In my last piece, I discussed the general compliance requirements of the Volcker Rule (VR) as it was proposed in 2011. This is now timely because the Secretary of the Treasury apparently told a group of bankers recently that the final rule would be published before the end of the year. Although there may be some adjustments to the proposed requirements, we should expect the basics to remain, and that is mostly what I will cover here.
To set the stage, 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 except debt issued by the US government or a municipality. Significantly, as was pointed out by foreign governments when the rule was first published, the rule does apply to trading in foreign sovereign debt.
The rule provides a range of exemptions, from very general to those with stringent conditions attached. Two exemptions without stringent requirements relate to the financing functions of banks, so we won’t spend much time on them.
– One covers trades that arise under a repurchase or reverse repurchase agreement.
– Another covers transactions in which the [bank] lends or borrows a security temporarily.
The remaining exemptions do contain requirements, and complying with those will constitute the bulk of this manual. The remaining exemptions are:
– Transactions for…liquidity management and in accordance with a documented liquidity management plan;
– The purchase or sale of a … position … in connection with … underwriting activities;
– The purchase or sale … that is made in connection with … market making-related activities;
– The purchase or sale … in connection with… positions, contracts, or other holdings … designed to reduce the specific risks … in connection with and related to such positions, contracts, or other holdings.
– The purchase or sale … on behalf of customers;
– The purchase or sale … by an insurance company or any affiliate of an insurance company; and
– The purchase or sale…by…[a] banking entity…not…organized under the laws of the United States or of one or more States.
We can dismiss the last three exemptions as being of a very different nature, and concentrate on the first four. But before we go into each exemption specifically, let’s see if there are any requirements that apply to all four. And there are several.
Compliance Program
All three main exemptions require their own compliance program, as described below.
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… this section, including reasonably designed written policies and procedures, internal controls, and independent testing.
Although the requirement is common, the contents of the program will be different for each exemption. The program headings will generally follow the list at the beginning of each exemption section.
Dealer Status
The underwriting and market-making exemptions (but not the hedging exemption) require that the bank be a dealer in the instruments generating the exemption (“the exemption instruments”), but not necessarily in the instrument traded as principal.
The exact language for underwriting is:
The [bank] is:
(A) With respect to a purchase or sale effected [sic] in connection with a distribution of… securities, other than exempted securities, security-based swaps, commercial paper, bankers’ acceptances, or commercial bills:
- A dealer that is registered with the SEC under section 15 of the Exchange Act (15 U.S.C. 78o), or a person that is exempt from registration or excluded from regulation as a dealer thereunder; or
- 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;
(B) With respect to a purchase or sale effected as part of a distribution of…municipal securities, a municipal securities dealer that is registered under section 15B of the Exchange Act (15 U.S.C. 78o-4) or exempt from registration thereunder; or
(C) With respect to a purchase or sale effected as part of a distribution of …government securities, a government securities dealer that is registered, or that has filed notice, under section 15C of the Exchange Act (15 U.S.C. 78o-5) or exempt from registration thereunder;
The language for market-making is the same, except the references to a distribution are omitted, and the following section is added:
With respect to a purchase or sale of … swaps:
- A swap dealer that is registered with the CFTC under the Commodity Exchange Act (7 U.S.C. 1a) or a person that is exempt from registration thereunder; or
- Engaged in the business of a swap dealer outside the United States and subject to substantive regulation of such business in the jurisdiction where the business is located;
(C) With respect to a purchase or sale of … security-based swaps:
- A security-based swap dealer that is registered with the SEC under section 15F of the Exchange Act (15 U.S.C. 78o-10) or a person that is exempt from registration thereunder; or
- Engaged in the business of a security-based swap dealer outside of the United States and subject to substantive regulation of such business in the jurisdiction where the business is located.
The Rule determines dealer status based on registration, so the bank’s current registration status will be part of the documentation to be supplied to examiners should they question an exemption. For exemption instruments traded outside the U. S., the bank will need to supply its current registration status in the country of issuance.
As a practical matter, the evidence of dealer registration can be automatically added to the compliance response, based on the ID of the exemption instrument, but that means that the ID of the exemption instrument will have to be included in the trade record.
Compensation
All three main exemptions have the same compensation requirement:
The compensation arrangements of persons performing [the exempted] activities are designed not to reward proprietary risk-taking.
This language is ambiguous enough that the agencies added the following language to the rule:
Absent explanatory facts and circumstances, the trading activity of a trading unit that provides compensation incentives to employees that primarily reward proprietary risk taking will be considered to be prohibited proprietary trading, and not permitted market making-related activity.
[Agency] will base such a determination on all available facts and circumstances, including, among other things, an evaluation of: (i) the extent to which compensation incentives are provided to trading unit personnel that reward revenues from movements in the price of retained principal positions and risks; (ii) the extent to which compensation incentives are provided to trading unit personnel that reward customer revenues; and (iii) the compensation incentives provided by other covered banking entities to similarly-situated personnel.
This requirement may be a source of confusion, and possibly contention, between the bank and the examiners, so it behooves the bank to establish incentive compensation packages that are fairly uniform across all affected trading desks, and which do not expressly encourage relying on market movement. If the incentive package is based on the profitability of a trading account, the bank may want to assign higher profitability measures to positions either opened or closed with customers. Finally, it may be worth reviewing the standard incentive packages with the regulators or examiners at the time they are being instituted, in order to determine, as much as possible, whether they will cause a problem with future compliance reviews.
In the next article, I will look at the requirements for liquidity and underwriting.
