FINANCIAL SERVICES FLASH REPORT
The Volcker Rule: The End of Proprietary Trading?
October 13, 2011
This week in the United States, the Federal Reserve Board, the Office of the Comptroller of the
Currency, the Federal Deposit Insurance Corporation, and the Securities and Exchange
Commission coordinated the release of proposed regulations implementing the “Volcker Rule”
as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Commodity
Futures Trading Commission is in the process of releasing similar regulations.
If enacted as written, these regulations, in addition to restricting bank investments in hedge and
private equity funds, will likely achieve the primary goal of forcing insured depository institutions,
bank holding companies, as well as their subsidiaries and affiliates (“banking entities”) to exit
the proprietary trading business. In addition to the loss of potential profitability from proprietary
trading, these banking entities will also incur additional compliance costs associated with their
utilization of proprietary trading instruments to manage risk and to support customer
transactions. While the Volcker Rule is focused on banking entities, systematically important
nonbank financial companies engaged in proprietary trading may still be subject to additional
capital requirements and quantitative limits.
Rules Regarding Proprietary Trading
Proprietary trading is defined by the proposed regulations as the act of engaging as the principal
for a trading account of a banking entity in any security, derivative or certain other financial
instruments, collectively referred to in this document as “proprietary trading instruments.” This
definition includes transactions in commodities that will be physically settled. There are several
provisions that allow the banking entity to act solely as agent, broker or custodian for an
unaffiliated party. These are viewed in the press as wide loopholes that will permit business as
usual. We do not believe that to be the case and we anticipate that the compliance burden
related to these activities will be significant.
The most significant components of the regulations that will impact the ability of a banking entity
to conduct proprietary trading are embodied in two specific requirements.
•
The market making activities must be designed to generate revenues primarily from
fees, commissions, bid/ask spreads or other income not attributable to the appreciation
in value of the covered financial positions it holds in trading accounts or the hedging of
covered financial positions it holds in trading accounts.
•
The compensation arrangements of persons performing the market making, underwriting
or hedging related activities must be designed not to reward proprietary risk-taking.
The entire purpose of proprietary trading is to take positions in a market in order to profit from
anticipated price movements. These activities are not driven by fees or commissions and only
under a tortured definition of the bid\ask spread could anyone argue that gains and losses
derived from proprietary trading are generated through changes in the bid/ask spread over time.
Further, limiting the compensation arrangements of traders will more than likely drive these
personnel to organizations that are not classified as banking entities in a rapid manner. This is
the intent and core objective of Congress.
Compliance Requirements Associated with the Use of Proprietary Trading
Instruments
Banking entities will not escape the utilization of proprietary trading instruments. Customers will
still seek to execute such transactions through banking entities. Additionally, banking entities will
create risks within their own operations that need to be mitigated through the utilization of
proprietary trading instruments. In order to ensure that these activities do not constitute
proprietary trading, the compliance requirements will be necessarily onerous. The proposed
regulations require banking entities to demonstrate affirmatively that the utilization of proprietary
trading instruments falls within the approved guidelines. In other words, institutions must be able
to prove their innocence.
The proposed regulations do allow the utilization of proprietary trading instruments for
underwriting activities, customer market making activities or for risk management requirements.
According to the proposal, compliance requirements will include evidencing and demonstrating
the following:
•
Existence of an internal compliance program that is designed to ensure the banking
entity’s compliance with the requirements of Trading Account definitions, including
reasonably designed policies and procedures, internal controls and independent testing.
•
The purchase or sale of a proprietary trading instrument is affected solely in connection
with a distribution of securities for which the banking entity is acting as underwriter.
•
The trading desk regularly holds itself out to conduct transactions in the market and that
it regularly executes such transactions.
•
Underwriting or market making activities are designed not to exceed the reasonably
expected near-term demands of clients, customers or counterparties.
•
Underwriting, market making or risk management activities are designed to generate
revenues primarily from fees, commissions, or normal underwriting or bid/ask spreads.
•
Underwriting, market making or risk management-related activities of the trading desk
are consistent with the regulations and commentary regarding identification of permitted
nonproprietary trading related activities.
•
Proprietary trading instruments are utilized for specific risk management purposes,
including market risk, counterparty or other credit risk, currency or foreign exchange risk,
interest rate risk, basis risk, or similar risks that did not evolve from proprietary trading
activities.
•
For proprietary trading instruments utilized for risk management, there is reasonable
correlation between the underlying risk and the hedging position, as well as the liquidity
of those positions.
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•
At the time of purchase or sale of a proprietary trading instrument acquired for a riskmitigating purpose, the transaction is designed to reduce risk and that the hedge
relationship is documented.
•
Compliance with multiple regulatory quantitative measurements and ratios designed to
detect the existence of proprietary trading.
•
Compensation arrangements of persons performing underwriting, market making or risk
management activities are designed not to reward proprietary risk-taking.
•
The banking entity is a dealer registered with the SEC or CFTC or exempt from
registration within the United States, but subject to substantive regulation of such
business in the jurisdiction where the business is located.
•
Trading activities are subject to continuing review, monitoring and management by the
banking entity.
Broadly, the regulations provide that the banking entities develop and implement compliance
programs that can evidence and demonstrate the above, including the following:
•
Internal written policies and procedures reasonably designed to document, describe and
monitor trading activities
•
A system of internal controls reasonably designed to monitor and identify potential areas
of noncompliance
•
A management framework that clearly delineates responsibility and accountability for
compliance
•
Independent testing for the effectiveness of the compliance programs conducted by
qualified personnel of the banking entity or by a qualified outside party
•
Training for trading personnel and managers, as well as other appropriate personnel, to
effectively implement and enforce the compliance program,
•
Making and keeping records sufficient to demonstrate compliance
As these proposed regulations imply, the compliance requirements associated with the
utilization of proprietary trading instruments will be significant in order to demonstrate that the
banking entity is not involved in proprietary trading. Documentation requirements will be
required from the outset of executing such transactions. This will require enhancements to
existing processes, procedures and systems to track, measure and manage proprietary trading
instruments and the underlying risks, as well as changes in controls and processes regarding
how such activities are documented and managed. This will occur under the backdrop of
changing business strategies as a result of the termination of proprietary trading strategies.
Ramifications for Non-Financial Institutions
For companies that are not classified as banking entities, the final adoption of the Volcker Rule
is expected to have real ramifications in the markets. Over the last decade, banking entities
have often taken the lead in market making within commodities, currency and interest rate
markets. These same institutions have also generally used their lending facilities to drive
business to their trading desks. This has generally been viewed as efficient from an execution
and credit perspective. The prohibition of proprietary trading within banking entities will likely
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have important ramifications. For example, it may lead to a decrease in liquidity within certain
markets and/ or a decrease in the ability of a banking entity to transact in such markets on a
rapid basis. As a result, non-financial institutions will need to look carefully at their requirements
as they consider the entities through which to execute their own risk management needs.
Ensuring the Prohibition on Proprietary Trading
In order to ensure that banking entities are not involved in proprietary trading, the Volcker Rule
also prohibits investments of greater than 3 percent in hedge funds, investment funds or other
similar investment vehicles that may be engaged in proprietary trading.
Additional Exceptions
The most significant exception to this legislation is that it does not restrict foreign banks
operating within the United States as banking entities from engaging in proprietary trading so
long as the transaction occurs completely outside the United States. It will be interesting to
observe the ramifications of this exception within the market. Further, there are additional
exceptions to the Volcker Rule related to transacting in governmental and municipal securities.
Comment Period and Proposed Implementation Timeline
The proposed regulations are open for comment for a 90-day period that will end on January 13,
2012. The entities impacted by this legislation will have two years (July 2014) within which to
implement the required compliance requirements. Certain extensions can be requested to
extend the compliance deadline to July 2017 and to July 2022 for certain illiquid assets. The
length of this implementation timeline represents the most significant loophole remaining for
changing political will.
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About Protiviti
Protiviti (www.protiviti.com) is a global consulting firm that helps companies solve problems in
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Contacts
Carol Beaumier
Executive Vice President – Global Industry Programs
Global Leader – Financial Services Practice
+1.212.603.8337
carol.beaumier@protiviti.com
Cory Gunderson
Managing Director – U.S. Financial Services Practice Leader
Global Leader – Risk & Compliance Solutions
+1.212.708.6313
cory.gunderson@protiviti.com
David Johnson
Managing Director – Market Risk & Commodity Trading Solutions
+1.713.314.5020
david.johnson@protviviti.com
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