Volcker Rule Finalized

Practical Law Legal Update 8-551-5245 (Approx. 10 pages)

Volcker Rule Finalized

by Practical Law Finance

Background: Statutory Requirements of the Volcker Rule

The Volcker Rule, which is codified in Section 13 of the Bank Holding Company Act (BHC Act) prohibits banking entities (including depository institutions and their parent holding companies and affiliates) from:

Engaging as principal in proprietary trading for the purpose of selling financial instruments in the near term or otherwise with the intent to resell in order to profit from short-term price movements. Exemptions from this prohibition are provided for certain activities, including:
- Trading in US government, agency and municipal obligations.
- Underwriting and market making-related activities.
- Risk-mitigating hedging activities.
- Trading on behalf of customers.
- Trading for the general account of insurance companies.
- Foreign trading by non-US banking entities.
Acquiring or retaining an ownership interest in, or sponsoring, a hedge fund or private equity fund. The Volcker Rule provides several exemptions that allow banking entities to make limited investments in hedge funds and private equity funds, subject to a number of restrictions designed to ensure that banking entities:
- do not rescue investors in these funds from loss; and
- are not themselves exposed to significant losses from investments or other relationships with these funds.

Although the Volcker Rule prohibitions do not apply to a nonbank financial company designated as a Systemically Significant Financial Institution (SSFI), it does require that Volcker Rule-covered activities by a SSFI be subject to additional capital charges, quantitative limits or other restrictions.

General Approach of Final Rule

The final rule builds on the risk-based and compliance-focused approach laid out in the October 2011 proposed rule (see Legal Update, Agencies Issue Proposed Regulations Implementing the Volcker Rule). Apart from clarifying the statutory prohibitions and exemptions spelled out in the Volcker Rule, the final rule also imposes compliance and metrics reporting requirements. The final rule also provides some compliance burden relief for smaller banking organizations and those banking entities not engaged in activities covered under the Volcker Rule.

In the preamble to the final rule, the agencies state they have designed the final rule to meet the need for "clear, robust, and effective implementation" of the Volcker Rule's prohibitions and restrictions, while continuing to permit banking entities to provide important client-oriented financial services, such as underwriting, market making and asset management services.

Proprietary Trading Prohibition

The final rule implements the Volcker Rule's proprietary trading prohibition and restrictions by both clarifying the transactions covered and providing further details and requirements for the various available exemptions.

Clarification of Prohibition

The final rule includes several key definitions, including "proprietary trading", "trading account" and "financial instruments."

Proprietary Trading

The final rule definition parallels the statutory definition of proprietary trading, and covers engaging as principal for the trading account of a banking entity in any transaction to purchase or sell specified types of financial instruments.

The definition also contains clarifying exclusions for certain purchases and sales of financial instruments that generally do not involve the requisite short-term intent of proprietary trading, including:

The purchase and sale of financial instruments arising under certain:
- repurchase and reverse repurchase arrangements; or
- securities lending transactions.
Securities acquired or taken for bona fide liquidity management purposes.

Trading Account

The final rule is consistent with the statutory definition of trading account. The definition includes three classes of positions:

The purchase or sale of one or more financial instruments taken principally for the purpose of:
- short-term resale;
- benefitting from short-term price movements;
- realizing short-term arbitrage profits; or
- hedging another trading account position.
The final rule also contains a rebuttable presumption that the purchase or sale of a financial instrument by a banking entity is for the trading account of the banking entity if the banking entity:
- holds the financial instrument for fewer than 60 days; or
- substantially transfers the risk of the financial instrument within 60 days of purchase or sale.
For banking entities with large trading books that are subject to the Market Risk Capital Rules, the purchase or sale of one or more financial instruments subject to the prohibition on proprietary trading that are treated as “covered positions and trading positions” (or hedges of other market risk capital rule covered positions) under those capital rules, other than certain foreign exchange and commodities positions. (For more information on the applicability of those rules, see Article, Final Market Risk Capital Rule.)
The purchase or sale of one or more financial instruments that would require the banking entity to be licensed or registered as a dealer, swap dealer, or security-based swap dealer.

Financial Instrument

The final rule's definition of "financial instrument" is consistent with the statutory language, and includes:

Securities.
Derivatives.
Commodity futures.
Options on any of the above financial instruments.

The definition does not include:

Loans.
Spot foreign exchange.
Spot physical commodities.

Exemptions from Proprietary Trading Prohibition

Underwriting and Market Making Activities

As required under the statute, the final rule provides exemptions for qualifying underwriting and market making-related activities. The final rule both defines exempt underwriting and market making activity and provides a number of requirements to rely on the exemption, including:

Maintaining a compliance program targeted to the activity.
Limits on positions, inventory and risk exposure to ensure the banking entity does not exceed the reasonably expected near term demands of clients, customers or counterparties.
Limits on the duration of holdings and positions.
Defined escalation procedures to change or exceed limits.
Analysis justifying established limits.
Internal controls and independent testing of compliance with limits.
Senior management accountability and limits on incentive compensation.

While the final rule does not require market making activities to be designed to generate revenues from fees or other customer revenues, it does impose data reporting requirements. Firms with significant market-making or underwriting activities must report data involving several metrics that may be used by the banking entity and the banking agencies to identify trading activity that may require more detailed compliance review. Banking entities will also be required to demonstrate their historical customer demand and provide the regulators with the current inventory of financial instruments they hold.

Risk-mitigating Hedging

The final rule implements the Volcker Rule exemption for risk-mitigating hedging, including portfolio hedging, and spells out a number of requirements for banks seeking to rely on the exemption. These requirements are designed to ensure that hedging only be designed to reduce or significantly mitigate one or more specific, identifiable risks related to the banking entity's other contracts or holdings. Banking entities will be required to document each hedging transaction and, in certain cases where a transaction poses heightened compliance risks, the final rule requires banking entities to document, at the time of the transaction's execution, the entity's hedging rationale. They will also be required to closely monitor the effectiveness of their hedges, and recalibrate as necessary on an ongoing basis.

Other Exemptions

The final rule implements the other proprietary trading statutory exemptions, including for:

Trading in certain government obligations, including:
- US government and agency obligations;
- obligations and other instruments of specified government sponsored entities;
- state and municipal obligations; and
- certain foreign government obligations, if traded by affiliates of foreign banking entities in the US or foreign affiliates of a US banking entity abroad.
Trading on behalf of customers. The final rule identifies the types of transactions that would qualify for the exemption.
Trading by a regulated insurance company or an affiliate for the general account of the insurance company. The final rule also permits those entities to trade for a separate account of the insurance company.
Trading by certain foreign banking entities outside of the US. The final rule clarifies when a foreign banking entity will qualify to engage in such trading, including with respect to a foreign banking entity not currently subject to the BHC Act. The final rule requires, consistent with the statute, that the risk as principal, the decision-making and the accounting for this activity must occur solely outside of the United States. The final rule also states that exemptions would be permitted for transactions that:
- occur with foreign operations of US entities;
- are cleared with an unaffiliated market intermediary acting as principal; or
- are cleared through an unaffiliated market intermediary acting as agent, conducted anonymously on an exchange or using a similar trading facility.

Situations Where Exemption is Not Available

The final rule prohibits a banking entity from relying on any proprietary trading exemption if the activity would do any of the following:

Involve or result in a material conflict of interest.
Result in a material exposure to high-risk assets or high-risk trading strategies.
Pose a threat to the safety and soundness of the banking entity or to the financial stability of the United States.

The terms "material conflict of interest", "high-risk asset," and "high-risk trading strategy" are also described.

Fund Activities and Investments Restrictions

Clarification of Prohibition

The final rule implements the prohibition on covered fund activities and investments by banking entities. It also defines a number of key terms, including "covered fund” and “ownership interest.” The final rule also defines a number of other relevant terms, including “prime brokerage transaction,” “sponsor,” and “trustee.”

Covered Fund

The final rule's definition of "covered fund" is narrower than the definition in the proposed rule.

For example, under the final rule, the covered fund definition only covers commodity pools for which there is a registered commodity pool operator and either:

The operator has claimed an exemption for a pool offered solely to qualified eligible persons (see 17 C.F.R. § 4.7).
The pool has certain characteristics, including that substantially all participation units are owned by qualified persons (see 17 C.F.R. §4.7(a)(2), (3)).

The definition also contains a number of exclusions for entities that may rely on exclusions from the Investment Company Act of 1940 contained in section 3(c)(1) or 3(c)(7) of that Act but that are not engaged in investment activities of the type contemplated by the Volcker Rule. These include:

Wholly-owned subsidiaries.
Joint ventures.
Foreign pension or retirement funds.
Insurance company separate accounts.
Public welfare investment funds.

The final rule also implements the Volcker Rule's statutory rule of construction and states that a securitization of loans is not subject to the covered fund prohibition. This exclusion includes:

Loan securitizations.
Qualifying asset-backed commercial paper conduits.
Qualifying covered bonds.

However, there is no separate exclusion for CLOs.

Ownership Interest

The final rule's definition of “ownership interest” provides further guidance on the various types of interests that would be considered an ownership interest in a covered fund. The definition of ownership interest also explicitly excludes from the definition “restricted profit interest” that is solely performance compensation for services provided to the covered fund by the banking entity (or an employee or former employee of the banking entity), under certain circumstances.

Exemptions

Traditional Asset Management and Advisory Businesses

The final rule:

Implements the Volcker Rule exemption allowing banking entities to organize and offer a covered fund for the purposes of engaging in certain traditional asset management and advisory businesses.
Clarifies how these requirements apply to covered funds that are issuing entities of asset-backed securities.
Implements the statutory exemption for underwriting and market making in ownership interests of a covered fund, including explaining the limitations imposed on such activities under the final rule.

Seed Funding and De Minimis Investments

Consistent with the statute, the final rule permits a banking entity to make an investment in a covered fund that the banking entity organizes and offers, or for which it acts as sponsor, for the purposes of either:

Establishing the covered fund and providing the fund with sufficient initial equity for investment to permit the fund to attract unaffiliated investors.
Making a de minimis investment in the covered fund.

The final rule imposes certain limitations and requirements on these exempted activities, including:

Limitations on the amount and value of any individual per-fund investment and the aggregate value of all such permitted investments.
A requirement that the aggregate value of all investments in covered funds, plus any earnings on these investments, be deducted from the capital of the banking entity for purposes of the regulatory capital requirements.

The final rule also:

Clarifies how a banking entity must calculate its compliance with these investment limitations (including by deducting such investments from applicable capital).
Describes how a banking entity may request an extension of the period of time within which it must conform an investment in a single covered fund (for details on requesting seeding period extensions, see Legal Update, Fed Issues Guidance on Volcker Seeding Period Extension).
Explains how a banking entity must apply the covered fund investment limits to a covered fund that is an issuing entity of asset-backed securities or a covered fund that is part of a master-feeder or fund-of-funds structure.

Other Exemptions

The final rule implements a number of other exemptions that permit a banking entity to:

Acquire and retain an ownership interest in a covered fund as a risk-mitigating hedging activity related to employee compensation.
Acquire and retain an ownership interest in, or act as sponsor to, a covered fund solely outside the United States, if the banking entity is a non-US banking entity.
Acquire and retain an ownership interest in, or act as sponsor to, a covered fund by an insurance company for its general or separate accounts.

Situations Where Exemption is Not Available

Similar to the proprietary trading exemption, the final rule prohibits a banking entity from relying on any covered fund exemption if the activity would do any of the following:

Involve or result in a material conflict of interest.
Result in a material exposure to high-risk assets or high-risk trading strategies.
Pose a threat to the safety and soundness of the banking entity or to the financial stability of the United States.

"Super 23A" Restrictions

The final rule implements the Volcker Rule's "Super 23A" requirements, which prohibit a banking entity from entering into certain transactions with a covered fund that would be a covered transaction as defined in Section 23A of the Federal Reserve Act. The final rule also:

Describes the transactions between a banking entity and a covered fund that remain permissible.
Implements the Volcker Rule's requirement that any permitted transactions between the banking entity and a covered fund be subject to the "market terms" requirements of Section 23B of the Federal Reserve Act.

For more information on affiliate transaction restrictions, see Practice Note, Affiliate Transaction Restrictions for Banks.

Metrics Reporting Requirements

Under the final rule, a banking entity that engages in significant trading activity (identified at specified aggregate trading asset and liability thresholds) must furnish the following quantitative measurements for each of its trading desks engaged in covered trading activity. The final rule delays the metrics reporting requirement until:

June 30, 2014 for banking entities with $50 billion or more in trading assets and liabilities.
April 30, 2016 for banking entities with $25 billion or more (but less than $50 billion) in trading assets and liabilities.
December 31, 2016 for banking entities with $10 billion or more (but less than $25 billion) in trading assets and liabilities.

In calculating a banking entity's trading assets and liabilities, the entity must include all affiliates and subsidiaries, and calculate using the average gross sum of trading assets and liabilities on a worldwide consolidated basis over the previous four calendar quarters (excluding trading assets and liabilities involving obligations of or guaranteed by the United States or any agency of the United States).

Banking entities subject to the reporting requirements must supply the following quantitative seven metrics (reduced from the 20 proposed metrics in the proposed rule):

Risk and Position Limits and Usage.
Risk Factor Sensitivities.
Value-at-Risk and Stress VaR.
Comprehensive Profit and Loss Attribution.
Inventory Turnover.
Inventory Aging.
Customer Facing Trade Ratio.

Metrics must be calculated for each trading day, and must be reported to the relevant bank regulatory agency:

On a monthly basis by banking entities with $50 billion or more in consolidated trading assets and liabilities.
On a quarterly basis by all other banking entities subject to the metrics reporting requirement.

Compliance Program Requirements

The final rule requires a banking entity engaged in covered trading activities or covered fund activities to develop and implement a program reasonably designed to ensure and monitor compliance with the Volcker Rule's prohibitions and restrictions. Regulatory expectations for these compliance programs will depend on the size and activities of the banking entity in question.

To reduce the compliance burden, the final rule provides that:

A banking entity that does not engage in covered trading activities (other than trading in US government or agency obligations, obligations of specified government sponsored entities, and state and municipal obligations) or covered fund activities and investments is only required to establish a compliance program prior to becoming engaged in such activities or making such investments.
Smaller banking entities with total consolidated assets of $10 billion or less that engage in activities covered under the Volcker Rule may satisfy the compliance requirements by including in existing compliance policies and procedures appropriate references to the applicable requirements, and making adjustments to the entity's policies and procedures as appropriate given its activities, size, scope and complexity. For example, smaller banks that engage in risk mitigating or other trading activities may be expected to adopt an appropriate liquidity plan.

For banking entities with total assets greater than $10 billion and less than $50 billion, the final rule specifies six elements that each compliance program must, at a minimum, include. These include written policies and procedures reasonably designed to ensure compliance with the final rules, including:

Limits on underwriting and market making.
A system of internal controls.
Clear accountability for compliance and review of limits, hedging, incentive compensation and other matters.
Independent testing and audits.
Additional documentation for covered funds.
Training.
Recordkeeping.

A banking entity with $50 billion or more of total consolidated assets (or a foreign banking entity that has total US assets of $50 billion or more) or that is subject to the final rule's metrics reporting requirements is required to adopt an enhanced compliance program with more detailed policies, limits, governance processes, independent testing and reporting. In addition, the CEO of the banking entity must attest that the entity has in place a program reasonably designed to achieve compliance with the Volcker Rule requirements. This CEO attestation requirement was not included in the proposed rule.

Phase-in Period

Additional time is being provided to banking entities to conform their activities and investments to the requirements of the final rule. Although the Volcker Rule became effective on July 21, 2012, the original statute gave banking entities until July 21, 2014 to conform their activities and investments. The statute also permits the FRB to extend this conformance period, one year at a time, for a total of no more than three additional years. The FRB has, in a separate action connected with the final rule, extended the conformance period until July 21, 2015. Although the FRB has not promised further extensions beyond this date, it has stated that it will continue to monitor developments to determine whether to grant additional one-year extensions, potentially to July 21, 2017.

Volcker Rule Finalized | Practical Law