Non-US banks will not escape the net of national measures aimed at prohibiting proprietary trading at American institutions, according to one leading lawyer.
Designed to prevent banks registered in the US from engaging in what are perceived to be high-risk, high-reward activities, such as proprietary trading, the Volcker rule is part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, drafted jointly by the Federal Deposit Insurance Corporation, the Securities and Exchange Commission, the Federal Reserve and the Department of Treasury.
But the rules apply to any banking entity – including foreign banks – which have a presence in the US or employ American residents, warned Mike Dunn, US corporate finance partner at international legal practice Norton Rose.
“All US branches belonging to any foreign bank are banned from prop trading,” said Dunn. “The rules are also surprisingly limiting in respect of activity outside the US. Almost all types of prop trading by a US bank – whether inside or outside the US – would be completely banned.”
Except where explicitly permitted in the Volcker rule, US banks will be banned from conducting all proprietary trading, defined as “engaging in the purchase or sale of one or more covered financial positions as principal for the trading account of the banking entity”.
Since the ban applies to all companies incorporated in the US, any foreign offices or branches will also be banned from prop trading, no matter where in the world they are. Furthermore, any resident of the United States is banned from prop trading – potentially causing difficulties even for non-US banks that employ US staff. Accounts held offshore for the benefit of US residents are also banned from involvement in prop trading.
Under these broad and sweeping restrictions, a transaction can only be determined to have occurred completely outside the US – and therefore outside the scope of Volcker – if it is conducted by a banking entity not organised in any way under US law, with no party resident in the US, using no personnel of any bank physically located in the US, with no part of the transaction conducted within the US.
The impact of the rules on foreign banks has already been criticised, with some market participants complaining such a heavy-handed solution is likely unworkable long-term.
“Vague language in the proposed rules could be interpreted to mean that, if two UK banks are trading a US stock, they will be prohibited from prop trading in that stock,” said Dunn. “The impact is far-reaching and may cause damage to the ability of foreign banks to interact with international capital markets, as well as the quality of their relationships with their US counterparts.”
In addition, some banks may now be reconsidering their status as ‘holding companies’, as a means of avoiding the Volcker rule, suggested Dunn – although, he conceded the current draft may yet change significantly as it goes through the public comment process between now and the end of the year.
A recent report by law firm Allen & Overy argues that foreign banks will face a “disproportionate burden” from the Volcker rule, which extends into many other jurisdictions beyond the US.
“Even if a foreign bank successfully fulfils the conditions, that bank will still inherit a tremendous ongoing compliance burden to show US regulators that each and every trade complies,” states the document.
It also notes that since no personnel of the banking entity that is directly involved in the transaction can be physically located in the United States, foreign banks may simply move operations and personnel outside of the US to avoid coming under the rule.
Furthermore, its impact on market makers has been called into question, with some commentators arguing that the division between prop trading and genuine market making is not sufficiently rigorously defined. Since market making is effectively allowed via exemption, it is argued market makers will be forced to comply with burdensome record keeping duties that will only add further costs to their activities – a situation which Dunn considers hardly likely to be popular with market participants, and might simply result in reduced market maker activity and less efficient markets.
The Volcker rule is named after former Federal Reserve chairman Paul Volcker, who proposed that US banks’ proprietary trading activities and investments in private equity and hedge funds be restricted in order to reduce risk in the US banking system.
A draft released on 30 September requests feedback on over 150 questions and confirms that the proposed rules are scheduled to take effect on 21 July 2012.