Sunday, January 01, 2012

Canadian Bank Regulator Urges Volcker Rule Proprietary Trading Exemption for Foreign Government Securities

The proposed regulations implementing the Volcker Rule provisions of the Dodd-Frank Act could inadvertently hinder the ability of foreign financial institutions to efficiently manage their risks, thereby potentially undermining the financial condition of those entities and the systemic stability of foreign financial systems, in the view of the prudential regulator of Canadian banks. In a letter to the SEC and the federal banking agencies, Julie Dickson, Superintendent, Financial Institutions of Canada, said that these concern are especially acute given the deep inter-linkages between the Canadian and US financial systems.

Canadian financial institutions use US-owned infrastructure to conduct financial transactions in support of their market making activities in Canada, said the Superintendent, and in their risk management activities more broadly in support of their Canadian and US banking operations. For example, Canadian financial institutions actively rely on the systems operated by The Depository Trust & Clearing Corporation (DTCC) for clearing and settlement of transactions involving US securities. Moreover, they regularly employ US financial exchanges for transacting futures and options derivatives involving both Canadian dollar and other currencies to manage financial risk exposures.

The draft regulations would only allow proprietary trading by banking entities in US Treasury, state, and municipal general, limited, and pass-through obligations. Question 122 of the consultative document asks whether US federal regulators should adopt an additional exemption for proprietary trading in the obligations of foreign governments and international and multinational development banks.

The Superintendent believes that additional exemptions from the restrictions on proprietary trading should be given to foreign government securities, at least for banking groups whose parent bank is located outside of the US. Many foreign banks play important market making roles in the trading of government securities in their home jurisdictions, she noted, and they also actively rely on government securities of their home jurisdiction to efficiently manage their liquidity and funding requirements at a global enterprise level.

This is a practice that will be further reinforced in the future by new bank liquidity requirements that have been proposed by the Basel Committee on Banking Supervision. Thus, the Superintendent believes that a failure to include these additional exemptions, at least for banking entities with parents outside of the US, would undermine the liquidity of government debt markets outside of the US and could significantly impede the ability of foreign banks to efficiently manage their liquidity and funding requirements at an enterprise-wide level.

More broadly, the Superintendent urged the SEC and other federal regulators implementing the Volcker Rule to keep in mind that US financial institutions and markets, and their supporting infrastructure, are deeply connected to the broader global financial system. Indeed, in many cases they represent core segments for global financial inter-mediation. Thus, when implementing reforms like the Volker Rule, emphasized Ms. Dickson, it is important to not only focus on the implications for the US financial system, but also to take care that these restrictions do not give rise to prudential issues for other jurisdictions.