Exceptions for securities lending and certain types of market making and customer facilitation trades will be included in the Volcker rule that bans proprietary trading by banks licenced in the US, according to a draft version.
Part of the Dodd-Frank Act, the Volcker rule is due to be released by the Federal Deposit Insurance Corporation on 11 October and the three other regulatory bodies involved in its drafting – the Securities and Exchange Commission, the Federal Reserve and the Department of the Treasury – shortly thereafter. The 205-page draft, dated 30 September 2011, requests feedback by 16 December and confirms that the proposed rules are scheduled to become effective on 21 July 2012.
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. The measure was included in the Dodd-Frank Act, but the detail of what constitutes proprietary trading has not been outlined by regulators until now.
The draft acknowledges that “the delineation of what constitutes a prohibited or permitted activity … often involves subtle distinctions that are difficult both to describe comprehensively within regulation and to evaluate in practice”. As such, banks will be required to report “meaningful quantitative data” to help regulators identify inadmissible trading behaviour.
Except where explicitly permitted in the 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”. However, banks may continue to act as an agent, broker or custodian for an unaffiliated third party as these roles do not involve trading as principal. The draft rule defines a bank's trading account as one in which positions are taken to achieve a short-term resale, benefit from short-term price movements, realise a short-term arbitrage profit or to hedge one or more positions. It may also include any account subject to Market Risk Capital Rules as well as any account used by a bank in its dealing activities as a securities dealer, swap dealer, or security-based swap dealer. The leaked draft defines a covered financial position as “any long, short, synthetic or other position” in a security, derivative, commodities futures contract, or an option on any of these instruments, but it does not include loan, a commodity, or foreign exchange transaction.
What it means to be American
The Volcker rule will apply to foreign banks in certain circumstances. Any bank organised under the laws of the US or any state, as well as its subsidiaries and branches, is subject to the rule as is any US subsidiary or branch of a foreign banking entity. Moreover, a transaction will only be considered to have occurred solely outside the US only if it is conducted by a banking entity not organised under US law, with no party resident of the US, no personnel of any participating bank physically located in the US, and no part of the transaction conducted within the US.
Holes in the net
Exclusions to the Volcker rule include positions that arise under a repurchase or reverse repurchase agreement, because such positions “operate in economic substance as a secured loan, and are not based on expected or anticipated movements in asset prices”. Similarly securities lending is also permitted on grounds that such trades are “a means to facilitate settlement of securities transactions”. Liquidity management transactions are also exempt if they are executed to provide a bank with sufficient liquid assets to meet its short-term cash demands. Given the potential scope to misrepresent liquidity management positions, the rule states that such transactions must be conducted in accordance with a documented liquidity management plan that meets five permitted criteria.
Underwriting and market making are permitted under the rule but only under specific conditions. Sale and purchase of positions as part of underwriting activities must “not to exceed the reasonably expected near-term demands of clients, customers, or counterparties” and must meet seven specified criteria, including establishment of an internal compliance program in accordance with the rule.
Bona fide market making
Acknowledging the difficulties of distinguishing “principal positions that appropriately support market making-related activities from positions taken for short-term, speculative purposes”, the rule outlines seven criteria that a bank's market making activities must meet before being considered ”bona fide', including implementation of “effective policies, procedures and internal controls” to ensure prohibited positions are not taken under the guise of permitted market making activity. Banks must also “report certain quantitative measurements” for each trading units.
In liquid markets, the draft states that genuine market making-related activity should include: making two sided quotes “and holding oneself out as willing to buy and sell on a continuous basis”; making purchases and sales in roughly comparable amounts to provide liquidity; making continuous quotations that are at or near the market on both sides; and providing widely accessible and broadly disseminated quotes. Hedging transactions related to market-making positions and holdings will be permitted, as will other hedges designed to “reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings”.
Acting for the customer
Other permitted activities include trading in certain government obligations, trading on behalf of customers and trading by insurance companies. A bank will be considered to be acting on behalf of a customer if it is acting as an “investment adviser, commodity trading advisor, trustee, or in a similar fiduciary capacity” in transactions where the customer is the sole beneficial owner. Other permitted transactions on behalf of customers include where the bank is acting as riskless principal and where it is trading for the separate account of insurance policyholders as bank that is an insurance company.