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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