Yesterday, the U.S. SEC, CFTC, FDIC, Federal Reserve, and Office of the Comptroller of the Currency approved the final rules implementing the provision of the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act commonly referred to as the Volcker Rule. The Volcker Rule is ultimately designed to restrict the finance industry in the wake of the 2008-09 financial crisis and generally limit risk-taking by banks with federally insured deposits.
Named after former Federal Reserve chairman Paul Volcker, the long awaited final rules generally prohibit banking entities (defined to include insured depository institutions, companies controlling insured depository institutions, companies treated as bank holding companies for the purpose of the U.S. International Banking Act of 1978, and their respective affiliates and subsidiaries) from (i) engaging in short-term proprietary trading of securities, derivatives, commodity futures and options on these instruments for their own account; and (ii) owning, sponsoring or having certain relationships with hedge funds or private equity funds, referred to as “covered funds”.
The final rules provide certain exemptions, including for market-making and some hedging, define limits for banks’ investments in private equity and hedge funds, and set parameters for how banks may buy and sell financial products for clients and manage their own risks in the process. While the final rules are generally targeted at U.S. trading by banking entities, they will affect Canadian institutions that operate or have branches or affiliates in the U.S. particularly to the extent that those branches or affiliates are making trading decisions for the Canadian institution.
Highlights of the Rule
- Underwriting and Market Making Activities. While the final rules prohibit proprietary trading, they allow banks to continue making markets for clients. To rely on such exemption, a trading desk must, among other things, stand ready to purchase and sell one or more types of financial instruments relating to its financial exposure and be willing and available to quote, purchase and sell, or otherwise enter into long and short positions in those types of financial instruments. These trades must not exceed the reasonably expected near-term demands of clients, on an ongoing basis. Additionally, banks will be permitted to act as an underwriter for a distribution of securities provided, among other things, that the underwriting position is designed not to exceed the reasonably expected near-term demands of customers. For both underwriting and market making activities, compensation arrangements of persons performing such activities cannot be designed to reward or incentivize prohibited proprietary trading.
- Risk-Mitigating Hedging Activities. The final rules provide an exemption for risk-mitigating hedging activities of a banking entity in connection with and related to individual or aggregated positions, contracts or other holdings of the bank that are designed to reduce specific risks to the bank in connection with and related to such positions, contracts or other holdings. In order to rely on this exemption, the final rules require banks to demonstrate on an ongoing basis that their trades hedge specific risks. Banks will be required to analyse and independently test that a hedge demonstrably reduces or otherwise significantly mitigates one or more specific, identifiable risks of individual or aggregated positions of the banking entity. Similar to the underwriting and market-making exemption, compensation arrangements of persons performing hedging activities for the bank cannot be designed to reward or incentivize prohibited proprietary trading.
- Foreign and Domestic Government Obligations and Trading by Foreign Banks. The final rules provide an exemption from the ban on proprietary trading for the buying and selling of certain financial instruments backed by a foreign or domestic sovereign. This exemption includes financial instruments issued by foreign central banks and further applies to U.S. banks with overseas operations as well as foreign firms with affiliates in the U.S. The final rules generally do not prohibit trading by foreign banking entities, provided that the trading decisions and principal risks of the foreign banking entity occur and are held outside of the U.S.
More specifically, the final rules exempt transactions (i) with the foreign operations of U.S. entities, (ii) in cleared transactions with unaffiliated market intermediaries acting as principal, or (iii) in cleared transactions through an unaffiliated market intermediary acting as agent, conducted anonymously on an exchange or similar trading facility. The final rules specify that for the purposes of the exemption for trading activity of a foreign banking entity, a U.S. branch, agency or subdivision of a foreign bank, or any subsidiary thereof, is located in the U.S., however a foreign bank that operates or controls such branch, agency or subdivision is not considered to be located in the U.S., ultimately clarifying that the U.S. operations of foreign banking entities may not conduct proprietary trading based on the foreign trading exemption.
- Fund Investments. The final rules limit banks’ ability to invest in private equity, hedge funds and commodity pools but provide exemptions for some types of funds, including joint ventures, issuers of asset-backed securities and wholly-owned subsidiaries.
- Non-U.S. Mutual Funds. The final rules generally exempt funds organized and publicly offered outside of the U.S. that are the rough equivalent of U.S. mutual funds from the prohibition on banks’ investing in or sponsoring private funds.
- CEO Responsibility. Under the final rules, CEOs will now be required to annually attest in writing that their company has processes to establish, maintain, enforce, review, test and modify the compliance program established by the company. 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 United States operations of the foreign banking entity who is located in the U.S.
- Other Permitted Activities. The final rules exempt trading on behalf of a customer in a fiduciary capacity, provided that the bank does not have or retain beneficial ownership of the financial instruments, as well as trades where the bank is acting as riskless principal and activities of an insurance company for its general or separate account, provided that certain requirements are met.
Compliance requirements under the final rules vary depending on a bank’s size and the scope of its activities, with a reduced burden on smaller, less-complex institutions. The final rules will become effective April 1, 2015 and the Federal Reserve Board has extended the conformance period until July 21, 2015.
The final rules will have staggered implementation for banks of varying sizes, with the largest banks (banking entities with $50 billion or more in consolidated trading assets and liabilities) being required to report quantitative measurements beginning June 30, 2014, and smaller banks (banking entities will at least $10 billion but less than $25 billion in consolidated trading assets and liabilities) being subject to this requirement on December 31, 2016.