The Financial Stability Oversight Council, including the SEC, CFTC and the Fed, has kicked off the rulemaking under the Volcker provisions of Dodd-Frank with a study and recommendations. Dodd-Frank commands that the federal financial regulators adopt final regulations implementing the Volcker provisions within nine months of the study and that they consider the recommendations of the Council in adopting such regulations. The regulations must erect a comprehensive compliance and oversight regime focused on monitoring and enforcing the two prongs of the Volcker provisions: 1) the prohibition on impermissible proprietary trading and 2) impermissible investments in and sponsorship of hedge fund and private equity funds. CFTC Chair Gary Gensler noted that the study provides a basis on which the regulators can move forward with the required rule-writing to carry out the Dodd-Frank mandate, particularly noting that the study helps prevent regulatory arbitrage by covering both the cash and derivatives markets.
As a preliminary matter, the Council suggested that the new Office of Financial Research established by Dodd-Frank could assist regulators in enforcing the Volcker Rule‘s prohibitions. For instance, the SEC and CFTC will have access to significant amounts of new data that must be reported as part of oversight of the derivatives markets. Further, by utilizing this trade data, OFR may be able to help analyze effective metrics over time as a key research project.
The Council sets out both a holistic and specific approach to the Volcker rulemaking. Holistically, the Council recommends that the implementation of the Volcker Rules be guided by five principles, which are intended to ensure that the Volcker Rules will strictly prohibit impermissible proprietary trading while allowing permitted activities that benefit consumers and the economy. First, the regulators should build a programmatic compliance regime using all available tools, including attestation, analytical metrics, and examination resources to evaluate metrics and to detect prohibited proprietary trading. Second, the regulations should be dynamic and flexible. Third, the regulations should allow for comparisons among regulated financial institutions. Fourth, the regulations should facilitate the predictable evaluation of outcomes. Fifth, the regulations should account for differences among asset classes, such as the uniqueness of derivatives.
The Volcker Rule mandates that financial institutions cease proprietary trading, except for permitted activities such as market making and hedging. Since significant proprietary trading can take place in the context of activities that would otherwise be permitted by the statute. FSOC said that an essential part of implementing the Volcker provisions is creating a regulatory regime that effectively prohibits proprietary trading activities throughout the entity, not just within certain business units, and that appropriately distinguishes between prohibited proprietary trading and permitted activities.
The four primary exceptions to the Volcker Rule on proprietary trading, and also those that present the most challenge for regulators in differentiating prohibited proprietary trading from permitted activities, are market making, risk-mitigating hedging, underwriting, and transactions on behalf of customers.
Since market making often includes elements of proprietary trading, regulators were cautioned to be vigilant to ensure that firms do not conceal impermissible proprietary trading activities within larger market making operations. Also, with regard to market making, application of the principle of differentiating among asset classes will be very important.
For example, in the case of over-the-counter derivatives markets, which are structured differently from liquid securities markets, market making typically entails a customer-initiated transaction involving a bespoke financial instrument. The trading desk provides the customer with a price and upon execution will hold the financial instrument in its portfolio. As these are customized derivatives, they do not typically have a matching offset. The market making desk will typically dynamically hedge to offset the exposures. The ability to hold inventory in this context is a presents a major complexity since the same inventory built with the intention of facilitating liquidity for clients could also be built with the intention of engaging in impermissible proprietary trading. Consequently, a key challenge for the regulations will be to identify inventory levels that are appropriate to facilitate client-driven transactions but not to take prohibited proprietary risks.
Regarding the hedging exception, federal regulators were advised to consider factors such as the nature of the risks being hedged; the extent to which banks measure, monitor and control risks at a portfolio level; the extent to which portfolio hedging is part of an entity‘s formal hedging strategy; whether traders are compensated based on earnings generated by portfolio hedging activity; and the overall efficacy of portfolio hedging activities in reducing risk throughout the firm, and the methods allowing regulators to determine which desk-specific positions are being hedged on an aggregate basis.
All of the permitted activities are subject to a Dodd-Frank backstop that prohibits these activities if they result in a material conflict of interest, result in material exposure to high-risk assets or high-risk trading strategies, pose a threat to safety and soundness, or pose a threat to financial stability
In addition to requiring firms to sell or wind down all impermissible proprietary trading desks, noted FSOC, the regulations should also require the divestiture of impermissible proprietary trading positions and the imposition of penalties when warranted. Firms should also be required to perform quantitative analysis to detect potentially impermissible proprietary trading without provisions for safe harbors. There must be a review of trading activity to distinguish permitted activities from impermissible proprietary trading. Further, firms should be required to employ a mechanism that identifies to regulators which trades are customer-initiated.
The recommendations also identify indicia of permitted activities that will help prevent banking entities from migrating proprietary trading activities into areas of the banking entity that otherwise conduct permitted activities. Implementing these indicia-based tests would require certain banking entities to change their business practices to bring trading activities into compliance with the statutory definitions of the permitted activities.
The regulations should also bake in a corporate governance component under which the board of directors and the CEO are effectively engaged in and accountable for compliance with the prohibition on impermissible proprietary trading. More specifically, the board and the CEO should develop a program reasonably designed to achieve compliance with the Volcker Rule. For example, the board could be made responsible for such matters as: approving the compliance program; overseeing the structure and management of the firm’s compliance with the Volcker Rule; setting an appropriate culture of compliance; and ensuring that these policies are adhered to in practice.
The CEO could be made responsible for communicating and reinforcing the compliance culture established by the board, implementing the program, reporting to the board and regulators on the effectiveness of the program, and escalating compliance matters as appropriate. FSOC expects that programs approved by the board and the CEO will designate an individual or individuals responsible for compliance and will include training for appropriate personnel. In order to ensure the highest level of accountability, the CEO should be required to attest publicly to the ongoing effectiveness of the internal compliance regime.
Prohibition on Sponsoring Hedge Funds
The Volcker Rule prohibits hedge fund and private equity fund sponsorship or investment by financial institutions except in narrow circumstances. A financial institution is allowed to organize and offer a fund to its bona fide trust, fiduciary, and investment advisory customers. The firms are not permitted to invest in these types of funds beyond a specified de minimis amount in order to establish funds and attract unaffiliated investors in connection with their customer-related business.
The hedge fund and private equity fund provisions generally prohibit a financial institution from investing in, or having certain relationships with, any fund that is structured under exclusions commonly used by hedge funds and private equity funds under the Investment Company Act of 1940. In other words, under the Volcker Rule, hedge funds and private equity funds are defined only as issuers that rely on the exclusion from the definition of investment company under sections 3(c)(1) or 3(c)(7) of the 1940 Act or such similar funds as the regulators determine.
Sections 3(c)(1) and 3(c)(7) of the 1940 Act provide exclusions from the definition of investment company for an issuer that is not making and does not presently propose to make a public offering of its securities and either has outstanding securities that are beneficially owned by not more than one hundred persons or has outstanding securities that are owned exclusively by qualified purchasers
Although widely used by traditional hedge funds and private equity funds, noted FSOC, these statutory exclusions were not designed to apply only to such funds. As such, they do not specifically address or closely relate to the activities or characteristics that are typically associated with hedge funds or private equity funds. Thus, in implementing the Volcker Rule, FSOC advised regulators to consider criteria for providing exceptions with respect to certain funds that are technically within the scope of the hedge fund and private equity fund definition in the Volcker Rule but that Congress may not have intended to capture in enacting Dodd-Frank.
Conversely, not all investment vehicles that share the characteristics of traditional private equity funds or hedge funds rely on the exclusions contained in Section 3(c)(1) or 3(c)(7). Congress recognized this by authorizing regulators bring similar funds within the scope of the Volcker Rule. FSOC noted that it is possible to create an investment fund pursuing a hedge fund or private equity fund strategy in reliance on other sections of the Investment Company Act which therefore would not necessarily be captured by the Volcker Rule definition of hedge fund and private equity fund.
FSOC is essentially advising regulators to expand the statutory definition by bringing under the Volcker Rule funds that engage in the activities or have the characteristics of a traditional private equity fund or hedge fund by deeming them similar funds. In determining which funds should be brought within the scope of the Volcker Rule as similar funds, FSOC said regulators should consider the investment activities and other characteristics of such funds, including related compensation structure, trading strategy, the use of leverage, and the investor composition of the fund.
The Volcker Rule requires that organized or sponsored funds only be offered to customers of the financial institution. The term customer is not defined in the statute. The study outlines factors that regulators should consider in determining who is a customer and the necessary nature of that relationship. For example, regulators should consider whether there is a continuing or previous relationship with the firm, whether the relationship is direct or through an agent, and whether the relationship was initiated by the potential customer.
The de minimis investment calculation applies both to restrict the exposure of a firm to 3% of any single fund and to limit the its aggregate exposure to 3% of Tier 1 capital. Regulators should calculate these limits in a manner requiring full accounting of the firm’s risk and requiring ongoing monitoring of these limits through the life of the fund.
The regulations should also require financial institutions to establish internal programmatic compliance regimes that will involve strong investment and risk oversight of permissible hedge fund and private equity fund activities with engagement by the board of directors and public attestation of the adequacy of such compliance regime by the CEO. In addition, in the limited instances in which a firm is permitted to invest in a hedge fund or private equity fund to facilitate customer-related business, disclosure of the nature and amount of any such investment should be mandated.