Sun, Oct 22, 2017
A A A
Welcome Guest
Free Trial RSS
Get FREE trial access to our award winning publications
Industry Updates

Exceptions to Volcker Rule’s general prohibition on proprietary trading

Wednesday, October 19, 2011
Opalesque Industry Update - The Volcker Rule on proprietary trading will have sweeping repercussions for the financial system, as banks will be banned from proprietary trading and from owning, sponsoring or having certain relationships with hedge funds and other private funds, subject to a number of exemptions. Hedge funds which have no relations with banks will not be affected; those who have monetary agreements with banks will have to review them, and hedge funds that are run by banks will have to comply with this part of the Volcker rule.

On Oct. 11th, the Federal Deposit Insurance Corporation, the Federal Reserve Board, and the Office of the Comptroller of the Currency each issued a joint Notice of Proposed Rulemaking to implement the Volcker Rule, which the SEC also issued the next day.

The Volcker Rule is part of the Dodd-Frank Act and restricts the proprietary trading and private investment fund activities of U.S. banks and bank affiliates, as well as foreign banks with banking operations in the United States and their affiliates.

The notice contains more details than the Dodd-Frank Act, but some aspects are still open to interpretation. It is soliciting comments and also poses nearly 400 questions (till Jan.13, 2012). Once finalised, banks will have till July 21, 2014 to comply, but the Fed will be able to grant banks up to three one-year extensions.

With those rules, banks’ ability to undertake proprietary trading will be affected. To make matters a little more complex, the Commodities Futures Trading Commission (CFTC) should issue a separate, but similar, rule at a later date.

According to last week’s alert authored by Joseph P. Vitale, a lawyer at Schulte Roth & Zabel (SRZ), an international law firm, the proposed regulation would generally prohibit any activity where a banking entity is acting as principal in the purchase or sale of a “covered financial position” for its own “trading account.” The proposed regulation also establishes exemptions from the general prohibition for certain underwriting, market making, hedging and other specified activity.

Vitale defines a “covered financial position” as any position, including any long, short, synthetic or other position, in any security; derivative; commodity futures contract; or option. Not a position in loans, commodity, or forex.

A “trading account” is defined to include any account that is used to hold covered financial positions for resale, for arbitrage or hedging; used by a bank that is subject to the Market Risk Capital Rules to acquire or take one or more covered financial positions; and used by a bank that is registered in the U.S., or engaged in the business of a dealer outside of the U.S. It is not if it is used solely for positions arising under repurchase, securities lending, or bona fide liquidity management.

Exceptions to the general prohibition on proprietary trading

Vitale lists the various exceptions to the Rule as follows:

Permitted Underwriting Activities: This is where the purchase or sale of a covered financial position by a banking entity made in connection with its underwriting activities is exempt as long as: it complies with an internal compliant program; the position is a security; the transaction is related to securities for which the bank is acting as an underwriter; the bank is registered (if it must be); the activity is not meant to exceed near-term demands of clients and counterparties; it should generate its main revenues from fees, commissions or spreads (and not from appreciation of the value of the covered positions); and compensations do not encourage prop risk taking.

Permitted Market-Making-Related Activities: The purchase or sale of a covered financial position by a banking entity made in connection with its market-making-related activities is exempt as long as: again, an internal compliance program is established; the bank’s unit doing the deed wants to both buy and sell covered financial positions for its own account, regularly; the activity should not exceed clients’ near-term demands; the bank is registered (if it must be); the activity should generate revenues from fees; the compensations should not encourage prop risk taking; the activity must be consistent with other guidelines aimed at distinguishing permitted activities from prop trading. And finally, according to Vitale, the proposed rule contemplates that certain hedging activities will qualify as permissible market-making-related activities when they are conducted to reduce the specific risks to the banking entity in connection with the holdings held pursuant to the market-making-related exemption, and when they meet the criteria for the general exemption on risk-mitigating hedging activities.

Permitted Risk-Mitigating Hedging Activities: The purchase or sale of a covered financial position by a banking entity made in connection with and related to its positions and designed to reduce the specific risks of these holdings will be exempt as long as: again, an internal compliance program is established; relevant trading activities are made in accordance with such a program; the transaction hedges actual risks arising in connection with positions of the bank either on an individual or on aggregate basis; the transaction is reasonably correlated; the hedging transaction does not give rise to significant exposures that are not themselves hedged in a contemporaneous transaction; the transaction is continually reviewed and monitored; the compensations do not reward risk-taking. Finally, a special documentation requirement is imposed where a banking entity conducts a hedging transaction established at a level of organization that is different than the level of organization establishing the positions holdings the risks of which the hedging transaction is designed to reduce.

Other Permitted Proprietary Trading Activities: Here you find permitted prop trading in government obligations; permitted trading “on behalf of customers;” permitted trading by a regulated insurance company; and permitted trading outside of the U.S.

Limitations on Permitted Proprietary Trading: Permitted prop trading itself has its very own limitations, namely that no transaction or activity can be allowed if it would: involve or result in a material conflict of interest between the banking entitiy and its clients (or counterparties); materially expose the bank to a high-risk asset or trading strategy; pose a threat to the safety and soundness to the bank or to the financial stability of the U.S.

These are necessarily subjective analyses that a banking entity will have to undertake, but that will ultimately be judged by its primary federal regulator, concludes the SRZ alert.
B. Gravrand

What do you think?

   Use "anonymous" as my name    |   Alert me via email on new comments   |   
Today's Exclusives Today's Other Voices More Exclusives
Previous Opalesque Exclusives                                  
More Other Voices
Previous Other Voices                                               
Access Alternative Market Briefing

 



  • Top Forwarded
  • Top Tracked
  • Top Searched
  1. Regulatory - David Stockman: Trump tax reform overhaul is a pipe dream, stocks are heading for 40-70% plunge, Carried interest tax: How much does it matter?, Odey sees 'terrifying' mix in MiFID, tapering, asset values, Hedge funds come together to share cost of MiFID and research, SEC turns up the heat on U.S. investment advisers, India's Sebi asks hedge funds to report investments in commodity derivatives[more]

    David Stockman: Trump tax reform overhaul is a pipe dream, stocks are heading for 40-70% plunge From CNBC.com: David Stockman is warning about the Trump administration's tax overhaul plan, Federal Reserve policy, saying they could play into a severe stock market sell-off. Stockman, the R

  2. North America - Puerto Rico rejects loan offers, accusing hedge funds of trying to profit off hurricanes[more]

    From TheIintercept.com: Puerto Rico has rejected a bondholder group's offer to issue the territory additional debt as a response to the devastation of Hurricane Maria. Officials with Puerto Rico's Fiscal Agency and Financial Advisory Authority said the offer was "not viable" and would harm the islan

  3. Investing - WPP targeted by short-selling American hedge fund, Sun co-founder sells secretive hedge fund on big chip trade[more]

    WPP targeted by short-selling American hedge fund From Cityam.com: An American hedge fund has mounted a bet against WPP, the world's largest advertising group, with a trade worth almost £90m. Lone Pine Capital has built a short position worth 0.51 per cent of the FTSE 100 company,

  4. Hedge funds up as industry adjusts to rising rates[more]

    Komfie Manalo, Opalesque Asia: Hedge funds have reshuffled their portfolio after nearly four weeks of rising rates as the Lyxor Hedge Fund Index was up +0.2% from 19 September to 26 (+1.1% YTD), fuelled by strong results of global macro funds, Lyxor Ass

  5. Manager Profile - How the world's hedge fund king used 'idea meritocracy' to become a billionaire[more]

    From Forbes.com: In 1982, Ray Dalio made what he calls the biggest mistake of his life. He made a bet that there would be an economic collapse stemming from a debt crisis. And he was wrong. He lost money. He lost his client's money. He had to let people go from his firm and borrow money from his dad