The proprietary trading prohibition in the Volcker Rule relates to trading as “principal” for the “trading account” of a “banking entity” in any purchase or sale of one or more “financial instruments”. A “trading account” is any account used for acquiring or taking positions in financial instruments principally for the purpose of selling in the near-term or with the intent to resell in order to profit from short-term price movement, short-term arbitrage or hedging such resulting positions. A trading account can generally be contrasted with an investment account that is maintained for longer term appreciation. If a banking entity calculates risk-based capital ratios under the market risk capital rule, trading of financial instruments that are both market risk capital covered positions and trading positions (or related hedges) constitute proprietary trading.
Purchases and sales of financial instruments for its own account by a registered dealer, swap dealer or security-based swap dealer affiliate for any purpose within the scope of its dealing activities constitutes proprietary trading. In the supplementary commentary accompanying the text of the final rule, the Agencies noted that positions held by a registered dealer in connection with its dealing activity are generally held for sale to customers upon request or otherwise support the firm’s trading activities, which is indicative of trading intent. These types of activities conducted outside of the United States also constitute proprietary trading. Therefore, subject to the exemptions discussed below, all trading activities by registered broker-dealers and their foreign equivalents, such as Canadian investment dealers, are subject to this prohibition.
In addition, a purchase and sale of a financial instrument is subject to a rebuttable presumption that it is for the trading account of a banking entity if it is held for fewer than 60 days or the risk of the financial instrument is substantially transferred within such period. However, the Agencies did not adopt the converse of this presumption. Therefore, a purchase or sale of a financial instrument that is held for more than 60 days does not necessarily mean that it is not for the trading account of a banking entity.
As used in the Volcker Rule, financial instruments consist of the following:
- securities, including options on securities;
- derivatives (including swaps and security-based swaps), including options on derivatives and forwards;7 or
- commodity futures, or commodity futures options.
Since the U.S. securities law definition of “security” is utilized, loan syndications, highly-rated short term commercial paper, and spot transactions in physical commodities such as gold, among other non-securities, are not subject to the Volcker Rule.
Although there are limited exemptions to the broad ban on proprietary trading for banking entities, for foreign entities, the Agencies have crafted two important exemptions that help mitigate the extraterritorial effects of the proprietary trading prohibition.
A. Foreign Sovereign Debt Exemption
The proprietary trading prohibition does not apply to financial instruments that are sovereign debt obligations (including debt obligations of multinational central banks, such as the European Central Bank, of which the foreign sovereign is a member), including obligations of agencies and political subdivisions of that sovereign, in cases in which:
- the banking entity is organized or is controlled by an entity organized under the laws of the foreign sovereign, and is not directly or indirectly controlled by a top-tier banking entity organized in the United States;
- the financial instrument is an obligation of such a foreign sovereign; and
- the purchase or sale is not made by an insured depository institution.
A similar exemption is afforded to a foreign entity that is a foreign bank or regulated by the foreign sovereign as a securities dealer, even if controlled by a top-tier U.S. bank, provided that the financial instrument is owned by the foreign entity and is not financed by an affiliate located in the United States or organized under U.S. law. The Agencies noted, however, with respect to this exemption, that they intend to monitor activity of banking entities to ensure that U.S. banking entities are not seeking to evade the restrictions of the Volcker Rule by using an affiliated foreign bank or broker-dealer to engage in proprietary trading in foreign sovereign debt on behalf of or for the benefit of other parts of the U.S. banking entity.
The foregoing exemption provides a weak parallel to the full exemption under the U.S. securities laws for U.S. sovereign, political subdivision (including municipal) and agency securities by any banking entity.
B. “Solely Outside the United States” Foreign Banking Exemption
The Agencies have also afforded a circumscribed exemption for certain proprietary trading activities of foreign banking entities conducted “solely outside of the United States”. The final version of this exemption significantly expands on the exemption that had been proposed and that had been widely criticized by the international banking community. However, the Agencies still placed a number of conditions on the availability of the foreign banking exemption, as outlined below. In the supplementary commentary accompanying the final rule, the Agencies noted that these conditions were designed to ensure that any foreign banking entity engaging in trading activity under this exemption would do so in a manner that ensures that the risk, decision-making, arrangement, negotiation, execution8 and financing of the activity occurs solely outside of the United States.
The foreign banking exemption is applicable to the purchase and sale of any financial instrument if:
- The banking entity is not organized or directly or indirectly controlled by a banking entity organized in the United States;
- The foreign banking organization (e.g., generally, a foreign bank that operates a branch, agency or commercial lending company subsidiary in the United States) meets the “qualifying foreign banking organization” requirements of Federal Reserve Board Regulation K;9
- The activity or investment by the banking entity is pursuant to paragraph (9) or (13) of section 4(c) of the BHC Act10;
- The banking entity engaged in the principal transaction, including any personnel of the banking entity or its affiliate, “that arrange, negotiate or execute such purchase or sale” is not located in the United States or organized under U.S. law;
- The transaction, including any risk-mitigating hedging, is not accounted for as principal or on a consolidated basis by any branch or affiliate located in the United States or organized under U.S. law;
- No financing is provided for such transactions directly or indirectly by any branch or affiliate located in the United States or organized under U.S. law; and
- The purchase or sale is not conducted with or through any U.S. entity, other than (A) a transaction with the foreign operation of a U.S. entity if no personnel of such U.S. entity located in the United States are involved “in the arrangement, negotiation, or execution” of the transaction; (B) a transaction with an unaffiliated market intermediary (either a U.S. registered broker-dealer, swap dealer, security-based swap dealer or futures commission merchant or such entity that is exempt from registration) acting as principal, provided the transaction is promptly cleared and settled through a clearing organization; or (C) a transaction with an unaffiliated market intermediary acting as agent, provided that the transaction is executed anonymously on an exchange or similar trading venue and promptly cleared and settled through a clearing organization.
While personnel located in the United States acting for the foreign entity cannot be involved in soliciting, arranging, negotiating, making the decision to transact, or executing a transaction, personnel performing back office functions, such as clearing and settlement, would be able to do so in the United States.11
For purposes of this exemption, a “U.S. entity” is considered to be any entity that is, or is controlled by, or is acting on behalf of, or at the direction of, any other entity that is located in the United States or organized under the laws of the United States or any state. A U.S. branch, agency or subsidiary of a foreign banking entity is considered to be located in the United States. However, the foreign banking entity is not treated as being located in the United States solely by virtue of operating or controlling such an office or subsidiary.
C. Other Available Exemptions
Examples of the constraints arising from the strict conditions applicable to the sovereign debt exemption and “solely outside the United States” foreign banking exemption include the following:
- U.S.-based personnel will not be able to manage portfolios for their parent companies beyond the scope of these additional exemptions. This will impose a human resources constraint on foreign banking entities since personnel will need to be based outside of the United States even if U.S. markets are involved or the most skilled traders in particular financial instruments reside in the United States.
- If a U.S. subsidiary, including a U.S.-based registered broker-dealer, is required to be consolidated for accounting purposes, it is not clear how transactions effected under the foreign banking exemption could be excluded from the effect of such consolidation. If it can be “de-consolidated”, this may have adverse financial consequences for the banking group.
- As noted above, the Volcker Rule added two additional exemptions for transactions by a foreign bank with unaffiliated market intermediaries (such as unaffiliated registered broker-dealers), thus preserving the prohibition on entering into a proprietary trading transaction with an affiliated U.S. banking entity. If the market intermediary is acting as agent, then the transaction also must be conducted anonymously on an exchange or trading facility. The Agencies have acknowledged that an anonymous trade could result in a transaction between a foreign bank and its U.S. affiliate, but they have concluded that this is an acceptable consequence so long as the trade is indeed anonymous. Nevertheless, many foreign banking entities will need to reorganize their methods of executing transactions in U.S. markets, even for foreign-based U.S. exchange-listed securities, to utilize unaffiliated market intermediaries for both principal and agency transactions. Thus, foreign entities are substantially denied the benefits of having an affiliated U.S. broker-dealer to facilitate their own U.S. trading activities. Related hedges effected in the United States will also have to be effected with unaffiliated U.S. intermediaries. This will increase execution costs and complexities for foreign banks. Foreign banks will also, as a result, be forced to disclose sensitive proprietary trading information to unaffiliated U.S. entities.
In light of these constraints, it is important to note that the “solely outside the United States” foreign banking exemption and the home country sovereign debt trading exemption are not the only exemptions from the proprietary trading ban that may be utilized by foreign banking entities and their affiliates. There are also certain other exemptions that may be available to foreign entities, including heavily conditioned exemptions for:
- repurchase agreements and securities lending on the basis that such transactions resemble secured loans;
- transactions effected as agent, broker or custodian;
- underwriting and market-making activities;
- risk-mitigating hedging activities; and
- riskless principal transactions, on the basis that if an offsetting order is in hand, such transactions resemble agency transactions.
Certain of these other exemptions are discussed in the sections that follow.
D. Underwriting Exemption
Underwriting activities of a banking entity are exempted from the proprietary trading prohibitions only if:
- The banking entity is acting as an “underwriter” for a “distribution” of securities and the trading desk’s “underwriting position” is related to such distribution;
- The amount and type of the securities in the trading desk’s underwriting position are designed not to exceed the reasonably expected near term demands of clients, customers or counterparties, and reasonable efforts are made to sell or otherwise reduce the underwriting position within a reasonable period of time, taking into account the liquidity, maturity and depth of the market for the relevant type of security (unlike in normal underwriting practice, so called “Sticky Deal” securities cannot merely be moved to the firm’s investment account);
- An internal compliance program is established that is reasonably designed to ensure the banking entity’s compliance with the requirements of the underwriting exemption, including written policies and procedures, internal controls, analysis and independent testing;
- The compensation arrangements for persons performing the underwriting activities are designed not to reward or incentivize prohibited proprietary trading; and
- The banking entity is appropriately registered to conduct underwriting activities.
For purposes of this exemption, a “distribution” is either a U.S.-registered offering or any other offering of securities that is distinguished from ordinary trading transactions by the presence of special selling efforts and selling methods. Offerings that qualify as distributions include, among other offerings, private placements made in reliance on the SEC’s Rule 144A or Rule 506 of Regulation D or other available exemptions and, to the extent that commercial paper being offered is a security, commercial paper offerings that involve the underwriter receiving special compensation.
Unlike the SEC Regulation M definition of distribution (governing purchases and offers to purchase during a distribution and market stabilization), the definition used in the Volcker Rule excludes the magnitude of the offering as a relevant factor.12 However, the Agencies noted that they would rely on the same factors considered under Regulation M to analyze the presence of special selling efforts and selling methods, including, delivering a sales document (e.g., a prospectus or offering memorandum), conducting road shows, and receiving compensation that is greater than that for secondary trades but consistent with underwriting compensation.
For purposes of the exemption, an “underwriter” is defined as:
- a person who has agreed with the issuer or selling security holder to:
(A) Purchase securities from the issuer or selling security holder for distribution;
(B) Engage in a distribution of securities for or on behalf of the issuer or selling security holder; or
(C) Manage a distribution of securities for or on behalf of the issuer or selling security holder; or
- A person who has agreed to participate or is participating in a distribution of such securities, i.e., a selling group member.
The definition of “underwriter” includes members of an underwriting syndicate or selling group. Engaging in the following activities may indicate that a banking entity is acting as an underwriter as part of a distribution of securities:
- assisting an issuer in capital-raising;
- performing due diligence;
- advising the issuer on market conditions and assisting in the preparation of a registration statement or other offering documents;
- purchasing securities from an issuer, a selling security holder, or an underwriter for resale to the public;
- participating in or organizing a syndicate of investment banks;
- marketing securities; and
- transacting to provide a post-issuance secondary market and to facilitate price discovery.
A trading desk’s underwriting position constitutes the securities positions that are acquired in connection with a single distribution for which the banking entity is acting as an underwriter. A trading desk may not aggregate securities positions acquired in connection with two or more distributions to determine its “underwriting position”. A trading desk may, however, have more than one “underwriting position” at a particular point in time if the banking entity is acting as an underwriter for more than one distribution. Therefore, the underwriting exemption’s requirements pertaining to a trading desk’s underwriting position will apply on a distribution-by-distribution basis.
Unlike the way securities practitioners generally think of a “U.S. distribution”, a distribution for purposes of the underwriting exemption will include foreign SEC Regulation S distributions of all categories. Thus, this exemption will potentially affect local underwriting practices of banking entities on a worldwide basis unless, instead, the foreign banking exemption, discussed above, can be utilized. It will also apply to Rule 144A transactions not conducted on a riskless principal basis.
For firms that effect a foreign public offering in conjunction with a U.S. private placement conducted on an agency basis or in a riskless principal Rule 144A transaction, if these transactions are conducted as separate distributions, it may be possible to effect the foreign offering under the foreign banking exemption and the U.S. portion under the exemptions for agency and Rule 144A transactions, without resorting to the underwriting exemption. If this is the case, then foreign underwriting practices would not be affected by the limitations in the underwriting exemption. This position is consistent with the non-integration of these offerings for U.S. securities law purposes and the need to use separately licensed entities and personnel in such offerings. However, it remains uncertain whether dually-registered personnel of these distinct entities located outside of the United States, acting in distinct capacities, can be used in both distributions. These matters will need to be clarified with the staff of the functional regulators.
This position may potentially apply in the case of offerings using the Canada-U.S. multi-jurisdictional disclosure system in which an underwriting commitment is entered into by a Canadian investment dealer and U.S. offers and sales are made by an affiliated U.S. registered broker-dealer on an agency basis. If these offerings can be viewed as distinct, separate exemptions could also be utilized. However, in many of these cases, dually registered personnel are utilized, so clarification concerning this issue will be needed.
Under the terms of the underwriting exemption, it appears that an underwriter’s compensation warrants or other stock-based compensation would not constitute an underwriting position since these units would be for compensation rather than in connection with a distribution and, therefore, would not fit within the underwriting exemption. Since such compensation arrangements are common in Canadian and other foreign investment banking transactions, the foreign banking exemption may instead be useful in this context with the foreign investment banking affiliate exclusively receiving such compensation. Such compensation could be received for the investment account of a U.S. firm rather than for its trading account, but the resale of such securities would be subject to more restrictive conditions than under the foreign banking exemption because of the 60 day holding presumption noted above.
E. Market Making-Related Activities
As noted above, another exemption from the ban on proprietary trading was created for market-making related activities. Market making-related activities are exempted from the proprietary trading ban if:
- The trading desk that establishes and manages the financial exposure routinely stands ready to purchase and sell one or more types of financial instruments related to its financial exposure and is willing and available to quote, purchase and sell, or otherwise enter into long and short positions for those types of financial instruments for its own account in commercially reasonable amounts and throughout market cycles on a basis appropriate for the liquidity, maturity, and depth of the market for the relevant types of financial instruments;
- The amount, types, and risks of the financial instruments in the trading desk’s market maker inventory are designed not to exceed, on an ongoing basis, the reasonably expected near term demands of clients, customers, or counterparties, based upon the particular financial instruments and demonstrable analysis of historical customer demand, current inventory and market and other factors, including block trades;
- A compliance program is in place that is reasonably designed to ensure the banking entity’s compliance with the requirements of this exemption;
- To the extent any trading limit based on the nature and amount of the trading desk’s market making-related activities outlined in the firm’s compliance program is exceeded, the trading desk takes action to bring the trading desk into compliance with the limits as soon as possible after the limit is exceeded;
- Compensation arrangements do not reward or incentivize prohibited proprietary trading; and
- The banking entity is licensed or registered to conduct these activities.
For these purposes, a trading desk or other organizational unit of another banking entity cannot be treated as a customer, client or counterparty if that other entity has trading assets and liabilities of $50 billion or more, unless the trading desk documents why they should be treated as such an entity or the transaction is conducted anonymously on an exchange or trading facility that permits trading by a broad range of market participants.
Under this exemption, affiliated broker-dealers would need to be approved by the Financial Industry Regulatory Authority, Inc. (“FINRA”) (or foreign regulators in foreign markets) to engage in market-making activities and be permitted to act in this capacity on marketplaces on which such activities are conducted. In addition to being appropriately registered in this manner, the broker-dealer would need to demonstrate consistency and substantial market-making activity, whether effected on an exchange, alternative trading systems or in other over-the-counter markets, either domestically or in foreign markets, in order to rely on this exemption. Thus, practices such as withdrawing from market making during periods of market stress or auto-quoting away from the market may disqualify a firm from relying on the exemption if not combined with robust bona fide market-making activities.
F. Risk-Mitigating Hedging Activities
The prohibition on proprietary trading also exempts risk-mitigating hedging activities. These activities are permitted in connection with, and related to, individual or aggregated positions, contracts, or other holdings of the banking entity that are designed to reduce the specific risks to the banking entity in such connection. Risk-mitigating hedging activities of a banking entity are permitted if the following conditions are met:
- the banking entity has established and implements a compliance program that is reasonably designed to ensure the banking entity’s compliance with this exemption;
- the risk-mitigating hedging activity is conducted in accordance with the compliance program; and at the inception of the hedging activity, the risk-mitigating hedging activity is designed to reduce or otherwise significantly mitigate and reduce specific, identifiable risks correlated with an underlying position, including market risk, counterparty or other credit risk, currency or foreign exchange risk, interest rate risk, commodity price risk, basis risk or similar risks arising in connection with and related to identified positions, contracts, or other holdings of the banking entity; and does not give rise, at the inception of the hedge to any significant new or additional risk that is not itself hedged contemporaneously; and is subject to continuing review, monitoring and management by the banking entity; and
- the compensation arrangements of persons performing the risk-mitigating hedging activities are designed not to reward or incentivize prohibited proprietary trading.
As noted above, the determination of whether an activity or strategy is risk-reducing or mitigating must be made at the inception of the hedging activity.13
G. Trust Preferred Securities
Although not originally permitted under the final rule, the Agencies issued a supplemental interim final rule (the “Supplemental Rule”), effective April 1, 2014, that also permits banking entities to retain interests in certain collateralized debt obligations that are backed primarily by trust preferred securities (TruPS CDOs).14 Under the Supplemental Rule, banking entities may retain an interest in TruPS CDOs if the TruPS CDO was established, and the interest was issued, before May 19, 2010, the banking entity reasonably believes that the offering proceeds received by the TruPS CDO were invested primarily in Qualifying TruPS Collateral and the banking entity’s interest in the TruPS CDO was acquired on or before December 10, 2013.15
Qualifying TruPS Collateral means any trust preferred security or subordinated debt instrument that was issued prior to May 19, 2010, by a depository institution holding company that as of the end of any reporting period within 12 months immediately preceding the issuance of such trust preferred security or subordinated debt instrument, had total consolidated assets of less than $15 billion, or a trust preferred security or subordinated debt instrument that was issued prior to May 19, 2010 by a mutual holding company.
H. Limitations on Exemptions
Notwithstanding the exemptions from the proprietary trading ban described above, transactions will be deemed to be impermissible if they:
- Involve or result in a material conflict of interest with the entity’s clients, customers or counterparties and such conflict has not been mitigated by timely and effective disclosure and/or information barriers;
- Result, directly or indirectly, in a material exposure to a high-risk asset or a high-risk trading strategy; or
- Pose a threat to the safety and soundness of the banking entity or to the financial stability of the United States.
A “high-risk asset” means an asset or group of assets that would, if held by a banking entity, significantly increase the likelihood that the banking entity would incur a substantial financial loss or would pose a threat to the financial stability of the United States. A “high-risk trading strategy” includes any strategy that would, if engaged in by a banking entity, significantly increase the likelihood that the banking entity would incur a substantial financial loss or would pose a threat to the financial stability of the United States. The Agencies have not identified any particular assets or trading strategies that are per se high-risk, noting instead that a determination of whether a particular asset or strategy is “high-risk” depends on the particular facts and circumstances. However, the amount of capital at risk in a transaction, whether or not the transaction can be hedged, the amount of leverage present in the transaction and the general financial condition of the banking entity engaging in the transaction, should be considered.