Those entities with less than $50 billion, but at least $25 billion in assets would be required to begin this reporting on April 30, 2016. Finally, banking entities with at least $10 billion, but less than $25 billion, will not have to begin this reporting until December 31, 2016.

Not only must larger institutions worry about a shorter compliance period, but their CEOs must annually attest in writing to compliance. These obligations, while less onerous than rumored, still apply to institutions with more than $50 billion in assets.

Regulators also made changes to allow foreign trading of sovereign debt under more circumstances than previously proposed. Earlier drafts of the Volcker rule had drawn criticism from international regulators for its potential to reach overseas banks’ activities and the sovereign debt market. To resolve these concerns, the final Volcker rule adopts a territorial approach, exempting trades outside the U.S., assuming “the trading decisions and principal risks of the foreign banking entity occur and are held outside of the United States.”

The Regulators Voted

While the day began with news that weather complications had forced the CFTC to change its public meeting to a private vote, snow did not stop regulators from voting to finalize the long-delayed Volcker rule.

The Fed was the first regulator to formally announce it had approved the rule in a unanimous vote to apply its provisions to the large bank and financial holding companies under its jurisdiction. The FDIC also approved the rule in a unanimous 5–0 vote. While Vice Chairman of the FDIC Thomas Hoenig expressed reservations about the complexity of the rule, he agreed with the remainder of the Board that the rule is a “necessary step in ensuring that the current financial industry structure is less vulnerable.”

Although the Fed and FDIC votes were uncontentious, much of the debate over the final rule in weeks leading up to the vote appears to have been amongst CFTC and SEC commissioners. In the end, the SEC voted 3–2 to approve the final rule, with the Commission’s two Republicans, Michael Piwowar and Daniel Gallagher, opposing.

The CFTC followed the SEC, approving the rule in a 3–1 vote. While the vote was private, CFTC Commissioner Scott O’Malia, who opposed the rule in its proposed form, also voted down the final rule. In his dissenting statement, O’Malia cited concerns that the rule does not adequately address the CFTC’s jurisdiction and enforcement powers, adding that he cannot support a proposal that had not been meaningfully vetted by the full Commission.

Comptroller of the Currency Thomas Curry’s approval made the OCC the fifth and last agency to approve. Notably, the OCC has also released a budgetary impact statement under the Unfunded Mandates Reform Act of 1995. The release states that the OCC has “determined that the final rule qualifies as a significant regulatory action under the UMRA because its Federal mandates may result in expenditures by the private sector in excess of $100 million or more.”

Stakeholders Respond

At the release of the final rule, Senators Jeff Merkley (D-OR) and Carl Levin (D-MI), the sponsors of the Volcker rule amendment to the Dodd-Frank Act, released a statement reiterating the need for “a firewall between traditional banking and hedge fund style gambling.” Though the lawmakers said they were still reviewing the specifics of the rule, finalizing the proprietary trading ban was a “big step” forward and that “hedging looks tougher, market-making looks simpler, trader compensation remains appropriately structured, and CEOs are required to set the tone at the top.”

Chairman of the Senate Banking Committee Tim Johnson (D-SD) also praised the final rule, saying it is a “milestone” in the progress toward full implementation of the Dodd-Frank Act and that it will “help improve the integrity of our banking system.”

After reports late last week that the final Volcker rule would be a stronger version of the proposed, industry groups expressed disappointment that regulators did not re-propose the Volcker rule before finalization. The head of the Chamber of Commerce’s Center for Capital Markets Competitiveness, David Hirshmann, warned that the rule is the most complex of the “convoluted Dodd-Frank law” and that it has the potential to shut out small business, raise the cost of capital, and place the U.S. at a competitive disadvantage to the global economy. While not as pessimistic as the Chamber, other industry groups, such as the Financial Services Roundtable and Financial Services Forum have warned against the broad economic implications of the rule. Rob Nichols, head of the Financial Services Forum, expressed hope that regulators “implement it in a way that recognizes the economic importance of hedging and market-making.”

Industry backlash may be tempered by looser than expected market-making requirements and the narrowing of the fund activities restrictions; however, it is still conceivable that a legal challenge to the Volcker rule could be brought, just as legal challenges to other Dodd-Frank related rulemaking efforts (e.g., the Fed’s Durbin Amendment rules, the CFTC’s initial position limit rules, and the CFTC’s mutual fund regulations) have proceeded with varying degrees of success. In the interim, banks must now begin to plan their compliance programs for this much anticipated legacy of Dodd-Frank.