It has been more than two years since the proposed Volcker Rule (VR) was published by a consortium of US regulators. With not much being said publicly about it over the ensuing period, and all the public attention paid to derivatives reform worldwide, one might be forgiven if one took one’s eye off that particular ball. As it turns out, that would have been a mistake.
In a recent article on Bloomberg, Cheyenne Hopkins and Jesse Hamilton report that Secretary of the Treasury Jack Lew told a meeting of bankers that the VR would be finalized before year end, and that it would be tougher than they had hoped. Because the VR covers much more than derivatives, it requires a whole different compliance approach than Title VII did.
In 2011, I wrote a Volcker Rule Trading Compliance Manual, based on the proposed rule as it then existed. This manual addressed only the principal trading part of the VR, not the ownership of hedge funds or PE firms. This first article will cover the general compliance requirements, and later articles will cover the specific exemptions.
To begin with, the manual points out that, “the rule has neither a safe harbor provision nor the concept of granting an exemption before the fact on the part of a regulator. In addition, the nature of the exemption language in the rule means that compliance may require a case-by-case determination. Furthermore, the primary enforcement responsibility will reside with the banking examiners, who may not have much familiarity with trading practices in the capital markets, particularly in exotic instruments. For all those reasons, and because the nature of the instruments, not to mention market levels and trading strategies, can change rapidly, banks will have to be assiduous in documenting their compliance, both before and after the fact.”
The manual also points out the requirement for extensive policies and procedures (P&Ps) covering, among many others (italicized text is quoted directly from the rule):
- 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;and…
- The compensation structure of the employees associated with the trading unit.
- 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;
The manual says: “Assuming that the bank already documents and monitors trading activities and risk (through confirmations and risk management systems), the new requirement here is to describe and link principal trades to exemptions so as to ensure that they comply with the VR… In any event, most banks will do too many transactions to allow for manual descriptions and linking of them, so dealers will have to build transaction codes or set up trading accounts which will trigger the appropriate descriptions and linkages for compliance officers and examiners.”
The manual also covers the testing requirement: “Independent testing for the effectiveness of the compliance program conducted by qualified personnel of the [bank] or by a qualified outside party;”
Banks that have instituted independent testing of compliance throughout their business may already have a methodology that can be used here. Banks that have not will have to make several decisions about the testing, including:
– Whether to contract the testing function to an outside firm or use internal re-sources.
– If internal resources, how to ensure that the testing is independent of the departments being tested.
– How often to test, and how to handle the test results.
Whichever is true, because of the nature of the VR, testing will have to cover three instances:
- Transactions that clearly violate the Rule,
- Transactions that clearly comply with the Rule, and
- Transactions that require approval before being executed.
Part of the testing compliance program will be to specify how often each test must be run, and whether any market or internal events would require an unscheduled round of testing.
And then there’s training, perhaps the most important requirement. According to the manual, “There are four groups who will need to be trained on the Rule: traders, their managers, information technology, and the Compliance Department. Based on the structure of the Rule, banks will have to construct two kinds of training for each group: training on what kinds of transactions the Rule allows and disallows, and training on the documentation of trades and linkage to exemptions. Because the Rule requires the collection and preservation of a large amount of data, the Information Technology Group will have to be trained on the collection, storage, organization and presentation of the data.
As trading strategies within a bank adapt to market changes, as customer expectations change, and as the instruments themselves evolve, the training will have to keep pace with all these changes. Thus the bank will not only have to provide and require participation in regularly updated training programs for current personnel, it will have to provide a way of rapidly disseminating updates to compliance strategies, descriptions and exemption linkages to traders, managers, and compliance staff.”
And last, there is record keeping. The rule says about this requirement, in its entirety:
Making and keeping records sufficient to demonstrate compliance with section 13 of the BHC Act and this part, which a [bank] must promptly provide to [Agency] upon request and retain for a period of no less than 5 years.
The manual points out that, “This would be a standard compliance rule except, for the large volume of data required to be captured, and the nature of the linkages between exempt transactions and the related underwriting or market-making activities. The most useful reporting method will be to embed linkage codes into the exempt transactions which will be used in generating regulatory reports. However, compliance may require that additional information about sources of revenue and personnel compensation be included in any report.”
In the next article, I’ll cover a set of specific requirements that are common to all the exemptions.
