Capital Markets Advisors

In my last piece, I discussed the exemption-specific compliance requirements of the Volcker Rule (VR) that are common to all, or most, of the exemptions. In this article I will discuss two specific exemptions and their requirements: liquidity management and underwriting.

As a reminder, the operative language of the Act is, “Except as otherwise provided in this subpart, a [bank] may not engage in proprietary trading, and further defines the term; proprietary trading means engaging as principal for the trading account of the [bank] in any purchase or sale of one or more covered financial positions.” Thus, unless a bank qualifies under the various exemptions provided in the rule, it may not do any principal transactions in any financial instrument for its own account except debt issued by the US government or a US municipality. Significantly, as was pointed out by foreign governments when the rule was first published, the prohibition does apply to trading in foreign sovereign debt.

The Liquidity Exemption

The requirements for the liquidity management exemption specify that the investment be:

For the bona fide purpose of liquidity management and in accordance with a documented liquidity management plan of the [bank] that:

1. Specifically…authorizes the particular instrument to be used for liquidity management purposes, its profile with respect to market, credit and other risks, and the liquidity circumstances in which the particular instrument may or must be used;
2. Requires that any transaction … be principally for the purpose of managing the liquidity of the [bank], and not for the purpose of short-term resale, benefiting from actual or expected short-term price movements, realizing short-term arbitrage profits, or hedging a position taken for such short-term purposes;
3. Requires that any position taken for liquidity management purposes be highly liquid and limited to financial instruments the market, credit and other risks of which the [bank] does not expect to give rise to appreciable profits or losses as a result of short-term price movements;
4. Limits any position taken for liquidity management purposes, together with any other positions taken for such purposes, to an amount that is consistent with the banking entity’s near-term funding needs, including deviations from normal operations, as estimated and documented pursuant to methods specified in the plan; and
5. Is consistent with [Agency]’s supervisory requirements, guidance and expectations regarding liquidity management.

If the bank does not have a liquidity management plan, it must prepare one prior to the finalization of the VR, and if the bank’s current liquidity plan does not conform to these requirements, it must be modified to conform. The plan must specify the approved investments and justify their inclusion on risk and liquidity grounds, and set forth an investment strategy primarily built around holding short-term securities to maturity. Additionally, the leveraging of liquidity investments will generally not conform to this exemption.

If longer-term securities are purchased or allowed under the plan, or if a significant number of holdings are sold prior to maturity, those positions and transactions will need to be justified in light of this part of the VR. It goes without saying that selling securities short in the liquidity account will be construed to be a prohibited transaction, although it might be allowed under the hedging exemption, to be covered in my next article.

The Underwriting Exemption

Section _.4 of the rule allows the purchase or sale of a … position … that is made in connection with … underwriting activities, and sets these requirements:

(2) A purchase or sale … shall be deemed to be made in connection … underwriting activities only if:

• (i) The [bank] has established the internal compliance program required by subpart D that is designed to ensure the [bank]’s compliance with the requirements of paragraph (a)(2) of this section, including reasonably designed written policies and procedures, internal controls, and independent testing;
• (ii) The covered financial position is a security;
• (iii) The purchase or sale is effected solely in connection with a distribution of securities for which the [bank] is acting as underwriter;
• (iv) The [bank] is:
  1. A dealer that is registered with the SEC, or
  2. Engaged in the business of a dealer outside of the United States and subject to substantive regulation of such business in the jurisdiction where the business is located;
  3. a municipal securities dealer that is registered; or
  4. a government securities dealer that is registered;
• (v) The underwriting activities … are designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties;
• (vi) The underwriting activities … are designed to generate revenues primarily from fees, commissions, underwriting spreads or other income not attributable to:
  • Appreciation in the value of … positions related to such activities; or
  • The hedging of covered financial positions related to such activities; and

• (vii) The compensation arrangements of persons performing underwriting activities are designed not to reward proprietary risk-taking.

The Underwriting Compliance Program

This section only refers to those parts of Appendix C which are specific to this exemption.

Trading Desk Organization

Appendix C says that the compliance program must address:

• Identification of trading account – the… policies and procedures must specify how the [bank] evaluates the… positions…and determines which of its accounts are trading accounts.
• Identification of trading units and organization structure – the policies and procedures must identify and document each trading unit within the organization and map each trading unit to the division, business line, or other organizational structure … used to manage or oversee the trading unit’s activities.
• Description of missions and strategies – the…policies and procedures for each trading unit must … document … the mission (i.e., the nature of the business conducted) and strategy (i.e., business model for the generation of revenues) of the trading unit, and include a description of:
  • How revenues are intended to be generated;
  • The activities that the trading unit is authorized to conduct, including (i) authorized instruments and products and (ii) authorized hedging strategies and instruments;
  • The expected holding period of, and the market risk associated with,… positions in its trading account;
  • The types of clients, customers, and counterparties with whom trading is conducted by the trading unit;

The first account(s) that must be identified and described is the underwriting account itself. The bank must describe what securities or types of securities will be underwritten, and the risk management policies applicable to those accounts. Revenue sources and holding periods should be self-explanatory, as well as the counterparty types.

By the same token, any trading accounts used to support the underwriting function must also be identified and described, and the types of transactions allowed in those accounts must be specified. Because the VR as proposed specifically restricts the underwriting exemption to trades in securities, the use of futures or OTC derivatives must be prohibited from these accounts (although they may be allowed under the hedging exemption, covered in my next article). In general the bank should set up separate trading accounts for underwriting support, so that trades in them can be automatically linked to the underwriting account for compliance reporting purposes.

One important requirement for the trading accounts is the revenue generation (How revenues are intended to be generated). The bank should specify that any profit or loss from the supporting accounts will be combined with the revenues from the supported underwriting accounts so as not to incentivize traders to run these accounts as a profit center. The bank should predetermine from the examiners, if possible, whether any transaction in the trading account, if it conforms to the restrictions, can be construed to qualify for the exemption, or whether each transaction must be linked to a specific underwriting.

Trader Mandates, Risk Management and Hedging Processes

Appendix C says:

– The [bank] must [implement] trader mandates for each trading unit. At a minimum, trader mandates must:

• Clearly inform each trader of the prohibitions and requirements [in the Rule] and his or her responsibilities for compliance with such requirements;
• Set forth appropriate parameters for each trader…, including:
  • The conditions for relying on the applicable exemptions;
  • The [instruments] the trader is permitted to trade;
  • The risk limits of the trader’s trading unit, and the types and levels of risk that may be taken; and
  • The … trading unit’s hedging policy

This requirement for underwriting can be handled as part of the general trading desk organization, but must include the description of the securities allowed to be traded and allowed trade types. This description can be as non-specific as saying that the securities must be of the same type (equities, fixed income, etc.) as the underwritten securities, and that the transactions must serve to facilitate the distribution of the underwriting or reduce its risk, or it can specifically describe the security types and transactions allowed. In addition, it should say that the positions in the account(s) cannot be larger than the amount being underwritten.

The bank should confer with its examiners when the mandate is being implemented to determine if it is likely to cause a compliance issue in production. To the extent possible, the mandate should be built into any automated trade monitoring software, so as to surface any transactions that could later cause a compliance issue.

Appendix C also says:

– The…policies and procedures … must … document a comprehensive description of the risks associated with the trading unit, including descriptions of:

• The supervisory and risk management structure governing the trading units, including a description of processes for initial and senior-level review of new products and new strategies;
• The types of risks that may be taken …, including …all significant price risks, such as basis, volatility and correlation risks, as well as any significant counterparty credit risk;
• An articulation of the amount of risk allocated … to such trading unit;
• An explanation of how the risks allocated to such trading unit will be measured; and
• An explanation of why the allocated risk levels are appropriate to the mission and strategy of the trading unit.

This section refers to both the risks in the underwriting account and in the trading account that supports it. One particular underwriting risk that must be codified is the risk of unfavorable market movement during the period when underwriters are restricted from offering the securities at any but the official offering price. If the market declines during that period, the underwriter’s only risk management option is to sell short securities whose price is likely to track the underwritten security. Such trades, frequently done by underwriters, may have to be linked directly to the position in the underwritten security in order not to endanger the exemption.

Appendix C also requires, about hedging:

– The policies and procedures for all of its trading units regarding the use of risk mitigating hedging instruments and strategies…including the following:

• How the [bank] will determine that the risks generated by each trading unit have been … hedged;
• The instruments, techniques and strategies [to be used] to hedge the risk of the positions or portfolios;
• The level of the organization at which hedging activity and management will occur;
• The manner in which hedging strategies will be monitored;
• The risk management processes used to control unhedged or residual risks; and
• The independent testing of hedging techniques and strategies.

Because the VR expressly restricts underwriting-related transactions to securities, this section would not allow the use of futures or OTC derivatives as a hedge for an underwriting. Options are technically securities, so they could be used here, if the policies allow. The risks outlined in the previous subsection, of being locked into an underwriting position in a falling market, may or may not be hedged at the option of the syndicate department, so the policies should not require all risks to be completely hedged. The bank will need to confer with its examiners to ensure that this requirement is not interpreted to mean that all risks inherent in underwriting positions must be hedged at all times.

Explanation

There is one subsection of Appendix C that requires special attention:

– Describe how the [bank] monitors for and prohibits … exposure to high-risk assets or high-risk trading strategies …, which must take into account … exposure to:

• Assets whose values cannot be externally priced or, where valuation is reliant on pricing models, whose model inputs cannot be externally validated;
• Assets whose changes in values cannot be adequately mitigated by effective hedging;
• New products with rapid growth, including those that do not have a market history;
• Assets or strategies that include significant embedded leverage;
• Assets or strategies that have demonstrated significant historical volatility;
• Assets or strategies for which the application of capital and liquidity standards would not adequately account for the risk; and
• Assets or strategies that result in large and significant concentrations to sectors, risk factors, or counterparties.

From time to time, the bank may underwrite securities that fit these descriptions, particularly new products or those with embedded leverage (such as asset-backed securities or LBO securities). Because an underwriter’s function is often to introduce new securities or security types to the market, the bank will have to clarify with its regulators the exact implications of this subsection.

The Underwriting Linkage

One of the most important exemption requirements pertains to the linkage:

The purchase or sale is effected solely in connection with a distribution of securities for which the [bank] is acting as underwriter.

As mentioned before, the underwriting linkage applies to two kinds of transactions – those in the underwritten security and those in other securities traded in support of the underwriting. With regard to transactions in the underwritten security, if the bank is a member of the syndicate, we can assume that any transactions in that security during the underwriting period will automatically be exempt. There is, however, one kind of transaction which may technically be non-exempt. Banks that are not members of the syndicate may buy securities at a discount (usually called the selling concession) from an underwriter to resell to their clients. Because these banks would not technically be acting as underwriter, they would need clarification from their regulator that selling group transactions do qualify under this exemption.

Transactions done in support of the underwriting require more documentation to qualify for this exemption. The most common support transactions involve swaps done by customers, where they sell older securities in exchange for the underwritten ones. Underwriters that enter into these swaps would have two kinds of transactions: the purchase of the swapped securities, and the sale of those securities, either to other customers or to other dealers. The sale can be done before the underwriting, in the form of short sales, or after the customers do the swaps.

The next most common support transaction is the short sale of securities that resemble the underwritten securities, done to hedge against a market decline during the restricted underwriting period. This is most common when the underwriter is not the book-running manager of the offering, and thus cannot terminate the restricted period on his own. These transactions, if done in the account set up for support of underwritings, will qualify for the exemption if the bank can link them to the underwriting account.

Banks will have to create linkages within their trade processing systems to connect these trades, and any others done in support of an underwriting, to the underwriting itself. In the case of short sales, these transactions are a form of risk mitigation, and should be identified as such.

Transaction and Position Size

Subpart B says this about appropriate sizes:

The underwriting activities … are designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties;

While banks will generally not underwrite issues that are larger than the market can absorb, from time to time the underwriter may overestimate the market’s appetite for a particular security or security type. Should that happen, the bank may wish to hold the unsold portion of an underwriting until sufficient demand is generated to absorb it. That decision will probably not conform to the holding period section of the P&P, so the bank will need language in the P&P allowing for such an extended holding period. That language notwithstanding, examiners may find after the fact that the decision to hold the securities invalidates the underwriting exemption in a particular case.

The size requirement for supporting transactions would probably be violated if the total size of these positions, at their largest, exceeds the volume of the underwriting to which they are linked.

Revenue Sources and Risk

Subpart B says about revenue sources and risk:

The underwriting activities … are designed to generate revenues primarily from fees, commissions, underwriting spreads or other income not attributable to:

(A) Appreciation in the value of … positions related to such activities; or

(B) The hedging of covered financial positions related to such activities.

For underwritten securities sold during the restricted period, this part of the exemption is satisfied. It is also satisfied for securities purchased at the selling concession and sold to customers. For underwritten securities not sold during the restricted period, but sold at or below the offering price afterwards, participation in the syndicate is prima facie evidence that the positions were designed to generate revenues from underwriting spreads. However, any underwritten securities sold above the syndicate offering price would be interpreted as positions designed to generate revenues from appreciation in value, and thus are prohibited transactions.

Positions in support of the underwriting are potentially more of a problem with regard to this requirement, because they may be construed to benefit from a change in value. Short positions established in anticipation of swaps into the underwriting may appreciate in value if the market falls during the underwriting period, and securities bought on swap might likewise appreciate if the market rises during or after the underwriting. Thus the bank will have to document the purpose of those transactions at the time the positions are opened, so as to prove that the positions were not designed solely to benefit from market movement.

Securities sold short as a hedge during the restricted period are definitely designed to benefit from market movement, but, if they are designated as hedges for the unsold underwriting position, they will be exempt. However, the bank must document the purpose when the positions are opened, and must close the positions within a reasonable period after the underwriting position is sold. Holding shorts for significant periods after the underwriting position is sold may be construed as invalidating the exemption, unless the bank changes the exemption to the market making one, which has its own requirements.

In the next article, I will look at the requirements for market-making and hedging.