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Five federal regulatory agencies — the SEC, CFTC, the Board of Governors of the Federal Reserve System, the Office of the Comptroller and the FDIC — implemented the 900 plus page Volcker Rule. Many consider the Volcker Rule to be the center piece of the Dodd-Frank Wall Street Reform Act.
The final rules generally prohibit banking entities from engaging in short term proprietary trading in securities, derivatives, commodity futures and options on these instruments for their account. The rules also prohibit banking entities from owning, sponsoring or having certain relationships with what are called “covered funds,” essentially hedge or private equity funds. The rules apply to insured depository institutions and their affiliates.
Critical to the Rule are certain definitions and exemptions, including:
Underwriting: There is an exemption for underwriting activities for a distribution of securities.
Market making: Another exemption is provided for market making and related activities. To qualify for the exemption the inventory of the trading desk would have to be designed not to exceed the expected near term demand.
Hedging: Hedging activity which is designed to reduce, and demonstrably reduces or mitigates, identifiable risks of individual or aggregated positions are exempt. The institution would have to conduct an analysis of its strategy and periodically calibrate it.
Government securities: The rules also permit proprietary trading in U.S. government, agency, state and municipal obligations.
Foreign banks: Foreign banks are exempt from the rules if the trading decisions and principal risks of the foreign banking entity occur, and are held outside, the U.S.
Hedge and private equity funds: The rules prohibit the ownership of “covered funds,” that is, hedge and private equity funds and their affiliates. Essentially, these funds are issuers that are an investment company under the Investment Company Act if it would not be excluded under certain provisions.
Compliance: Generally banking entities are required to establish an internal compliance program reasonably designed to ensure and monitor compliance with the rules. Larger institutions have more detailed requirements, including a CEO attestation. Banking entities are also required to maintain records which can be monitored.
Despite two years of work, the final rules were not implemented without controversy. At the SEC, for example, Chair Mary Jo White favored the Rule calling it “central to the framework put in place by the Dodd-Frank Act . . . The final rule has been written to carry out these objective [to prevent risks to U.S. taxpayers that can flow from proprietary trading] while maintaining the strength and flexibility of the U.S. capital markets by allowing both domestic and foreign financial firms to continue to participate meaningfully in those markets . . .” Similarly, Commissioner Luis Aguilar noted that “[t]oday’s adoption [of the Rule] is a step forward in reining in speculative risk-taking by banking entities and preventing future crises.”
In contrast, Commissioner Daniel Gallagher dissented, arguing that the rules would impose enormous costs at a time when the economy is still in recovery. He went on to note that the “Volker rule is being finalized in the shadow of perhaps the greatest display of governmental hubris in our lifetimes, as millions of Americans struggle to navigate the unprecedented disaster arising from governmental intrusion into our health care system.” Commissioner Michael Piwowar also dissented, arguing that the rules should be re-proposed to give adequate notice and that the agencies “failed both at the proposing and adopting stages to prepare an economic or other regulatory analysis . . .”
The final rule becomes effective April 1, 2014. The Federal Reserve has extended the conformance period until July 21, 2015.
For more commentary on developing securities issues, visit SEC Actions, a blog by Thomas Gorman.
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