Henry M. Fields
hfields@mofo.com
Oliver I. Ireland
oireland@mofo.com
Kenneth E. Kohler
kkohler@mofo.com
Daniel A. Nathan
dnathan@mofo.com
Gary M Rosenblum
gary.rosenblum
@bankofamerica.com
©2013 Morrison & Foerster LLP | All Rights Reserved | mofo.com
Volcker Rule:
The Final Rule
Volcker Rule
• The Volcker Rule is the popular name for Section 619 of
the Dodd-Frank Act, enacted in July 2010
• Codified as Section 13 of the Bank Holding Company Act
• The statute prohibits (with exceptions) banking entities
from:
• Engaging in proprietary trading; and
• Sponsoring, or acquiring or retaining an interest in, private equity
and hedge funds
2
Volcker Rule
• The statute is broad
• Congress left regulators to construe it, without much specific
direction
• October 2011: Proposed Rules
• Proposed rules drew significant comments, including from
international banking community
• December 10, 2013: Final Rule (71 pages) approved by the five
relevant U.S. regulatory agencies
• Effective April 1, 2014
• 900 page preamble
3
Conformance Period
• The Volcker Rule took effect by statute on July 21, 2012
• Provides for a two-year conformance period, ending July 21, 2014
• Conformance period recently extended by one year by Federal Reserve to July
21, 2015
• Each banking entity is expected to make good faith efforts to conform
by end of conformance period
•
•
•
•
Develop plan for disposition or restructuring of existing prohibited investments
New capital commitments likely prohibited
Honoring capital calls under existing commitments
Holding on to CDOs and CLOs awaiting guidance
• Banking entities expected to terminate/divest stand-alone proprietary
trading operations promptly
4
Conformance Period
• Two one-year extensions possible, upon application
• Further extension of up to five years available, upon application, for
continued investment/activity with respect to an “illiquid fund”
• To qualify for “illiquid fund” extension, must demonstrate that
retention of interest necessary to fulfill a contractual commitment in
effect on May 1, 2010
• Condition not met if a “regulatory-out” allows sale or redemption of interest
• Banking entity required to make reasonable best efforts to get consent for sale or
redemption, and to have that consent denied
• No expansion of impermissible activities or investments during the
conformance period with expectation of extensions
5
What the Volcker Rule Covers
• Banking entities include
• US banks and thrifts
• Bank and thrift holding companies
• Foreign banking organizations (FBOs) that operate a
branch/agency or commercial lending company in the US
• Affiliates of these entities (US and foreign)
• Banking entities do not include
• A covered fund (unless it is a banking entity included in one of
the first three categories above)
• A portfolio company held by a financial holding company under
the merchant banking or insurance company authority or held by
a SBIC (unless it is a banking entity included in one of the first
three categories above)
• Non-banking entities, such as broker-dealers not affiliated with
banks, are not subject to the rule
6
Proprietary Trading
7
Proprietary Trading
• The general rule is that a banking entity may not engage in
proprietary trading – “engaging as principal for” its own “trading
account” in a “purchase or sale of one or more financial
instruments,” including derivatives
•
•
Definition of “trading account” incorporates concept of “short-term” resales,
price movements or arbitrage profits
Definition of “financial instrument” includes most derivatives
• There is a rebuttable presumption that if a banking entity holds in its
trading account a financial instrument for less than 60 days, the
purchase or sale of such instrument is for the banking entity’s
trading account
• Trading as agent on behalf of a customer is not prohibited
8
Financial instrument
• A financial instrument includes:
• A security (including an option on a security);
• A derivative (including an option on a derivative);
• A contract of sale of a commodity future (or an option on same)
• Certain instruments are not financial instruments:
• Loans
• A commodity that is not an “excluded commodity,” a derivative,
or a commodity future
• Foreign exchange or currency
9
Trading account
• An account that satisfies any one of three criteria:
• Purpose test: trading for short-term resale (presumed if held for
fewer than 60 days) or for benefitting from short-term price
movements, short-term arbitrage profits, etc.
• Market Risk Capital Rule test: if a US bank or thrift or US bank
or thrift holding company is subject to the US banking agencies’
market risk capital rules, a trading account includes an account
used to trade in financial instruments that are both market risk
capital rule covered positions and trading positions
• Status test: if the banking entity is a securities dealer, swap
dealer or securities-based swap dealer, all trades that would
require them to be licensed as such are deemed to be in a
trading account
10
Proprietary Trading Exclusions
•
•
•
•
•
•
•
•
•
•
Repos or reverse repos
Trades arising under certain securities lending or borrowing arrangements
Trades for liquidity management pursuant to a plan
Trades by a derivatives clearing organization* and clearing agency** in
connection with their clearing and settlement activities
Trades in connection with “excluded clearing activities”
Trades to satisfy an existing delivery obligation
Trades to satisfy a judicial, administrative, arbitration or similar proceeding
Trades where the banking entity is acting solely as agent, broker or custodian
Trades through a deferred compensation or pension plan
Trades made in the ordinary course of collecting a debt previously contracted
(DPC exclusion)
*Registered under § 5b of the Commodity Exchange Act, or exempt from registration pursuant to
CFTC regulations, or a foreign derivatives organization permitted to clear for a foreign board of
trade registered pursuant to CFTC regulations
**Securities Exchange Act of 1934, § 3(a)(23).
11
Permitted Proprietary Trading
• The following trading activity as principal is
permitted:
• Trading in US government/agency securities
• Trading in US municipal securities
• But trading in derivatives in these two categories of securities
does not come within this exemption
• For such derivatives consider market making or riskmitigating hedging exemptions discussed below
• Trading by a banking entity that is a regulated
insurance company (foreign or domestic)
12
Permitted Proprietary Trading (cont’d)
• The prohibition on proprietary trading does not apply to
trading as principal on behalf of a customer in a
fiduciary capacity or as a riskless principal
• A banking entity may conduct a transaction for the account of, or
on behalf of a customer, but the banking entity cannot have or
retain beneficial ownership of the financial instruments
• A banking entity also can conduct riskless principal activities so
long as these are “customer-driven” and may not “expose the
banking entity to gains (or losses) on the value of the traded
instruments as principal”
• Possible, as we discuss later, that more business will be
structured as “agency” or “riskless principal” business
13
Permitted Proprietary Trading (cont’d)
• Also permitted are
• Certain risk-mitigating hedging activities
• Certain market-making activities
• Certain underwriting activities
• Overall conditions to these permitted activities
• The banking entity must maintain an internal compliance program
• The compensation arrangements of personnel involved in these activities
must not be designed to reward proprietary trading
• The banking entity must be appropriately registered or licensed, or not
subject to registration or licensing, to engage in market making or
underwriting
• This is highly complex area
See our Client Alert: http://www.mofo.com/files/Uploads/Images/131227-Volcker-Rule-Capital-MarketsOfferings.pdf
14
Permitted Hedging Activities
• Permitted risk-mitigating hedging activities must be specifically
focused on mitigating identified risks
• A banking entity may not hedge with respect to “generalized risks
that a trading desk or combination of desks, or the banking entity as
a whole, believe exists, based on non-position-specific modelling or
other considerations”
• However, a banking entity may engage in hedging activities that are
• “In connection with and related to individual or aggregated
positions, contracts or other holdings” and
• “Designed to reduce the specific risks to the banking
entity” that are “related to such positions, contracts or
other holdings”
15
Permitted Hedging Activities (cont’d)
• Additional requirements for risk-mitigating hedging activities:
• Activity must not give rise, at the inception of the hedge, to any
significant new or additional risk that is not itself hedged
contemporaneously
• Continuing review, monitoring and management that requires
ongoing recalibration of the hedging activity
• Compensation arrangements of persons performing risk-mitigating
hedging activities are designed not to reward or incentivize
prohibited proprietary trading
• Additional documentation requirements apply with respect to riskmitigating hedging activities established by a trading desk other
than the desk responsible for the underlying positions, or to hedge
aggregated positions across trading desks
16
Permitted Hedging Activities (cont’d)
• Additional requirements for risk-mitigating hedging activities:
•
•
An internal compliance program containing written policies and procedures
regarding positions, techniques and strategies that may be used for hedging,
including:
• Documentation indicating what positions, contracts or other holdings a
particular trading desk may use
• Position and aging limits
• Analysis designed to ensure that the positions, techniques and strategies
that may be used for hedging may be reasonably be expected to
demonstrably reduce or otherwise significantly mitigate the specific,
identifiable risks being hedged
The extent of the required internal compliance program will depend upon the
size and activities of the relevant banking entity, but for entities engaging in
proprietary trading with consolidated assets of $10 billion or more, it will be quite
substantial (discussed below)
• Rule is quite prescriptive with respect to reporting and recordkeeping
requirements, as set out in Appendices A and B
17
Permitted Market-Making Activities
• Requirements for permitted market-making activities:
• Trading desk that establishes and manages the financial exposure
“routinely stands ready” to purchase and sell one or more types of
financial instruments related to its financial exposure and is willing
and available to quote, purchase and sell, or otherwise enter into
long and short positions in those types of financial instruments for
its own account in commercially reasonable amounts and
throughout market cycles
• The amount, types, and risks of the financial instruments in the
trading desk’s market-maker inventory are designed not to
exceed, on an ongoing basis, the reasonably expected near term
demands of clients, customers, or counterparties
18
Permitted Market-Making Activities (cont’d)
• “Routinely standing ready” to make a market may differ depending on
market conditions and on the type of financial instrument
• “Routinely standing ready” means more frequently than
occasionally
• “Trading by appointment” may meet the requirement
• Block positioning activity also would meet the requirement
• For “illiquid derivatives or structured instruments” a trading desk
would “need to be able to demonstrate a pattern of taking actions
in respond to demand from multiple customers with respect to
both long and short risk exposures”
19
Permitted Market-Making Activities (cont’d)
• Gauging “near-term” customer demand also may
be challenging for certain products
• Requires assessing historical demand, market
conditions, and other factors
• Preamble contemplates anticipatory trading in
connection with creating and distributing structured
products
20
Permitted Market-Making Activities(cont’d)
•
Additional Requirements for permitted market-making activities:
•
Internal compliance program that states
• The instruments in which each trading desk will make a market
• Actions the trading desk will take to demonstrably reduce or otherwise
significantly mitigate promptly the risks of its financial exposure
• Hedging market making exposures must comply with the market
making exception, not the risk-mitigating hedging exception
• Limits for each trading desk, based on the nature and amount of the trading
desk’s market making-related activities
• Internal controls and ongoing monitoring and analysis of each trading
desk’s compliance with its limits
• Authorization procedures, including escalation procedures that require
review and approval of any trade that would exceed a trading desk’s limit(s)
• The compensation arrangements of persons performing the
market-making activities are designed not to reward or incentivize
prohibited proprietary trading.
21
Permitted Underwriting Activities
• Permitted only if the trading desk’s underwriting position is related
to a “distribution” of securities for which the bank is an underwriter
•
33 Act registered, or otherwise characterized as different from ordinary trading
by virtue of selling efforts
• This differs from the definition of a “distribution” used for Regulation M
purposes
• A Rule 144A offering, a 4(a)(2) offering, bought deal, etc. all may be
considered “distributions”
• The underwriting position must be designed not to exceed the
reasonably expected near term demands of clients
• Reasonable efforts must be made to sell or otherwise reduce the
underwriting position within a reasonable period, taking into account
the liquidity, maturity, and depth of the market for the relevant
security
22
Permitted Underwriting Activities (cont’d)
• Underwriter: defined broadly to include selling group members and
other distribution participants
• Preamble identifies distribution participants that would be
included
• Preamble also identifies activities that may be conducted
by an underwriter—such as stabilization activities,
syndicate shorting, helping an issuer mitigate its risk
arising from the issuance of securities in the distribution,
etc.
• However, certain activities, examples of which are
provided in the preamble, would not be considered to
have been undertaken in connection with underwriting
23
Permitted Underwriting Activities (cont’d)
• Amount and type of securities in the underwriting
position cannot exceed the reasonably expected near
term demands of clients, customers, counterparties, etc.
• The underwriter must rely on historic experience
• Can retain an unsold allotment that it was unable to sell,
but…
• The trading desk must use reasonable efforts to reduce
the position within a reasonable time
• The underwriter cannot hold the unsold allotment
indefinitely
• The underwriter cannot routinely retain unsold allotments
24
Effect on Rule 144A transactions
• Purchase by FBO or its affiliate of securities for resale in a Rule 144A
transaction are prohibited as proprietary trading unless (i) within the
SOTUS exemption or (ii) the exemption for permissible underwriting
activities (discussed above)
• The SOTUS exemption will not be available if resale as principal is
directly to US QIBs (because SOTUS exemption requires trade with
an unaffiliated intermediary for prompt clearance and settlement
through a clearing agency or organization acting as a central
counterparty)
• Participation in a global (non-US) tranche should satisfy SOTUS
exemption as long as the FBO/affiliate does not participate in the US
tranche
• For US tranche, consider restructuring transaction as private
placement to QIBs by issuer, with FBO/affiliate acting as agent
25
Effect on Rule 144A transactions (cont’d)
• Underwriting exemption may be available for Rule 144A transactions, but
only if the trading desk underwriting position is related to a “distribution” of
securities for which the bank is an underwriter
• Distribution: registered under the Securities Act of 1933, or otherwise
characterized as different from ordinary trading by virtue of selling efforts
• Amount and type of securities in the underwriting position cannot exceed
the reasonably expected near term demands of clients, customers,
counterparties, etc.
• The trading desk must use reasonable efforts to reduce the position
within a reasonable time
• To rely on the underwriting exemption, banking entity is required to have a
compliance program and must comply with other requirements, including
compensation that does not incentivize proprietary trading
• May constitute underwriting in the US under Regulation K
See our Client Alert: http://www.mofo.com/files/Uploads/Images/140109-Volcker-Rule-Prohibition.pdf
26
Permitted Trading for FBOs
• The rule establishes an exemption for
proprietary trading by a foreign banking
organization (“FBO”) to the extent that the
trading is conducted solely outside the
United States (SOTUS exemption)
27
Permitted trading for FBOs (cont’d)
• Conditions:
• May not be a US banking entity or controlled by a US banking entity
• If an FBO, must be a qualified foreign banking organization (“QFBO”)
• If not an FBO, must be organized outside the US and have a majority
of its business outside the US
• The FBO or its affiliate (including relevant personnel who arrange,
negotiate or execute the trades, but not those who settle or clear) must
be located outside the US and organized under foreign law
• Trading decisions must be made outside the US
• Trades (and related hedging) must be booked and accounted for
outside the US by a non-US entity
• No financing of trade by a US branch/agency or US affiliate of the FBO
28
Permitted trading for FBOs (cont’d)
• Trades may not be with or through a US entity except:
• Trades with the foreign operations of US entity as long as no
personnel of that entity who are involved in arranging,
negotiating or executing the trade are in the US
• Trades with an unaffiliated intermediary acting as principal (if the
trade is promptly cleared and settled through a clearing agency
or organization acting as a central counterparty)
• Trades with an unaffiliated intermediary acting as agent if
conducted anonymously on an exchange and promptly cleared
and settled through a clearing agency or organization acting as
a central counterparty
29
Foreign Government Obligations
• Foreign Government Obligations
• Trading by a foreign subsidiary of a US banking entity that is a foreign bank or
regulated securities dealer in the debt of the foreign government in the country in
which the foreign subsidiary is organized
• A foreign banking entity or affiliate (including a US affiliate) may trade in
obligations issued or guaranteed by a foreign sovereign (or any agency or political
subdivision) or a multinational central bank of which the foreign sovereign is a part
if:
• The banking entity is not controlled by a top-tier US banking entity and is not a
US bank or thrift
• The obligations are issued or guaranteed by the foreign banking entity’s home
country sovereign (or agency or political subdivision) or a multinational central
bank of which such foreign sovereign is a part
• Trading in obligations of multilateral development banks not within these
exemptions
• NB: An FBO can trade any foreign debt if it complies with the
SOTUS exemption.
30
Deal flow under Rule 15a-6
• Under SEC Rule 15a-6, foreign broker-dealers and
foreign banks acting as principal or agent can solicit
securities transactions with US institutional investors if the
transactions are effected through a US registered brokerdealer, often a US affiliate. However, such trades as
principal by an FBO and/or its foreign affiliates through its
US registered broker-dealer affiliate would constitute
proprietary trading
• Trades by an FBO or its offshore affiliates as agent for its
customers are not considered proprietary trading and
thus can continue to be effected through a US registered
broker-dealer affiliate
31
Prudential Backstops
• Proprietary trading activities are not permissible if:
• The trading involves or results in a material conflict of interest
between the banking entity and its clients, customers or
counterparties unless (i) the banking entity makes clear and
timely disclosure of the conflict or (ii) uses information barriers,
such physical separation of personnel or functions, that address
the conflict;
• The trading would result in a material exposure by the banking
entity to a high-risk asset or a high-risk trading strategy; or
• The trading poses a safety and soundness threat to the
institution or a threat to US financial stability
32
TRADING DESK – Building Blocks for
Metrics, Compliance Programs
•
Super Banks (over 50 BB in trading assets)
• Metrics recordkeeping starts June 30, 2014
•
•
Metrics/Compliance Programs are built off of “Trading Desks”
Identifying Trading Desks
• Take inventory of activities to determine if in scope/out of scope
• Complex exercise
• Multiple divisions (retail banking; corporate banking; sales and
trading; private wealth management; trust/fiduciary;
corporate/treasury)
• Multiple jurisdictions
• Multiple booking entities
• Multiple asset classes
• Numerous technology platforms
33
TRADING DESK – Building Blocks for
Metrics, Compliance Programs
Determining what activity or activities comprise a
single/discrete Trading Account. Considerations
include:
•
•
•
•
•
PnL attribution historically
Reporting Lines
Licensing/Registration
Asset Classes
Consistency internally and awareness of peer
approach
34
TRADING DESK – Building Blocks
For Metrics, Compliance Programs (cont’d)
Classification of Trading Accounts
•
•
•
Market Making
• Primary
• Hedging
Underwriting
Risk Mitigating Hedging (multi-desk)
Different metric/compliance requirements dependent on
which category
•
•
•
MM Primary & Underwriting require customer metrics
Risk Mitigating Hedging has enhanced risk metrics
What is a customer:
• Other Super Banks – (i.e., CIO/Treasury; Asset Manager)
• Affiliates – more significant question
35
TRADING DESK – Building Blocks
For Metrics, Compliance Programs (cont’d)
Current State
• Number of Trading Desks - most Super
Banks are far along in the process of
determining the number of Trading Desks
• Testing – most Super Banks will begin
sample testing in March
36
Covered Funds
37
Covered Funds Prohibition
• A banking entity, as principal, may not directly or indirectly acquire or
retain an ownership interest in, or sponsor, a covered fund
• The prohibition on acquiring/retaining an ownership interest does not
apply if:
• The banking entity acts solely as agent, broker or custodian for the
account of or on behalf of a customer and does not have its own
ownership interest
• The banking entity’s ownership interest is held/controlled by it as
trustee in connection with a deferred compensation or similar plan;
• The ownership interest is acquired and held in the ordinary course of
collecting a debt; or
• The banking entity holds the interest as trustee or in a similar
capacity solely for a customer that is not itself a covered fund
38
Sponsorship
• A banking entity may not sponsor a covered
fund, subject to certain exceptions
• Sponsorship means
• To serve as a general partner, managing member,
trustee or commodity pool operator (CPO) of a
covered fund
• To select or control selection of a majority of directors,
trustees or management of a covered fund
• To share with the covered fund the same name or a
variation of the name
39
Ownership Interests
• A banking entity may not acquire/retain an ownership interest in a covered
fund, subject to certain exceptions
• Ownership interest means any equity, partnership or “other similar interest”
• “Other similar interest” is broadly defined to include
• Right to participate in the selection/removal of general partner, or managing member, director,
investment manager or adviser (but not including typical creditor’s rights in the event of a
default or acceleration)
• Right to receive a share of income, gains or profits or, after other interests redeemed or paid,
the underlying assets (e.g., the “residual” in a securitization)
• Right to receives income on a pass-through basis, or rate of return determined by reference to
the performance of the underlying asset
• Any synthetic right to receive, or be allocated, any of the foregoing
• Does not include “restricted profit interest” (carried interest)
• Ownership interest may include an interest in a covered fund not considered
an ownership or equity interest in other contexts
• Effect on securitizations discussed later
40
What is a Covered Fund?
• Statute prohibits investment in/sponsorship of private equity and
hedge funds (not defined)
• Under the Final Rule, a covered fund includes an issuer that would
be an “investment company” under the Investment Company Act of
1940 (1940 Act) but for Sections 3(c)(1) or 3(c)(7)
• Section 3(c)(1) exempts from the definition of “investment company” funds whose
securities are sold privately to less than 100 purchasers
• Section 3(c)(7) exempts from the definition of “investment company” funds whose
securities are sold privately only to “qualified purchasers”
• These two exemptions are the principal ones relied upon by private
equity and hedge funds, but many other investment companies rely
on these exemptions
• Concept imported from Title IV of the Dodd Frank Act, requiring
registration of investments advisers to private funds
41
Commodity Pools
• Certain commodity pools are covered funds
• A commodity pool is a covered pool when the CPO has
claimed
an exemption under Rule 4.7 under the Commodity
Exchange Act (CEA)
• The CPO is registered in connection with the operation of a
pool that limits investors to qualified eligible persons (QEPs)
• “Exempt” commodity pools are covered funds because they
have characteristics similar to those of hedge funds or
private equity funds
• They are restricted to investors that meet heightened qualification
standards
42
Foreign Covered Funds
• Certain foreign funds are covered funds. To
be discussed later in connection with
Volcker Rule’s treatment of foreign funds
43
What is Not a Covered Fund?
• Companies that do not meet the general definition of an “investment
company”
• For example, a fund may not be an investment company if it is
not engaged or proposes to engage in the business of investing
in securities that have a value exceeding 40% of the value of the
company’s total assets (excluding cash and government
securities)
• Funds that rely on an exception other than those found in Section
3(c)(1) or Section 3(c)(7) of the 1940 Act
• These could include funds invested primarily, for example, in real
estate instead of securities.
• See our Volcker Rule “User’s Guide”: http://www.mofo.com/files/Uploads/Images/131223-A-UsersGuide-to-The-Volcker-Rule.pdf
44
Other Exclusions
• The following entities are also excluded from the definition of
“covered funds”:
• Wholly owned subsidiaries/joint ventures/acquisition vehicles
• Registered investment companies (including seeding vehicles) and
business development companies
• Loan securitization issuers (discussed below)
• Foreign public funds (discussed below)
• Foreign pension or retirement funds
• Insurance company separate accounts
• Bank-owned life insurance company separate accounts
• SBICs and certain permissible public welfare and similar funds
• Entities used by the FDIC to dispose of assets as receiver/conservator
• Others that the federal agencies choose to exclude
45
What May or May Not Be a Covered Fund
• The federal agencies declined to exclude certain entities from the
definition of covered fund despite requests to do so
• In some cases, these are likely covered funds and in others not
• These entities include
• Financial market utilities
• Collateral cash pools
• Pass-through real estate investment trusts (REITs )
• Municipal securities tender option bond transactions
• Venture capital funds
• Credit funds
• Employee securities companies
46
Permitted Activities and Investments
• Customer funds
• A banking entity may acquire ownership interests in, and/or sponsor, a
covered fund as a means of offering investment opportunities to its
existing or future customers
• This customer fund activity must be in connection with the banking
entity’s trust, fiduciary or investment management services for
customers pursuant to a written plan
• Detailed conditions apply
• Among other things, the banking entity
• Cannot guarantee performance of customer funds
• Cannot share the same name as a customer fund
• Must make clear and conspicuous specified disclosures in
writing to prospective investors
47
Permitted Activities and Investments
• Asset-backed securities
• A banking entity may acquire ownership interests in an issuing entity
of asset-backed securities* that is a covered fund, but only in
connection with the banking entity’s organization and offering of the
covered fund’s ownership interests, subject, generally, to the same
conditions that apply to customer funds
• This exemption does not permit a banking entity to invest, as a passive
investor, in ownership interests in securitization vehicles that are covered
funds
• Underwriting and market-making activities
• A banking entity may acquire an ownership interest in a covered fund
in connection with the banking entity’s underwriting or market making
of the covered fund’s ownership interests, as long as those activities
conform to the Volcker Rule’s requirements for permissible
underwriting and market making-related activities
*See Securities and Exchange Act of 1934, §3(a)(79)
48
Investment Limitations
• Per-fund limits
• A banking entity’s and its affiliates’ investment in covered funds,
as a general rule, cannot exceed 3% of the value of, or the
number of ownership interests in, the covered fund
• During a seeding period of up to one year, the investment may
exceed the 3% limit while unaffiliated investors are actively solicited
• Special rules apply for calculating the per-fund investment limits
for ownership interests held in
• Asset-backed securities issuers in connection with a banking entity’s
organization and offering of that entity’s ownership interests and
• Covered funds whose ownership interests are underwritten by a
banking entity or in which a banking entity makes a market
49
Investment Limitations
• Aggregate investment limits
• The aggregate value of all ownership interests in such permitted
covered fund investments cannot exceed 3% of the banking
entity’s Tier 1 capital
• Capital deduction
• A US banking entity (but not an FBO) is required to deduct from
Tier 1 capital its investment in such funds
• The Volcker Rule treatment does not correspond to Basel III risk
weights and deductions for fund investments
• The Agencies intend to review the interaction between the
Volcker Rule and Basel III and propose steps to reconcile them
50
“Super 23A” and 23B Restrictions
• No banking entity that (i) advises or sponsors a covered fund, (ii)
organizes and offers a customer fund or an issuer of ABS, or (iii)
holds an ownership interest in an ABS issuer, and no affiliate of any
of these, may enter into any of the following transactions with the
fund*
• A loan or extension of credit to the fund (including repos)
• The purchase of securities issued by the fund (except for permitted ownership
interests)
• The purchase of assets from the fund
• The issuance of guarantees, acceptances or letters of credit on behalf of the fund
• Securities borrowing or lending or derivative transactions that result in the
banking entity having a credit exposure to the fund
*Section 23A also prohibits the acceptance of securities issued by an affiliate as collateral for a loan,
but as such a transaction would not be with the covered fund, it is not subject to Super 23A
51
“Super 23A” and 23B Restrictions
• These restrictions are called “Super 23A” because, unlike Section
23A itself, which allows affiliated transactions within limits, these
prohibitions are absolute
• However, the following transactions are permitted
• Acquisitions of ownership interests in a covered fund to the extent permitted
elsewhere in the Final Rule
• Subject to certain conditions, prime brokerage transactions (transactions that
would be subject to Super 23A but are provided in connection with custody,
clearance and settlement, securities borrowing and lending, trade execution, etc.)
with a covered fund in which a covered fund that is managed, sponsored or
advised by the banking entity or its affiliates has taken an ownership interest (a
“second-tier fund”)
• The “market terms” requirement of Section 23B of the Federal
Reserve Act also applies, as if the banking entity were a bank and
the fund it sponsors or advises, its affiliate
52
Other Permitted Fund Activities/Investments
• Risk-mitigating hedging activities
• Sponsorship of, and investment in, covered funds
engaged in permitted risk-mitigating hedging activities,
subject to extensive conditions, including a specific
internal compliance program
• Insurance companies
• Investment and sponsorship by regulated foreign and
domestic insurance companies of any covered funds,
if conducted in compliance with applicable insurance
investment laws
53
Prudential Backstops
• No permitted fund investments and activities are permissible if
• The investment/activity involves or results in a material conflict of
interest between the banking entity and its clients, customers or
counterparties, unless
• The banking entity makes clear and timely disclosure of the conflict, or
• The banking entity uses information barriers, such as physical separation of personnel
or functions, that address the conflict
• The investment/activity results in a material exposure by the banking
entity to a high-risk asset or a high-risk trading strategy
• The investment/activity poses a safety and soundness threat to the
institution or a threat to US financial stability
54
Foreign Funds
• Volcker Rule accords special treatment to
foreign funds
55
Foreign Covered Funds
• Certain foreign funds are covered funds
• For a banking entity that is, or is controlled by, a US banking
entity (which would include a US branch/agency of a foreign
bank), a covered fund includes a foreign fund with the following
characteristics
• The fund is organized outside the US;
• The fund’s interests are offered and sold only to non-US persons; and
• The fund is sponsored by the US banking entity (or an affiliate)
• Such a covered foreign fund would not include a foreign
fund that, if organized or offered in the US, would not rely
on Section 3(c)(1) or 3(c)(7) for an exemption from the
definition of an “investment company”
56
Foreign Fund Exclusion
• The Proposed Rule included as a covered fund any fund organized/offered
solely outside the US to non-US persons that would have been a covered
fund if organized/offered in the US—a “foreign equivalent fund”
• The narrowed definition in the Final Rule of a foreign covered fund implies that a
foreign equivalent fund is not a covered fund for purposes of sponsorship/
investment by a foreign banking entity (not controlled by a US banking entity)
• Same fund could be a covered foreign fund for a US banking entity but not for a
foreign banking entity
• Investment in or sponsorship of a foreign equivalent fund by a foreign
banking entity not controlled by a US banking entity should not be subject to
requirements applicable to covered funds (e.g., prudential backstops,
compliance program)
• Certain US connections with sponsorship or investment activity may make
the exclusion unavailable
• If foreign fund not a covered fund, could be a “banking entity” if controlled by
an FBO
57
Foreign Fund Exemption
• The Volcker Rule contains a specific exemption for a foreign fund.
The exemption corresponds to the SOTUS exemption for proprietary
trading. To qualify for the foreign fund exemption, the
investor/sponsor
• may not be a US banking entity or controlled by a US banking entity
• if an FBO, must be a qualifying foreign banking organization (“QFBO”)
• if not an FBO, must be organized outside the US and have a majority of its business
outside the US
• must make investment/sponsorship decisions outside the US through an entity
located and organized outside the US—i.e., decision-making personnel must be
outside the US
• back office and administrative functions can be in the US
• investment advice can be given from the US
• US-based entity can offer and sell the fund interests—but only to non-US
persons
58
Foreign Fund Exemption (cont’d)
• Additional conditions for foreign fund exemption
• Fund interests may be offered and sold only in an offering that
does not target US Persons (basically, compliant with SEC
Regulation S, with appropriate disclosures)
• Secondary trades
• Multi-tier funds
• Parallel funds
• Fund investment/sponsorship (including any related hedging)
cannot be booked or accounted for in a US entity (including in
any US branch/agency)
• No financing of any fund investment/sponsorship may be
provided by a US affiliate (including any US branch/agency)
• Conditions applicable to covered funds apply (e.g., prudential
backstops and compliance program)
See http://www.mofo.com/files/Uploads/Images/131211-Volcker-Rule.pdf
59
Investments by Foreign Funds
• No restrictions under Volcker Rule on a foreign
excluded fund or foreign exempt fund investing in
US portfolio companies or US securities
• An foreign banking entity would need to
determine whether the investment in the foreign
fund was otherwise permissible under the Bank
Holding Company Act
60
Foreign Public Funds
• A foreign public fund is not a covered fund if
• The fund is organized outside the US
• The fund is authorized to offer and sell its interests to retail investors in the fund’s
home jurisdiction (no investor suitability qualification)
• The fund sells its interests through one or more public offerings predominantly
outside the US (85% or more to non-US Persons)
• If a US banking entity sponsors the fund, the interests must be sold
predominantly to persons other than the sponsoring banking entity, its affiliates
and their employees and directors
• Foreign funds that do not meet the specific conditions of this
exclusion may not be covered funds for other reasons
• They may qualify for the foreign fund exclusion (discussed
above) or they may not rely on Section 3(c)(1) or Section 3(c)(7)
of the 1940 Act
• Foreign public funds may also qualify for the foreign fund
exemption
61
Securitizations
62
Securitization Overview
• Banking entities involved as investors in, sponsors of, or transaction
parties (e.g., credit or liquidity providers) with, securitization issuers
are subject to severe restrictions or divestiture if the securitization
issuer is a covered fund
• Congress stated in the Dodd-Frank Act its intention that the Volcker
Rule not limit or restrict the ability of banking entities to sell or
securitize loans
• In the Final Rule, the Agencies generally followed Congressional
intent by making clear that most securitizations of traditional loan
products (e.g., mortgage loans, auto loans, student loans and credit
card receivables) are not covered funds
63
Securitization Overview (cont’d)
• However, the Final Rule creates the possibility that
certain securitization vehicles whose assets include
securities or derivatives (as opposed to loans) may be
covered funds
• Banking entities should first closely examine the
securitizations with which they are involved to determine
if they are covered funds
• If a banking entity has an investment in, sponsors, or
engages in certain transactions with a securitization
vehicle that is a covered fund, it should closely examine
such relationships to determine if they are permissible or
require divestiture or restructuring
64
Securitization Overview (cont'd)
• The basic definition of “covered fund” is a three-pronged test
previously described.
• For most securitization issuers, the relevant test will be that set forth
in the first prong of the definition – whether the issuer would be an
investment company under the 1940 Act but for the exemptions set
forth in Section 3(c)(1) or 3(c)(7) of the 1940 Act.
• Many securitizations rely on other exemptions from the 1940 Act and
are therefore not covered funds.
• A banking entity involved with a securitization should be able to
determine the applicable 1940 Act exemption by reviewing the
offering documents.
• If beneficial ownership of securities is limited to 100 or fewer persons, the deal
probably relies on Section 3(c)(1)
• If investors are required to be “qualified purchasers” for purposes of the 1940 Act,
the deal probably relies on Section 3(c)(7)
65
Securitization Overview (cont'd)
• Note that the D-F Act expanded the definition of commodity interest
to include swaps
• Any securitization holding swaps will be a commodity pool and needs
to determine if it is required to register with the CFTC
• A number of no-action letters are available for securitizations; note
particularly CFTC Letters 12-14 and 12-45
• As noted previously, certain commodity pools will be covered funds
for purposes of the Volcker Rule
• Thus in addition to Sections 3(c)(1) and 3(c)(7) of the 1940 Act,
certain securitization holding swaps may also bring the issuer within
the ownership limitations of the Volcker Rule
66
Securitization Overview (cont'd)
• The Agencies have stated that a deal that relied on
Section 3(c)(1) or 3(c)(7) may still not be a covered fund if
another 1940 Act exemption is also available
• If a securitization issuer relied on 3(c)(1) or 3(c)(7), is
another 1940 Act exemption available?
• Section 3(c)(5)(C) – for certain mortgage-backed securities
• Rule 3a-7 – for many traditional securitizations
• Section 3(c)(5)(A) – for certain securitizations of consumer
receivables
• Section 3(c)(5)(B) – for certain securitizations of trade receivables
• Rule 3a-5 – for finance subsidiaries whose securities are
guaranteed by parent
67
Exclusions from Covered Fund Definition –
General
• If the issuer relied on Section 3(c)(1) or 3(c)(7) of the
1940 Act and another 1940 Act exemption is not
available, it may still avail itself of one or more of the 14
enumerated exclusions from the definition of covered
fund
• Of the 14 exclusions, four are most likely to be applicable
to a securitization issuer:
• Loan securitization exclusion
• Qualifying asset-backed commercial paper (ABCP) conduit
exclusion
• Qualifying covered bond exclusion
• Wholly-owned subsidiary exclusion
68
Loan Securitization Exclusion
• This exclusion applies to an issuer of ABS if its underlying assets are
comprised solely of:
• loans (defined as any loan, lease, extension of credit, or secured or
unsecured receivable that is not a security or derivative)
• rights or other assets designed to assure the servicing or timely
distribution of proceeds to security holders or related or incidental to
purchasing or otherwise acquiring, and holding loans, subject to certain
limitations
• certain interest rate or foreign exchange derivatives that (i) directly relate
to the loans in the issuing entity, the related ABS or certain related
contractual rights or assets and (ii) reduce the interest rate and/or foreign
exchange risks related to such loans, the related ABS or permitted
contractual rights or assets
69
Loan Securitization Exclusion (cont’d)
• certain special units of beneficial interest (“SUBIs”) and collateral
certificates (which are issued by certain intermediate special purpose
vehicles that themselves satisfy the requirements of the loan
securitization exclusion); and
• certain securities constituting cash equivalents and securities received in
lieu of debts previously contracted with respect to the loans underlying
the ABS
• In addition, in order to qualify for the loan securitization exclusion, the
issuer may not hold (i) a security, including an ABS, or an interest in
an equity or debt security other than as permitted above; (ii) a
derivative, other than as permitted above; or (iii) a commodity forward
contract
• The Agencies stated in the preamble that the determination whether
a loan or other financial asset is a “security” is made by reference to
the federal securities laws
70
Qualifying ABCP Conduit Exclusion
• This exclusion applies to an issuer of asset-backed commercial paper
(ABCP) if the underlying assets are comprised solely of:
• loans or other assets that would be permissible under the loan
securitization exclusion described above, and
• ABS that are supported solely by assets permissible under the loan
securitization exclusion and are acquired by the ABCP conduit as part of
the initial issuance of the securities
• In addition, to qualify for the qualifying ABCP conduit exclusion, a
“regulated liquidity provider” (as defined in the Final Rule) must
provide a legally binding commitment to provide full and
unconditional liquidity coverage with respect to all the outstanding
ABCP issued in the event that funds are required to redeem the
maturing ABCP
71
Qualifying Covered Bond Exclusion
• This exclusion applies to an entity that owns or holds a dynamic or
fixed pool of assets that covers the payment obligations of covered
bonds if such assets or holdings meet the requirements of the loan
securitization exclusion
• In addition, the covered bonds must be debt obligations that are
issued either directly
• by a foreign banking organization (“FBO”) (in which case, the payment
obligations of the covered bonds must be fully and unconditionally
guaranteed by the entity that owns the permitted cover pool), or
• by the entity that owns the permitted cover pool (in which case, the
payment obligations of the covered bonds must be fully and
unconditionally guaranteed by an FBO and the issuer of the covered
bonds must be a wholly owned subsidiary that satisfies the requirements
of the wholly owned subsidiary exclusion (described below) of the FBO
72
Wholly Owned Subsidiary Exclusion
• This exclusion applies to an entity if all of its outstanding ownership
interests are owned directly or indirectly by a banking entity or an
affiliate thereof, except that:
• up to five percent of the entity’s ownership interests may be owned by
directors, employees, and certain former directors and employees of the
banking entity or its affiliates; and
• within the five percent ownership interest, up to 0.5 percent of the entity’s
outstanding ownership interests may be held by a third party if the
ownership interest is held by the third party for the purpose of establishing
corporate separateness or addressing bankruptcy or insolvency
• This exclusion was added to the Final Rule to clarify that wholly
owned “depositors” and other intermediate transferors of assets in a
securitization are not considered covered funds. This exclusion is
also likely to be very helpful for banking entities that establish or rely
on special purpose funding programs that utilize trust or other tax
pass-through vehicles
73
Covered Fund Problem Areas
• Most covered fund problems arise for Section 3(c)(1) or Section
3(c)(7) funds whose assets include securities or derivatives:
• CDOs backed by securities or derivatives (including CDOs backed by trustpreferred securities (“TruPS”))
• CLOs that hold debt securities
• Certain CMOs backed by mortgage securities
• Re-securitizations
• Bond Repackagings
• Synthetic ABS
• Synthetic structured products
• Auction rate preferred securities
• Funding vehicles
• Domestic covered bonds
74
Covered Fund Restrictions
• If a securitization issuer is determined to be a covered fund, banking entities
are prohibited from:
• acquiring “ownership interests” in the securitization issuer,
• sponsoring the securitization issuer, and
• making loans to, or entering into certain other types of transactions with a
securitization issuer for which the banking entity acts as sponsor, investment
manager, investment adviser or commodity trading advisor
• The prohibitions described in the third bullet point above are defined in the
Final Rule by reference to the restrictions of Section 23A of the Federal
Reserve Act, and are commonly referred to by commenters as the “Super
23A” provisions. These restrictions, among other things, severely limit the
ability of banking entities to provide credit and liquidity support to covered
fund securitizations to which they are related as investors, sponsors or
advisors
• Additionally, permitted transactions between the banking entity and the
securitization issuer must be on market terms
75
Covered Fund Restrictions (cont’d)
• The Final Rule also includes a limited exemption from ownership and
sponsorship restrictions to the extent banking entities retain ownership
interests in sponsored securitizations not otherwise excluded from the
covered fund definition in order to comply with risk retention requirements
• This exemption, however, does not exempt banking entities from Super 23A
restrictions. Additionally, the exemption does not apply if banking entities
retain ownership interests in excess of the required retention under risk
retention rules, defeating its utility in situations in which rating agencies or
prospective investors require a retention in excess of the regulatory risk
retention requirement
• The Final Rule does not itself “grandfather,” or exempt, structures and
investments put in place before the effective date of the Final Rule or before
the enactment of the Dodd-Frank Act. Accordingly, banking entities will need
to closely examine their existing securitization investments and relationships,
and prospective transactions, for compliance with the Volcker Rule
76
Definition of “Ownership Interest”
• As previously discussed, an ownership interest includes any equity or
partnership interest in a covered fund or any other interest in or
security issued by a covered fund that exhibits any of certain
characteristics on a current, future or contingent basis, including:
• has the right to participate in the selection or removal of a general partner,
managing member, member of the board of directors, investment manager,
investment adviser or commodity trading advisor (not including rights of a creditor
to exercise remedies in the event of a default);
• has the right under the terms of the interest to receive a share of the income,
gains or profits of the covered fund (regardless of whether the right is pro rata with
other owners);
• has the right to receive the underlying assets of the covered fund, after all other
interests have been redeemed and/or paid in full (the “residual” in securitizations);
• has the right to receive all or a portion of excess spread;
77
Definition of “Ownership Interest” (cont’d)
• provides that the amounts payable by the covered fund with respect to the interest
could, under the terms of the interest, be reduced based on losses arising from the
underlying assets of the covered fund, such as allocation of losses, write-downs or
charge-offs of the outstanding principal balance, or reductions in the amount of
interest due and payable on the interest;
• receives income on a pass-through basis from the covered fund, or has a rate of
return that is determined by reference to the performance of the underlying assets
of the covered fund (excluding interests that are entitled to received dividend
amounts calculated at a fixed or floating rate); and
• any synthetic right to have, receive or be allocated any of the rights described
above (which would not allow banking entities to obtain derivative exposure to these
characteristics)
• Of particular importance to banking entities engaged in investment
banking activities, notwithstanding the general prohibition of a banking
entity acquiring an “ownership interest” in a covered fund, a banking
entity may acquire such an ownership interest in connection with
certain permitted underwriting and market making-related activities
78
Definition of “Ownership Interest” (cont’d)
• It is also important to note that the definition of ownership interest in
the Final Rule may include interests in a covered fund that might not
usually be considered an ownership interest or an equity interest
• Of particular concern is the first of the indicia of an ownership interest list above –
that the interest has the right to participate in the selection or removal of a general
partner, managing member, director, investment manager, investment adviser or
commodity trading advisor
• Many CLOs and CDOs provide rights to a “controlling class” of senior debt
security holders to participate in the designation of investment managers or
investment advisers, creating the potential that the holders of even the most
senior, highly rated debt securities may be considered to hold “ownership
interests”
• It is hoped that further regulatory guidance will clarify whether senior debt interests
in such structures are susceptible to classification as “ownership interests”
79
Definition of “Sponsor”
• The Final Rule defines “sponsor” to mean any entity that:
• serves as general partner, managing member, or trustee of a covered fund, or that
serves as a commodity pool operator of a covered fund,
• selects or controls (or has employees, officers, or directors, or agents who
constitute) a majority of the directors, trustees, or management of a covered fund, or
• shares with a covered fund, for corporate, marketing, promotional, or other
purposes, the same name or a variation of the same name
• A key question for trustees of ABS issuing trusts (which are typically appointed
by the party usually regarded as the sponsor of the securitization) is whether
such trustees may themselves be considered “sponsors” of the securitization
• The Agencies stated in the Preamble that the term “sponsor” includes a trustee that
has the right to exercise any investment discretion with respect to the securitization
• The Agencies also indicated that for ABS issuers, this would generally not include a
trustee that executes decision making, including investment of funds prior to the
occurrence of an event of default, solely in accordance with the provisions of a
written contract or at the written direction of an unaffiliated party
80
Interim Final Rule re TruPS CDOs
• The Final Rule caused considerable industry outcry over the definition
of “ownership interest” as applied to CDOs and CLOs—particularly from
community banks that hold CDOs backed by trust preferred securities
(“TruPS”)
• On January 14, 2014 the Agencies issued an interim final rule providing
grandfathering for certain existing TruPS CDOs
• The interim final rule allows the retention of an interest in or sponsorship
of covered funds by banking entities if, among other things, the following
conditions are met:
• The TruPS CDO was established, and the interest was issued, before May 19, 2010;
• The banking entity reasonably believes that the offering proceeds received by the
TruPS CDO were invested primarily in qualifying TruPS collateral; and
• The banking entity’s interest in the TruPS CDO was acquired on or before December
10, 2013, the date the Agencies issued the Final Rule implementing the Volcker Rule
81
Interagency Working Group
• February 5, 2014 – Federal Reserve governor Daniel Tarullo
testifies in Congress that CLO issues “at the top of the list” to be
addressed by interagency Volcker Rule working group
• February 11, 2014 – Federal Reserve Chair Janet Yellen confirms
in Congressional testimony that regulators are reviewing CLO
issues
• Neither regulator would commit to timing, but Yellen said
decisions could come “reasonably soon”
• Unclear what form relief, if any, would take
• Grandfather legacy CLOs
• Relax “ownership interest” definition
• Relax “covered fund” definition
82
Compliance Programs
83
Compliance Programs
•
•
Important focus of the Rule
All except the “less active” banking entities must implement six-point
compliance program:
•
•
•
•
•
•
Written policies and procedures reasonably designed to document, describe,
monitor and limit proprietary trading activities, and activities and investments with
respect to covered fund activities, to ensure compliance with the Rule
A system of internal controls reasonably designed to monitor compliance with the
Volcker Rule, and to prevent the occurrence of activities or investments that are
prohibited by the Rule
A management framework that delineates responsibility and accountability for
compliance with the Volcker Rule and includes management review of trading
limits, strategies, etc.
Independent testing and audit of the effectiveness of the compliance program;
Training for trading personnel and managers, as well as other “appropriate”
personnel, to appropriately implement and enforce the compliance program; and
Records sufficient to demonstrate compliance with the Volcker Rule
84
Compliance Programs (cont’d)
• “Less active” banking entities
• Those with no covered activities have no obligation to
establish a compliance program until they begin to
engage in those activities;
• banking entities with “modest activities,” (those with
total assets of $10 billion or less) need only refer to
the requirements of the Volcker Rule in its compliance
policies and procedures and make “adjustments as
appropriate given the activities, size, scope and
complexity of the [banking entity]”
85
Enhanced Compliance Programs
• Enhanced Minimum Standards for Compliance
Programs
• Provided in Appendix B
• Required of banking entities that:
• Engage in permitted proprietary trading and are required to
comply with the reporting requirements under Appendix A
(that is, have a certain minimum level of trading assets and
liabilities, as discussed below);
• As of the previous calendar year-end, had total consolidated
assets of $50 billion or more or, in the case of an FBO, had
total U.S. assets of $50 billion or more; or
• Are notified by the relevant Agency that it must satisfy the
standards of Appendix B
86
Enhanced Compliance Programs (cont’d)
•
For the largest firms, the Compliance Programs must:
•
•
•
•
•
Be reasonably designed to identify, document, monitor and report the
permitted trading and covered fund activities and investments; identify and
monitor the risks of those activities and potential areas of noncompliance; and
prevent prohibited activities and investments
Establish and enforce appropriate limits on the covered activities and
investments, including limits on the size, scope, complexity and risks of the
individual activities or investments consistent with the requirements of the
Volcker Rule
Subject the compliance program to periodic independent review and testing,
and ensure the entity’s internal audit, compliance and internal control functions
are effective and independent
Make senior management and others accountable for the effective
implementation of the compliance program, and ensure that the chief executive
officer and board of directors review the program, and
Facilitate supervision and examination by the Agencies
87
Enhanced Compliance Programs (cont’d)
• Enhanced Minimum Standards for Compliance
Programs impose additional requirements for
proprietary trading that address:
•
•
•
•
•
•
Trading desks
Descriptions of risks and risk management processes
Authorized risks, instruments and products
Hedging policies and procedures
Analysis and quantitative measurements
Remediation
88
Enhanced Compliance Programs –
Trading Desks
Written policies and procedures for each desk should describe:
•
•
•
•
•
•
•
•
•
•
Process for identifying, authorizing and documenting what each desk may
purchase or sell
Mapping each desk to the division responsible for supervision
Mission and strategy
Authorized activities, including products, and hedging strategies
Types and amounts risks allocated to each desk, and how risks will be measured
Limits on holding period of financial instruments
Process for setting new or revised limits, and escalation procedures for
exceptions
Process for identifying, documenting and approving new products and strategies
Type of clients, customers and counterparties
Compensation arrangements – which may not be designed to reward or
incentivize prohibited proprietary trading
89
Enhanced Compliance Programs – Risks
•
•
•
Compliance program must describe risk management program for
the trading activity
Trading activity in similar financial instruments should be subject to
similar governance, limits, testing, controls, and review
Must describe:
•
•
•
•
•
Supervisory and risk management structure governing all trading activity
Process for developing, documenting, testing, approving and reviewing;
• Risk models, and
• Limits for each desk
Process by which a security may be purchased or sold pursuant to liquidity
management plan
Management review process for approving temporary or permanent changes to
limits
Role of audit, compliance and risk management in conducting independent
testing of trading and hedging
90
Enhanced Compliance Programs –
Authorized risks, instruments and products
•
•
Banking entity must implement and enforce limits and internal
controls appropriate to each trading desk, based on:
• Measures of potential loss
• Measured under normal and stress conditions
Internal controls must monitor, establish and enforce limits on:
• Type and exposure of financial instruments each trading desk
may trade
• Types and levels of risk that each trading desk may take
• Types of hedging instruments used, hedging strategies
employed, and amount of risk hedged.
91
Enhanced Compliance Programs –
Hedging Policies and Procedures
•
Policies regarding use of risk-mitigating hedging instruments must
describe:
•
•
•
•
•
•
Positions, techniques and strategies that each desk may use
How the banking entity will identify risks related to positions that are to
be hedged and how it will determine that risks have been properly
hedged
Level of organization at which hedging activity and management will
occur
How the hedging strategies will be monitored, and by whom
The risk management processes used to control unhedged or residual
risks
Process for developing, documenting, testing, approving and reviewing
all hedging positions, techniques and strategies for each desk and the
banking entity
92
Enhanced Compliance Programs –
Analysis and Quantitative Measurements
•
•
•
Banking entity must perform robust measurement to:
• Ensure trading activity is consistent with compliance program
• Monitor and identity potential and actual prohibited prop trading
and
• Prevent prohibited trading activity.
Must test and review analysis and models, including periodic and
independent back-testing and revision of activities, limits, strategies
and hedging
Must develop quantitative measures in addition to those reported
pursuant to Appendix A
93
Enhanced Compliance Programs – Analysis
and Quantitative Measurements(cont'd)
•
The analysis and quantitative measurements must include:
• Internal controls and policies and procedures to ensure accuracy
of measurements
• Ongoing monitoring and review of measurements
• Numerical thresholds and measures for each trading desk and
heightened review of trading not consistent with those measures
• When measurements or other information suggest that the
trading desk has violated the Volcker Rule, immediate review
and investigation of the desk’s activities, escalation, notification
to the regulator, remedial action, and documentation of the
findings and remedial action
94
Enhanced Compliance Programs –
Other Compliance Matters
•
Compliance Program also must:
• Identify activities that will be conducted in reliance on market
making, underwriting and other exemptions
• Explain process for documenting, approving and reviewing
actions taken pursuant to liquidity management plan
• Describe how banking entity monitors for and prohibits potential
or actual material exposure to high-risk assets or high-risk
trading strategies presented by trading desks that rely on the
exemptions
• Establish responsibility for compliance with reporting and
recordkeeping requirements
• Establish policies for monitoring and prohibiting conflicts of
interest
95
Enhanced Compliance Programs –
Remediation of Violations
• Compliance Program must be designed to monitor and
identify any trading that may indicate violations of the Rule,
and prevent violations
• Must include a requirement to promptly document, address
and remedy any violation, and document all remediation
efforts
• Must include policies and procedures designed to assess
extent to which modification to compliance program is
warranted
• Must provide for prompt notification of material weaknesses
or deficiencies in compliance program to appropriate
management and the board of directors
96
Enhanced Compliance Programs (cont’d)
• Enhanced Minimum Standards for Compliance
Programs impose additional requirements for
covered funds activities or investments that
address:
•
•
•
•
Identification of covered funds
Identification of covered fund activities and investments
Explanation of compliance
Description and documentation of covered fund activities and
investments
• Internal controls
• Remediation of violations
97
Enhanced Compliance Programs – Responsibility and
Accountability for the Compliance Program
• Banking entity must:
• Maintain and enforce a governance and management
framework with a view to preventing violations of the
Volcker Rule
• Ensure that appropriate personnel are responsible and
accountable for the compliance program
• That there is a clear reporting line with a chain of
responsibility
• That senior management reviews the program periodically
• Ensure that management and the board have appropriate
resources to conduct their oversight activities effectively
98
Enhanced Compliance Programs – Responsibility and
Accountability for the Compliance Program (cont'd)
• Corporate Governance -- written compliance program must be
approved by the board of directors and senior management
• Management Procedures – must provide for designation of
appropriate senior management with authority
• Business line managers for trading desks are accountable for
implementation of compliance program
• Board and senior management must establish an appropriate
culture of compliance with the Rule
• CEO of a banking entity that is subject to the enhanced minimum
standards for a compliance program must, annually, attest that the
banking entity’s processes are adequate to achieve compliance with
the Rule
99
Enhanced Compliance Programs – Responsibility and
Accountability for the Compliance Program (cont'd)
• Independent Testing – occur with appropriate
frequency, conducted by qualified independent
party, such as internal audit
• Adequate Training – must be provided to
personnel and managers involved in relevant
activity
• Recordkeeping – sufficient to demonstrate
compliance. Must be retained for at least 5
years
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Reporting and Recordkeeping Requirements
• Provided in Appendix A
• Required of banking entities:
• Engaged in permitted proprietary trading activity
• Which, together with affiliates and subsidiaries, has trading assets and
liabilities, the average gross sum of which over the previous four
quarters is greater than or equal to:
• $50 billion between June 30, 2014 and April 29, 2016;
• $25 billion between April 30, 3016 and December 30, 2016; and
• $10 billion beginning on December 31, 2016
• Purpose of the reporting and recordkeeping requirements is
to assist banking entities and the Agencies in determining
whether the banking entities are complying with the Rule
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Reporting and Recordkeeping Requirements
(cont’d)
• Requires banking entities to:
• Measure seven metrics daily
• Report metrics for each calendar month within 30 days of the
end of the month
• For banking entities with $50 billion or more in trading assets
and liabilities, beginning with information for the month of
January 2015, report the information within 10 days of the end
of the month
• Create and maintain records documenting the preparation and
content of these reports for five years from the end of the
calendar year for which the measurement was taken
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Reporting and Recordkeeping Requirements
(cont’d)
The seven metrics, falling into three categories
• Risk management
• Risk and Position Limits and Usage
• Risk Factor Sensitivities
• Value-at-Risk and Stress Value-at-Risk
Revenue Measurements
• Comprehensive Profit and Loss Attribution
• Customer-Facing Activity Measurements
• Inventory Turnover
• Inventory Aging
• Customer-Facing Trade Ratio
Source-of-
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