“Volcker Rule” Regulations Finally See The Light Of Day

by Reed Smith

Federal financial regulators on December 10, 2013 released final regulations for the Volcker Rule, which is a key provision of the Dodd-Frank Act. The rule is found in section 619 of the Dodd-Frank Act, which adds a new section 13 to the Bank Holding Company Act of 1956 (“BHC Act”). The long-awaited Volcker Rule regulations apply to banking entities under the supervision of federal regulators and are aimed at restricting those entities from taking excessive risks in their investments. Perhaps most significantly, the regulations released Tuesday prohibit proprietary trading – subject to certain limited exemptions. The regulations also implement a statutory prohibition against acquiring or retaining “any equity, partnership, or other partnership interest or [sponsorship]” in a private equity or hedge fund above a de minimis exemption. Five regulators – the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission, and the Commodity Futures Trading Commission – approved the regulations Tuesday.

The final version of the rule includes a number of notable items.

Covered Entities

The regulations cover all insured depository institutions, any company that controls an insured depository institution (such as a bank holding company or a savings and loan holding company), any foreign bank treated as a bank holding company for regulatory purposes, and any affiliate or subsidiary of such banking entities [hereinafter “banks”].

Effective Dates

While the regulations become effective April 1, 2014, large banks would not have to begin conforming to the regulations until July 21, 2015. However, reporting requirements begin earlier on seven quantitative metrics. Banks with $50 billion or more in trading assets and liabilities would be required to report June 30, 2014; banks with at least $25 billion in trading assets and liabilities but less than $50 billion would not be required to report until April 30, 2016; and banks with at least $10 billion in trading assets and liabilities but less than $25 billion would not be required to report until Dec. 31, 2016.

Proprietary Trading Regulations

  • Market-making. The regulations exempt market-making from the prohibition on proprietary trading, subject to limitations. Banks relying on this exemption must ensure that the financial instruments within their trading desks’ inventories “are not designed to exceed, on an ongoing basis, the reasonably expected near term demands of clients, customers, or counterparties,” based on several criteria. One of these criteria is “[d]emonstrable analysis of historical customer demand, current inventory of financial instruments, and market and other factors regarding the amount, types, and risks, of or associated with financial instruments in which the trading desk makes a market, including through block trades.” The “ongoing basis” assessment essentially would allow banks to recalibrate their market-making activities based on market and customer demand factors. The regulations also require that banks establish written policies for market-making and compensate employees “in a way that does not reward or incentivize prohibited proprietary trading.” The regulations do not require that market-making “be designed to generate revenues primarily from fees or other customer revenues,” but banks must report data regarding revenue “that may warrant further review of the desk’s activities."
  • Underwriting. The regulations exempt underwriting from the prohibition on proprietary trading, but also require a compliance program to ensure that underwriting is conducted within the limitations of the regulations. Securities traded as part of an underwriting position must be designed “not to exceed the reasonably expected near term demands of clients, customers, or counterparties,” and banks must make “reasonable efforts” to sell or reduce their underwriting position “within a reasonable period.”
  • Short-term and Long-term Trading. The Dodd-Frank Act defines trading accounts as accounts used for positions taken “principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements) . . .” The final regulations impose a rebuttable presumption that holding a financial instrument “for fewer than sixty days” is trading activity under the statute. Also, the preamble to the final regulations states that the rebuttable presumption may be overcome by showing “unexpected developments” requiring a sale under 60 days. Examples of these developments could include “an unexpected increase in the financial instrument’s volatility or a need to liquidate the instrument to meet unexpected liquidity demands.” The Federal Reserve Board (“Board”) staff memorandum accompanying the final regulations notes that permitted short-term trading could include “clearing, liquidity management, transactions in satisfaction of debts previously contracted, or other types of transactions that do not involve an intent by the banking entity to resell in order to profit from short-term price movements.”
  • Trading as a Third Party. The regulations clarify that proprietary trading does not include “[a]ny purchase or sale of one or more financial instruments by a banking entity that is acting solely as agent, broker, or custodian.” It covers only those positions taken by banking entities as principal. The regulations specifically exempt fiduciary transactions, provided those transactions are “conducted for the account of, or on behalf of,” a customer; and the bank does not retain “beneficial ownership” of the financial instruments involved in the transactions.
  • Portfolio Hedging. While the regulations contain exemptions to the proprietary trading ban, the exemption for “risk-mitigated hedging activity” specifically does not allow for so-called “portfolio hedging.” Using this type of hedging, banks enter into trades designed to hedge against a broad array of risks not necessarily tied to their holdings. According to the Board staff memorandum, hedges must at their inception “be related to identified positions, contracts and other holdings of the banking entity.” It should be noted that the regulations allow hedging with respect to both individual and aggregate positions, as long as those positions are identified. However, the exempted hedging activity “may not give rise . . . to any significant new or additional risk that is not itself hedged contemporaneously,” and must be “monitored and managed over time.”
  • Securitizations. The final regulations exclude from the proprietary trading ban some types of securitizations, so long as certain criteria are met. The types of securitization exempted would be limited to “loan securitization, qualifying asset backed commercial paper conduit, and qualifying covered bonds.” This exemption would allow banks to continue securitization of home mortgages, credit card loans and auto loans.
  • Government Securities. The proprietary trading ban would not apply to certain U.S. and foreign government securities. Exempted government securities include U.S., state, municipal and government-sponsored entity (including Fannie Mae and Freddie Mac) obligations. The Board staff memorandum states that this exemption “does not extend to derivatives on those obligations.” Foreign government securities would not fall under the ban in two situations, according to the memorandum. First, “the U.S. operations of a foreign banking entity, other than an insured depository institution,” could trade the “obligations of the home chartering authority of the foreign banking entity.” Second, “a foreign bank or foreign securities broker-dealer owned by a U.S. banking entity” could trade the “obligations of the foreign sovereign that charters the foreign bank or foreign broker-dealer.” Under either situation, the exemption would include the obligations “of any agency or political subdivision” of the foreign sovereign.
  • Safety and Soundness / Material Conflicts of Interest. Trading permitted under the proprietary trading ban may not include any activities that would “[p]ose a threat to the safety and soundness of the banking entity or to the financial stability of the United States,” or “[i]nvolve or result in a material conflict of interest between the banking entity and its clients, customers, or counterparties.” The Board staff memorandum states that possible ways to avoid an impermissible conflict include making a “timely disclosure” to the other party, and using “information barriers, such as physical separation of personnel or functions” to address the conflict.
  • Compensation and Proprietary Trading. Bank employees trading under exemptions for market-making and underwriting may not be compensated under arrangements designed “to reward or incentivize prohibited proprietary trading.”

Hedge Fund and Private Equity Ownership Regulations

  • Covered Funds. The regulations prohibit banks from owning, sponsoring or engaging in other specified relationships, above a 3 percent ownership interest, in hedge funds and private equity funds. The same percentage limit applies to the ownership interest in “all covered funds” as a percentage of Tier 1 capital of the banking entity. Hedge funds and private equity funds are referred to jointly as “covered funds” in the regulations. According to the Board staff memorandum, the regulations exclude from the definition entities including “foreign public funds, wholly-owned subsidiaries; joint ventures that do not engage in investing money for others; acquisition vehicles; foreign pension or retirement funds; insurance company separate accounts; [small business investment companies] and public welfare investment funds; and registered investment companies.”
  • Affiliate Transactions. Under a part of the Volcker Rule known as “Super 23A,” banks are prohibited from entering into transactions with a covered fund if they serve as a “manager, adviser, or sponsor” to the covered fund. In essence, banks cannot conduct a “covered transaction,” as defined by section 23A of the Federal Reserve Act, with a covered fund. This prohibition is subject to the exemption on 3 percent ownership interests discussed above. Also, there is an exemption for prime brokerage transactions with a second-tier fund – a covered fund owned by another covered fund that is sponsored or advised by the bank. Exempted prime brokerage transactions are subject to section 23B of the Federal Reserve Act. Under section 23B, the transactions must be conducted on terms that are “substantially the same, or at least as favorable to” the bank “as those prevailing at the time for comparable transactions” with nonaffiliated companies or, in the absence of comparable transactions, on terms “that in good faith” would be offered to nonaffiliated companies.
  • Advisory Compensation. The “covered funds” section of the regulations exempts incentive arrangements that give ownership interests to banks acting as investment advisors. To be exempt, the compensation provided must be solely for performance, and any profit from the interests must be distributed promptly. These interests must be counted when determining a bank’s permitted investment in a fund and are not transferable except “to an affiliate, upon death of the employee, or upon sale of the business that provides advisory services to the fund.”

Specific Requirements for Executives, Community Banks, and Non-Chartered Institutions

  • CEO Attestation. The regulations require annual “CEO attestation” for banks with $50 billion or more in assets in the previous calendar year, and in the case of foreign banking entities, $50 billion or more in total U.S. assets. Under the CEO attestation requirements, chief executives for these banks would have to attest in writing that their banks have a compliance program designed to achieve compliance with the Volcker Rule.
  • Community Banks. Community banks with $10 billion or less in total consolidated assets have no compliance obligations, provided they do not engage in covered activities under the regulations. A statement released by the Board concurrently with the regulations noted that community banks generally limit their trading activity to “U.S. government, agency and/or municipal obligations” that are already exempted from the proprietary trading ban under the regulations. If a community bank undertakes broader trading activity, compliance program requirements “can be met by simply including references to the relevant portions of [the final regulations implementing the Volcker Rule] within the bank’s existing policies and procedures to address just the activities that the community bank actually conducts.”
  • Non-Bank Financial Institutions. While non-bank financial institutions are not necessarily subject to the Volcker Rule, the staff memorandum states that section 13 of the BHC Act allows agencies to impose new requirements on non-bank financial companies designated by the Financial Stability Oversight Council (“FSOC”). Under section 13, these companies may be subject to “additional capital requirements” and “additional quantitative limits” if they engage in proprietary trading or if they make investments in covered funds. So far, FSOC has designated only three companies for heightened regulatory oversight. The Board memorandum stated that “two of the three firms that have been designated by the Council currently control an insured depository institution, and are, therefore, banking entities subject to the final rules.” Board staff is “exploring” whether the third entity must comply with section 13 “and will propose action consistent with that section if appropriate and applicable.”

Foreign Banks

  • Applicability of Volcker Rule to Foreign Banks. Section 13 defines “banking entity” to include any foreign bank that is treated as a bank holding company pursuant to the International Banking Act of 1978. This would include, for example, a foreign bank operating a U.S. branch or a broker-dealer subsidiary.
  • Foreign Banks in U.S. Markets. As noted above, bank includes any foreign bank that is treated as a bank holding company pursuant to section 8 of the International Banking Act of 1978, or a foreign bank operating a U.S. branch, agency or broker-dealer subsidiary. The regulations allow foreign banks to conduct proprietary trades solely outside the United States (“SOTUS exemption”). However, there are limitations on such trading activity, such as the foreign bank is a principal for such trades and U.S. contacts are virtually non-existent, and that includes the role of U.S. personnel, purchases or sales, hedging, or financing. However, the trades can be conducted anonymously on U.S. exchanges or through an unaffiliated intermediary cleared and settled through a U.S. central counterparty, or with the foreign operations of a U.S. entity. The SOTUS exemption only applies to a foreign bank if it is not directly or indirectly controlled by entities organized under U.S. or state laws. Just because a foreign bank has a U.S. banking business does not mean it is “located” in the United States by virtue of its U.S. presence.
  • U.S. Banks in Foreign Markets. The SOTUS exemption is not available to U.S. banks because the prohibition on proprietary trading applies to the consolidated worldwide operations of U.S. banks, including their foreign branches and subsidiaries. Foreign subsidiaries or affiliates of U.S. banks can pursue trading activities with a foreign banking entity outside the United States, provided the actions of the foreign subsidiary or affiliate comply with the regulations other than the SOTUS exemption.

Monitoring and Compliance

The requirement that banks monitor and manage the risk of hedging activity likely will prove to be significant. According to the Board staff memorandum, the regulations place a burden on banks to conduct “analysis and independent testing” to ensure that hedging activity will “demonstrably reduce or significantly mitigate risk being hedged” when the hedge is put on the books. Banks also must document any hedging activity undertaken by a part of a bank other than the trading desk responsible for the risk being hedged against. Further, banks must document any hedging done through a method “not identified in the written hedging policy governing that trading desk.” According to the staff memorandum, compliance with the regulations involves, at a minimum, the following six elements:

  • Written policies and procedures that establish trading and exposure limits for the activities conducted by the banking entity and that are designed to ensure compliance with the requirements of the final rule
  • Internal controls
  • A management framework that delineates responsibility and accountability for compliance with the final rule
  • Independent testing and audit
  • Training
  • Recordkeeping


  • The bank examiners who decide whether a banking entity’s policies, procedures and activities comply with the regulations will play a critical role in determining the impact of the Volcker Rule on the financial services industry and markets.
  • Bank examiners’ views and recommendations will depend in large part on the guidance given to them by the federal regulators, as well as on their personal knowledge and experience.
  • The complexity and restrictiveness of the regulations will undoubtedly impose new costs on banking entities, and in some instances may require a rethinking of individual banking entities’ business models.
  • Issuance of the federal regulations has removed uncertainty in the markets as to how the Volcker Rule will be implemented. Consequently, affected banking entities are able to be more forward-looking in their business strategies. 
  • The proprietary trading ban implemented in the regulations should have the substantive effect of improving investor confidence in the banking sector as a whole, and enable the sector to better attract capital.
  • The extent to which the fully implemented Volcker Rule pushes market-making, for example, into the “shadow banking” sector, is an open question.
  • It is very important that the covered banking entities develop robust programs for compliance, investment risk management processes, and independent testing. They also should maintain and preserve documentation for all of these programs.
  • The multitude of agencies involved in Volcker Rule implementation will create some lingering uncertainty, because of their overlapping jurisdictions and differing approaches to regulatory compliance. This could be reflected in the enforcement arena as well.

We will continue to monitor the agencies’ implementation of the Volcker Rule, and more detailed analyses of issues raised by the rule are forthcoming.

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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