Volcker: The Final Rule

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1 DECEMBER 20, 2013 BANKING AND FINANCIAL SERVICES UPDATE Volcker: The Final Rule On December 10, 2013, the five agencies principally responsible for banking and financial market regulation in the United States (the Agencies) 1 adopted their final rule (the Final Rule) implementing the so-called Volcker Rule. 2 In doing so, not only did the Agencies bring to a close an important Dodd-Frank chapter, but they set in motion the writing of a new and similarly important one: the contours of the Final Rule ensure that the rule s requirements will evolve in practice, and that the Agencies will play a significant continuing role in determining the rule s practical meaning in the varied circumstances to which it will apply. This Sidley Update first provides an overview of several key themes associated with the Final Rule and then highlights a number of the Final Rule s most important elements. Following the overview and highlights, the Update addresses in greater detail the highlighted subject matters. Key Themes Throughout this Sidley Update, the following themes will be developed as we discuss important elements of the Final Rule and look forward to its practical application: The Agencies responded constructively to many (though not all) of the comments they received regarding their initial proposal (the Proposed Rule). 3 Although the regulatory process may not have been all that some had hoped, the outcome was collaborative, and in many respects the regulatory product was thoughtful. Facing a subject matter of great complexity proprietary trading and covered fund activities and investments the Agencies opted in important areas to define permitted activities in relatively broad, non-specific terms. For example, the hedging exemption to the prohibition on proprietary trading permits the hedging of aggregated positions across various trading desks 1 The Agencies are the Board of Governors of the Federal Reserve System (the Board), the Office of the Comptroller of the Currency (the OCC), the Federal Deposit Insurance Corporation (the FDIC), the Securities and Exchange Commission (the SEC) and the Commodity Futures Trading Commission (the CFTC). 2 Volcker Rule is short-hand for Section 13 of the Bank Holding Company Act of 1956 (the BHC Act), which was added to the statute by Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). The Final Rule implements the statutory provision. The Final Rule is available here. We note that the CFTC adopted a separate version of the Final Rule, and issued its own supplementary information, though both were substantively similar to those adopted and issued by the other Agencies. 3 The Agencies (other than the CFTC) published for public comment the Proposed Rule in October The Proposed Rule and its related preamble are available here. We discussed the Proposed Rule in a Sidley Update dated October 17, 2011, available here. Sidley Austin provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, ; One South Dearborn, Chicago, IL 60603, ; and 1501 K Street, N.W., Washington, D.C ,

2 as long as the hedging transactions address specific risks. The Final Rule provides some content for these phrases, but it will likely take iterative experience banking entities working with their regulators before the Final Rule s many nuances are understood. Perhaps because of terminology that is not overly specific, the Final Rule puts extraordinary emphasis on, and provides exceptionally prescriptive detail for, compliance programs and reporting regimes, particularly those for larger banking organizations. For example, the Final Rule addresses the oversight responsibilities of four different levels of management within a bank: boards of directors, CEOs, members of senior management and line managers. And, as to CEOs, the Final Rule imposes an annual attestation requirement. This combination of permitted-activity provisions that require significant interpretation (on the one hand) and very detailed compliance and reporting regimes (on the other) points in at least one likely direction: The Agencies intend to take an active, hands-on role in molding the application of the Final Rule to the discrete trading and covered fund activities of individual banking organizations. This approach will likely dovetail most readily with the supervisory mode in which prudential bank regulators traditionally operate; it is less clear how well it will mesh with the examination and enforcement mode to which non-bank regulators are more accustomed. The Final Rule was accompanied by supplementary information (the Supplementary Information) that runs close to 900 pages. 4 Between the Final Rule which itself is over 70 pages and the Supplementary Information, market participants have a great deal to digest. Highlights Banking Entities and Effective Dates Banking Entity Definition. The definition of banking entity remains essentially unchanged from the Proposed Rule, covering U.S. and foreign banks and their affiliates. However, the definition has been narrowed slightly in certain circumstances under the Final Rule. The Final Rule excludes from the definition of banking entity all covered funds that are not otherwise banking entities. By contrast, the Proposed Rule excluded only those covered funds organized, offered, and held by a banking entity in connection with providing bona fide trust, fiduciary, investment advisory or commodity trading advisory services. In addition, the Final Rule excludes from the definition of a banking entity any portfolio company held under merchant banking authority, provided the portfolio company is not itself a banking entity. This will help to limit the downstream applicability of the Final Rule and related bank holding company restrictions on covered funds and other portfolio companies. 4 The Supplementary Information is available here.

3 Interaction of Banking Entity and Covered Fund Definitions. As noted below, the Final Rule helpfully excludes certain additional entities from the definition of covered fund. Since those entities are not covered funds, they are not eligible for the covered fund exclusion from the definition of banking entity. As a result, an entity that is controlled by a bank but excluded from the definition of covered fund (such as a joint venture) would itself be picked up under the definition of banking entity, and thus become subject to the Final Rule s restrictions on proprietary trading and covered fund investments and activities. Effective Date and Conformance Dates. Although the Final Rule s effective date is April 1, 2014, and the conformance period provided in the statute ends on July 21, 2014, the Board extended the conformance period until July 21, 2015, subject to certain conditions. 5 In addition, there are important phase-in rules for those banks that are required to satisfy the detailed reporting requirements associated with significant permissible trading activities. Proprietary Trading Underwriting. The Final Rule broadens the scope of the definition of distribution by eliminating any reference to the magnitude of the offering. Thus, offerings of all sizes, including small offerings (involving less than 1% of an outstanding class) and private offerings, fit within the definition of distribution. Moreover, the Final Rule broadens the scope of permitted activities in connection with a distribution by eliminating the solely in connection requirement. Market Making. The definition of market making in the Final Rule routinely standing ready to purchase and sell one of more types of financial instruments modifies a more restrictive definition of market making regularly and continuously holding oneself out as a market maker on a security-by-security basis which had been modeled on a provision defining an equity market maker in the Securities Exchange Act of 1934 (Exchange Act). The final definition provides additional flexibility for a broader range of asset classes, such as fixed income securities. In addition, the Final Rule eliminates a requirement in the Proposed Rule that the market making activities of a trading desk be designed to generate revenues primarily from fees, commissions, bid/ask spreads or other income rather than the appreciation in the value of covered financial positions or the hedging of such positions. Hedging. The Final Rule allows hedging of aggregated positions so called portfolio hedging but requires that all hedging demonstrably reduce of otherwise significantly mitigate specific identifiable risks. Non-U.S. Government Securities. The Final Rule permits U.S. operations of foreign banking entities, as well as foreign affiliates of U.S. banking entities, to engage in proprietary trading in 5 The Board s Order stated, During the conformance period, each banking entity is expected to engage in good-faith efforts, appropriate for its activities and investments, that will result in the conformance of all of its activities and investments to the requirements of section 619 and the implementing rules by no later than the end of the conformance period. See Order Approving Extension of Conformance Period (December 10, 2013), available here.

4 foreign government obligations, so long as certain requirements are met. The Proposed Rule did not contain a similar exemption. Trading by Foreign Banking Entities. The Final Rule more generally authorizes a foreign banking entity, or its foreign affiliates, to engage in proprietary trading, so long as the banking entity is located outside the United States (as are any relevant personnel), is organized under non-u.s. law, and meets certain other requirements. In contrast to the Proposed Rule, which took a transaction-based approach, the Final Rule does not contain a blanket prohibition against transacting in U.S. markets or transacting with parties residing in the United States and instead focuses on whether the trading activity creates risks for U.S. banking entities. Compensation Practices. The Final Rule generally prohibits compensation practices from being designed to reward or incentivize prohibited proprietary trading. This will likely entail a host of interpretive issues for banking entities engaged in permitted trading activities. Related compliance and reporting requirements. As noted below, the Final Rule requires reporting across a broad set of trading metrics (though the number of metrics was been reduced) and sets forth extensive compliance procedures, internal controls and documentation requirements. Covered Funds Definition of Covered Fund. The Final Rule takes a fundamentally different approach to defining a covered fund than did the Proposed Rule. The Proposed Rule defined covered fund broadly, then allowed for certain permitted covered fund activities. The Final Rule instead excludes entities engaging in certain activities from the definition of covered fund (e.g., wholly-owned subsidiaries, joint ventures, loan securitizations and qualifying asset-backed commercial paper conduits) with the consequence that the related activities are removed from the scope of the Final Rule entirely. In addition, the Final Rule revises the references to commodity pools and foreign funds so as to include such entities in a more limited manner than initially proposed, which more closely aligns with the statutory goal of addressing bank activities and investments related to hedge funds and private equity funds and risks to U.S. financial markets. Definition of Ownership Interest. The Final Rule provides additional clarification by defining other similar interests which will be treated as ownership interests, though it does so in a potentially expansive way. The Agencies made clear that substance, not form, would determine whether an investment constitutes an ownership interest, noting in particular that debt securities were not excluded from consideration if they have certain equity characteristics. In addition, the definition of a restricted profit interest (referred to as carried interest in the Proposed Rule), which is excluded from the definition of an ownership interest, was also broadened somewhat in response to industry comment. Permitted Risk-Mitigating Hedge Activity. The Proposed Rule would have permitted hedging activity that resulted in the holding of ownership interests in covered funds if the activity either

5 arose out of a transaction conducted solely to accommodate a specific customer request with respect to the covered fund, or was directly connected to the banking entity s compensation of an employee investment adviser for the covered fund. The first of these exceptions was deleted in the Final Rule, and thus only compensation-related hedging is permitted, which is quite narrow. Super 23A. The Super 23A provision itself was largely unchanged. However, its scope was significantly curtailed by changes to the definition of covered fund that expanded the exclusions from the definition itself (e.g., for loan securitizations, asset-backed commercial paper conduits and public welfare funds). In addition, the Supplementary Information clarifies that the Super 23A provision applies only to transactions with related covered funds. Section 23A s attribution rule does not apply and transactions such as loans to unaffiliated third parties that are secured by covered funds are not limited by Super 23A. The Agencies declined, however, to extend any of the standard Section 23A exceptions, such as the exception for intra-day credits; this will continue to create challenges for banks that provide services, such as custody services, that may involve incidental extensions of credit to covered funds. Securitizations Loan Securitization Exclusion. The revised definition of covered fund excludes loan securitizations, which are generally characterized as issuing entities of asset-backed securities (defined under the Exchange Act) collateralized by loans (broadly defined to include leases and other receivables, but not securities or derivatives), servicing assets, interest rate and foreign exchange derivatives and special units of beneficial interest and certain collateral certificates. Resecuritization vehicles and other issuers that hold securities or derivatives more generally and that rely exclusively on Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (the Investment Company Act) would not qualify for the loan securitization exclusion. ABCP Conduits. Many ABCP conduits will benefit from new express exemptions from the definition of covered fund under the Final Rule. In addition to providing more expansive relief generally for loan securitizations, which will be available to ABCP conduits that meet the related requirements, the Final Rule provides specific relief for qualifying asset-backed commercial paper conduits. To the extent ABCP conduits may have been actively considering a conversion to Section 3(c)(5) or Rule 3a-7 programs under the Investment Company Act, the focus will now likely turn to complying with the asset restrictions and 100% liquidity support requirements under the Final Rule. For ABCP conduits not sponsored directly or indirectly by U.S. banks, there is additional relief from the rule. Covered Bonds. The Agencies have provided significant relief for covered bonds sold into the United States by non-u.s. banks. Under the terms of the Final Rule, qualifying covered bonds are excluded from the definition of covered fund. In order to qualify for this protection, the assets that collateralized a banking entity s covered bonds must be loans as required for loan securitizations under the Final Rule. The great majority of covered bonds sold in the United

6 States by foreign banks already meet this requirement. The Final Rule does not address covered bonds that may be issued by U.S. banks in the future under pending legislation. Compliance and Reporting Compliance Requirements. The Final Rule uses measures of consolidated total assets to distinguish among those banking entities that may customize their compliance programs, those that are subject to specified compliance program requirements, and those that must meet additional enhanced requirements. The latter in particular, which apply to the largest banking entities, may prove to be onerous and costly. They also include an annual CEO attestation requirement. Reporting Requirements. Banking entities with significant trading assets and liabilities ($10 billion or greater) must track and report very detailed information regarding their trading activities. For banking entities with the greatest trading assets and liabilities ($50 billion or greater), this reporting starts as of June 30, Foreign Banking Entities. For purposes of the Final Rule s compliance and reporting regime, a foreign banking entity will measure related thresholds against total assets, or trading assets and liabilities (as the case may be), of the foreign banking entity s U.S. operations (including all subsidiaries, affiliates, branches and agencies of the foreign banking entity operating, located or organized in the United States). This may create interpretive questions given the generality of the regulatory text and the variety of U.S. operations of foreign banking entities.

7 Contents Banking Entity...1 Proprietary Trading... 2 Financial Instrument... 2 Trading Account... 3 Activities that Do Not Constitute Proprietary Trading... 3 Permitted Trading Activities... 4 Underwriting... 4 Market Making... 6 Risk-Mitigating Hedging... 7 Domestic Government Obligations Foreign Government Obligations On Behalf of Customers Regulated Insurance Companies...12 Foreign Banking Entities...13 Other Limitations on Permitted Proprietary Trading Activities Covered Fund Activities and Investments Ownership Interest Sponsor Covered Fund Exclusions from the Definition of Covered Fund Permitted Covered Fund Activities...21 Organizing and Offering a Covered Fund...21 Underwriting and Market Making in Covered Fund Ownership Interests Permitted Covered Fund Investments Establishing Seed Capital De Minimis Investment Other Permitted Covered Fund Activities and Investments Permitted Risk-Mitigating Hedge Activity Activity Undertaken By Certain Foreign Banking Entities Permitted Activities of a Regulated Insurance Company Super 23A Limitations on Relationships with a Covered Fund Other Limitations on Permitted Covered Funds Activities Application of the Volcker Rule to Securitization Transactions Loan Securitization Exclusion Asset Backed Securities Issuers that May Be Covered Funds Wholly-Owned Subsidiary Exclusion Asset-Backed Commercial Paper Conduit Exclusions Covered Bonds Exclusion... 35

8 New Exemption in Connection with Dodd-Frank Mandated Credit Risk Retention Exemption for Sponsorship and Ownership of Issuing Entities of Asset- Backed Securities that Are Covered Funds Limitations on Ownership Interests in Covered Funds that Are Issuing Entities of Asset-Backed Securities Exemption for Underwriting and Market Making of Asset-Backed Securities Issued by Covered Funds Application of Super 23A to Issuers of Asset-Backed Securities Status of Issuers of Asset-Backed Securities as Banking Entities Ownership Interests and Sponsors Within the Securitization Context Interaction of the Volcker Rule s Conflict of Interest Limitation with Section 27B of the Securities Act Compliance and Reporting Banking Entities with No Covered Activities Compliance Banking Entities with Less than $10 Billion Consolidated Total Assets Banking Entities with Consolidated Total Assets of $10 Billion or Greater Banking Entities with Consolidated Total Assets of $50 Billion or Greater Reporting: Banking Entities with Trading Assets and Liabilities of $10 Billion or Greater Tailored Rules for Foreign Banking Entities... 45

9 Page 1 Banking Entity The scope of the definition of a banking entity has been narrowed slightly under the Final Rule. A banking entity is defined as: any insured depository institution; any company that controls an insured depository institution; any company that is treated as a bank holding company for purposes of Section 8 of the International Banking Act of 1978, which includes all foreign banks with a branch or agency (and certain other presences) in the United States; and any affiliate or subsidiary of any of the foregoing. 6 However, the Final Rule excludes from the definition of a banking entity all covered funds that are not otherwise banking entities. This is a broader exclusion than was found in the Proposed Rule, which excluded only those covered funds organized, offered and held by a banking entity in connection with providing bona fide trust, fiduciary, investment advisory or commodity trading advisory services pursuant to Section.11. Thus, a covered fund controlled by a banking entity will not itself be treated as a banking entity and will not be subject to the Volcker Rule limitations applicable to banking entities. In addition, the Final Rule excludes from the definition of banking entity: any portfolio company held under the merchant banking authority contained in certain sections of the Bank Holding Company Act (BHC Act), 7 or any portfolio concern that is controlled by a small business investment company, 8 so long as the portfolio company or portfolio concern is not itself a banking entity under as described in the first three bullet points above; and the FDIC acting in its corporate capacity or as conservator or receiver under the Federal Deposit Insurance Act or of the Title II Dodd-Frank Act. While the prohibitions of the Final Rule still extend to foreign banking organizations and offices (including foreign offices of U.S. banking entities) unless an exemption is available, as discussed below the Final Rule largely excludes foreign funds from the definition of covered fund, provided they are not offered or sold to U.S. investors and the foreign banking entity investing in or sponsoring the fund is not ultimately owned by a U.S. banking entity. 6 Both affiliate and subsidiary are defined in the Final Rule by reference to definitions found in the BHC Act. See BHC Act Section 2(k) (defining affiliate as any company that controls, is controlled by, or is under common control with another company ) and Section 2(d) (defining subsidiary as (1) any company 25 per centum or more of whose voting shares... is directly or indirectly owned or controlled by [another] company, or is held by it with power to vote; (2) any company the election of a majority of whose directors is controlled in any manner by [another] company; or (3) any company with respect to the management of policies of which [another] company has the power, directly or indirectly, to exercise a controlling influence, as determined by the [Federal Reserve] ). 7 Sections 4(k)(4)(H) or (I) of the BHC Act (12 U.S.C. 1843(k)(4)(H), (I)). 8 See 13 CFR (definition of portfolio concern); Section 103(3) of the Small Business Investment Act of 1958 (15 U.S.C. 662) (definition of small business investment company).

10 Page 2 Proprietary Trading Under the Final Rule s prohibition on propriety trading, a banking entity is generally barred from engaging in the purchase or sale of any financial instrument as principal for the trading account of such banking entity. Financial Instrument The prohibition on proprietary trading restricts a banking entity from engaging as a principal for its trading account in any purchase or sale of one or more financial instruments. For these purposes, the term financial instrument is defined as a security, derivative, or futures contract, or option on any of the foregoing. The following are excluded from the term financial instrument: loans; commodities other than excluded commodities, 9 derivatives and futures or options on futures; or foreign exchange or currency. The defined term derivative serves as a key component of the definition of financial instrument. For these purposes, the term derivative means: any swap or security-based swap; 10 forward contracts in energy, metal, agricultural and other non-excluded commodities; foreign exchange forwards and foreign exchange swaps that have been exempted from the definition of swap pursuant to determination by the Secretary of the Treasury; certain leveraged, margined or otherwise financed foreign currency transactions 11 or commodity transactions 12 that involve a non-eligible contract participant; or certain metals transactions. 13 The term derivative does not include: any consumer, commercial, or other agreement, contract or transaction that the CFTC and SEC have further defined by joint regulation, interpretation, guidance or other action as not within the definition of swap or security-based swap; or certain identified banking products The term excluded commodity is defined under Section 1a(19) of the Commodity Exchange Act (CEA). Excluded commodities are generally defined to include interest rates, exchange rates and other financial and economic indices and interests. 10 Defined by reference to their definitions under the CEA and the Securities Act of 1933 (Securities Act). 11 Subject to Section 2(c)(2)(C)(i) of the CEA. 12 Subject to Section 2(c)(2)(D)(i) of the CEA. 13 Authorized under Section 19 of the CEA. 14 Subject to Section 403(a) of the Legal Certainty for Bank Products Act.

11 Page 3 The scope of the definition of financial instrument is fundamental to delineating the applicability of the restriction on proprietary trading, and we expect it will raise a number of consequential interpretive questions. Trading Account The definition of trading account comprises three independent prongs. If any one of these three prongs is met, then that account will fall within the definition of trading account: Any account that is used by a banking entity to purchase or sell a financial instrument for the purpose of: (i) short term resale; (ii) benefitting from actual or expected short-term price movement; (iii) realizing short term-arbitrage profits; or (iv) hedging one or more such positions resulting from the purchase or sale of those listed in (i), (ii) or (iii). Under this first prong, there is a rebuttable presumption that any purchase or sale of a financial instrument held for fewer than 60 days is for a trading account. Any purchase or sale of a financial instrument that is both a market risk capital rule covered position and a trading position. The purchase or sale of a financial instrument for any purpose, if the banking entity is (i) licensed or registered to engage in the business of a dealer, swap dealer or securities-based swap dealer; or (ii) engaged in the business of a dealer, swap dealer or securities-based swap dealer outside the United States. Note that a trading account may not be an account at all. As the Supplementary Information indicated: the Agencies note the term trading account is a statutory concept and does not necessarily refer to an actual account. Trading account is simply nomenclature for the set of transactions that are subject to the Final Rule s restrictions on proprietary trading. 15 Activities that Do Not Constitute Proprietary Trading The definition of propriety trading does not include any purchase or sale involving: a repurchase or reverse repurchase agreement; securities borrowed pursuant to a written securities lending agreement; positions for liquidity management purposes; certain positions held by derivatives clearing organizations or clearing agencies; excluded clearing-related activities by clearinghouse members; satisfying an existing delivery obligation or an obligation in connection with a judicial, administrative, selfregulatory organization or arbitration proceeding; transactions when acting solely as agent, broker or custodian; deferred compensation plans; or collecting a debt previously contracted. 15 Supplementary Information at 38 n. 124.

12 Page 4 The Final Rule excludes from the definition of proprietary trading any excluded clearing activity by a banking entity that is a member of a clearing agency, derivatives clearing organization or a designated financial market utility. By contrast, the Proposed Rule did not provide any relief from the definition of proprietary trading for members of a clearing agency, derivatives clearing organization or a designated financial market utility. As a result, the Final Rule now permits clearing members to engage in certain excluded clearing activities, such as the purchase or sale of a financial instrument: (i) to correct trade errors made by or on behalf of customers; (ii) related to management of a default or threatened imminent default; or (iii) required by rules or procedures that reference the member. In addition, the Final Rule excludes from the definition of proprietary trading any purchase or sale of a financial instrument by a banking entity through a deferred compensation, stock-bonus, profit-sharing or pension plan of the banking entity where the banking entity is acting for the benefit of its current or former employees as trustee. 16 This allows the banking entity to act in a principal capacity to execute trades for the benefit of its own employees, pursuant to a deferred compensation plan or similar plan. 17 However, a banking entity is prohibited from trading on behalf of an unaffiliated deferred pension plan or similar plan. Also, the Final Rule now explicitly requires any banking entity that makes a purchase or sale of a security for the purposes of liquidity management to incorporate into its compliance program internal controls, analysis and independent testing to ensure adherence to the requirements of Final Rule and its liquidity management plan. Permitted Trading Activities Notwithstanding the prohibition on proprietary trading, a banking entity may engage in certain underwriting, market making related, risk-mitigating hedging, and other activities as discussed below. Underwriting The Final Rule provides an exemption for underwriting 18 provided that a banking entity s underwriting activities comply with the five standards set forth in the rule. The banking entity must act as an underwriter for a distribution, 19 and the relevant trading desk s 20 underwriting position must relate to such distribution. 16 The banking entity s deferred compensation, stock-bonus, profit-sharing or pension plan must be established and administered in accordance with the law of the United States or of a foreign sovereign. 17 The Final Rule, with respect to covered funds, provides a similar exemption for acquiring or retaining an ownership interest in a covered fund by a banking entity acting as trustee for a pension plan or certain other employee benefit plans. However, the pension plan exemption in the covered funds section is broader in scope in that it permits a banking entity to engage in otherwise impermissible activities for the benefit of its affiliates employees, in addition to its own employees. We believe it is likely that the textual inconsistency is inadvertent as there is no apparent policy reason for the distinction, and that the proprietary trading exemption likely was intended to be read as broadly as the covered funds exemption. 18 Underwriter is defined as: (i) a person who has agreed with an 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 (ii) a person who has agreed to participate or is participating in a distribution of such securities for or on behalf of the issuer or selling security holder. Supplementary Information at Distribution is defined as: (i) an offering of securities, whether or not subject to registration under the Securities Act, that is distinguished from ordinary trading transactions by the presence of special selling efforts and selling methods; or (ii) an offering of securities made pursuant to an effective registration statement under the Securities Act. Supplementary Information at Trading desk is defined as the smallest discrete unit of organization of a banking entity that purchases or sells financial instruments for the trading account of the banking entity or an affiliate thereof. Thus, a trading desk is defined functionally, and may exist across legal entity lines (for example, a desk that trades securities booked in one legal entity, but hedges those securities with futures or swaps booked in a separate legal entity).

13 Page 5 The trading desk s underwriting position, with respect to amount and type of the security, must not exceed the reasonably expected near term demands of clients, customers or counterparties. In addition, the banking entity must make reasonable efforts to sell or otherwise reduce the underwriting position within a reasonable period. 21 The banking entity must establish and implement an internal compliance program as required by Section.20. The compliance program must be reasonably designed to ensure the banking entity s compliance with the underwriting exception. 22 The compensation arrangements shall not be designed to reward or incentivize prohibited proprietary trading, with respect to those persons performing underwriting activities. The banking entity must be licensed or registered in accordance with the law. The Final Rule as adopted is not substantially different from the Proposed Rule. However, there are a few key distinctions that provide additional clarity with respect to a broader range of transactions covered by the underwriting exemption and the scope of permitted trading as part of the underwriting process. First, the definition of distribution in the Final Rule no longer requires consideration of the magnitude of an offering. 23 As a result, the definition of distribution takes into account offerings of all sizes, including small offerings involving less than 1% of an outstanding class and private offerings. All that is required is special selling efforts and selling methods. In addition, the Final Rule introduces an alternative approach establishing a bright-line test whereby the definition of distribution now includes those offerings registered under the Securities Act of 1933 (the Securities Act). The Final Rule defines underwriting position as any long or short positions in one or more securities held by a banking entity or its affiliates, and managed by a particular trading desk, in connection with a particular distribution of securities for which such banking entity or affiliate is acting as an underwriter. 24 The definition as adopted differs from the Proposed Rule in one key aspect: the Final Rule does not require a transaction to be solely in connection with a particular distribution of securities. As a result, the rule as adopted clarifies that, for example, syndicate covering trades are within the scope of permitted activities in connection with underwriting. Another important change involves the addition of language that requires a banking entity to make reasonable efforts to sell or otherwise reduce the underwriting position within a reasonable period. The Proposed Rule did not specifically address the potential for unsold positions, even though the preamble to the Proposed Rule recognized residual positions may occur in connection with underwriting. The Final Rule specifically addresses this issue by permitting banking entities to purge themselves of any unsold position, if done so within a 21 Reasonableness is determined by taking into account the liquidity, maturity and depth of the market for the relevant type of security. 22 This requires a banking entity to create reasonably designed written policies and procedures, internal controls, analysis and independent testing identifying and addressing several areas. These areas include, among other things, (i) the types of products, instruments or exposures each trading desk is permitted to purchase, sell or manage with respect to its underwriting activities; (ii) establishing limits for each trading desk; (iii) establishing internal controls, while also engaging in ongoing monitoring and analysis to ensure each trading desk is in compliance thereof; and (iv) establishing authorization procedures that require review and approval for any trade exceeding the scope of a trading desk s authority. 23 According to the Supplementary Information, the consideration of magnitude was not needed due to the fact that the definition of distribution includes references to special selling efforts and selling methods. See Supplementary Information at See Section.4(a)(6).

14 Page 6 reasonable amount of time. The rule goes on to clarify that reasonableness is determined by taking into account the liquidity, maturity, and depth of the market for the relevant type of security. The Final Rule does not permit hedging the underwriter s risk exposure under the underwriting exception. Thus, a banking entity must employ the exemption for risk mitigating hedging. Market Making A trading desk at a banking entity is permitted to purchase or sell a covered financial position in connection with the entity s market making-related activities. The trading desk s market making activities must meet the following criteria: Market making is defined as routinely standing ready to purchase and sell one or more types of financial instruments related to its financial exposure and being willing and available to quote, purchase and sell 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. 25 The focus of this analysis is on the financial exposure of the trading desk as a whole, not its exposure on a trade-by-trade basis. Market making is defined to include hedging for the trading desk (and thus hedging for a trading desk need not meet the separate tests for risk-mitigating hedging discussed below). The market making definition permits ETF-authorized participant activity, block positioning and anticipatory market making if undertaken by a trading desk for the purpose of intermediating customer trading. 26 The market making-related activities of a trading desk must be designed not to exceed the reasonably expected near-term demands of clients, customers and counterparties, based on a demonstrable analysis of historical customer demand and other related factors, taking into account existing inventory. 27 The banking entity must establish a comprehensive compliance program (as set forth in Section.20 of the Final Rule) that is reasonably designed to ensure the compliance of each trading desk, including reasonably designed written policies and procedures, training, internal controls, analysis and independent testing. The compliance program must identify the financial instruments each trading desk stands ready to purchase and sell, the actions the trading desk will take to reduce or mitigate its financial exposures, its risk management procedures and strategies, its process for reviewing its risk management, and its trading limits and the process for obtaining approval to exceed or change those trading limits. Additional, enhanced compliance requirements, set out in Appendix B of the Final Rule, apply to the largest banking entities (generally those with $50 billion or more in total consolidated assets or more than $10 billion of trading assets and liabilities). These matters are discussed below under Compliance and Reporting Requirements. 25 Because of the separate exclusion of government, agency and municipal securities from the Volcker rule, market making in those securities is not subject to the limits discussed here. 26 However, high-frequency trading strategies that frequently enter and exit the market, and only execute trades when market conditions are favorable, would not meet the standing ready requirement of market making. 27 Clients, customers and counterparties for these purposes are defined as entities other than trading desks of other banks with assets of $50 billion or more. Although a trading desk may engage in inter-dealer trading, purely inter-dealer trading would not constitute customer demand. Trading desks are required to demonstrate why they treat someone as a client, customer or counterparty rather than as another trading desk.

15 Page 7 If a trading desk exceeds its trading limits, it must take action as promptly as possible to bring the desk back into compliance with those trading limits. The compensation arrangements of persons on the trading desk must be designed not to reward or incentivize prohibited proprietary trading. The banking entity must be appropriately registered as a dealer, or exempt from registration or excluded from regulation as a dealer, under applicable securities or commodities laws. The trading desk s market making activities must be monitored according to the seven groups of metrics listed in Appendix A of the Final Rule. Those metrics include: 1) risk and position limits and usage; 2) risk factor sensitivity analysis; 3) value-at-risk and stress value-at-risk; 4) comprehensive profit-and-loss attribution; 5) inventory turnover; 6) inventory aging; and 7) customer-facing trade ratio (both in terms of trade count and value). Some of these metrics must be calculated daily; others are calculated over 30, 60 and 90 day periods. These matters are discussed below under Compliance and Reporting Requirements. The definition of market making in the Final Rule routinely standing ready to purchase and sell one of more types of financial instruments modifies a more restrictive definition of market making - regularly and continuously holding oneself out as a market maker on a security-by-security basis which had been modeled on an Exchange Act provision defining an equity market maker. The definition in the Proposed Rule would not have worked well in, for example, fixed income markets. The final definition also drops a proposed bifurcation in this definition between more and less liquid markets. The compensation incentives provision in the Final Rule compensation must be designed not to reward prohibited proprietary trading is different from the Proposed Rule, which would have barred rewarding any proprietary risk-taking. The Final Rule abandons a provision in the Proposed Rule that the activities of the trading desk must be designed to generate revenues primarily from fees, commissions, bid/ask spreads or other income rather than the appreciation in the value of covered financial positions or the hedging of such positions. The Final Rule does not include Appendix B to the Proposed Rule, which had been designed in large part to provide metrics sufficient to track the permissible sources of revenue. The number of metrics that a trading desk compliance program is required to track and report, set out in Appendix A, dropped from 17 in the Proposed Rule to seven in the Final Rule. Risk-Mitigating Hedging The Final Rule provides an exemption from the prohibition on proprietary trading for risk-mitigating hedging activities designed to reduce the specific risks associated with a banking entity s individual or aggregated positions. The exemption seeks to ensure that permitted hedging activities reduce specific and identifiable risks and do not create new or additional risks. The Supplementary Information explains that permitted hedging activity does not extend to hedging of general risks that are not related to specific positions, such as risks associated with assets or liabilities generally or risks associated with general market movements or broad economic conditions See Supplementary Information at ( [H]edging of aggregated positions under this exemption must be related to identifiable risks related to specific positions, contracts, or other holdings of the banking entity. Hedging activity must mitigate one or more specific risks arising from an identified position or aggregation of positions. The risks in this context are not intended to be more generalized risks that a trading desk or combination of desks, or the banking entity as a whole, believe exists based on non-position-specific modeling or other considerations. For example,

16 Page 8 Under the Final Rule, a number of general and specific conditions must be satisfied for hedging activities to qualify for the hedging exemption, including the following: The banking entity must establish and implement an internal compliance program as required by Section.20 of the Final Rule. The compliance program must include (as described more fully below under Compliance and Reporting ): o o o written policies and procedures regarding the positions, techniques and strategies that may be used for hedging, including documentation indicating what positions, contracts or other holdings a trading desk may use in its risk-mitigating hedging activities and position and aging limits with respect to such positions, contracts or other holdings; internal controls and ongoing monitoring, management and authorization procedures; and analysis (including correlation analysis) and independent testing designed to ensure that the positions, techniques and strategies that may be used for hedging may reasonably be expected to demonstrably reduce or otherwise significantly mitigate the specific, identifiable risk(s) being hedged. The banking entity s risk-mitigating hedging activity must be designed to reduce specific, identifiable risk(s) arising from identified positions, contracts or other holdings, either individually or in the aggregate, determined at the time the hedging activity is undertaken or at the time any hedges are adjusted. 29 Identifiable risks include market risk, counterparty or other credit risk, currency or foreign exchange risk, interest rate risk, commodity price risk and basis risk. The banking entity s risk-mitigating hedging activity must not give rise to any significant new or additional risk at inception, so long as such exposure is not significant or is hedged contemporaneously. The compensation arrangements of persons performing risk-mitigating hedging activities must not be designed to reward or incentivize prohibited proprietary trading. For certain types of hedging activity, the banking entity must comply with enhanced documentation requirements. o The specific types of hedging to which enhanced documentation requirements apply are: Cross-Desk and Cross-Affiliate Hedging: Hedges not established by the specific trading desk establishing or responsible for the underlying positions, contracts or other holdings; 30 Portfolio Hedging: Hedges that are established to hedge aggregated positions across two or more trading desks; and the hedging activity cannot be designed to: reduce risks associated with the banking entity s assets and/or liabilities generally, general market movements or broad economic conditions; profit in the case of a general economic downturn; counterbalance revenue declines generally; or otherwise arbitrage market imbalances unrelated to the risks resulting from the positions lawfully held by the banking entity. Rather, the hedging exemption permits the banking entity to engage in trading activity designed to reduce or otherwise mitigate specified individual or aggregated risks that the banking entity is otherwise lawfully permitted to have. ) 29 The Final Rule does not prohibit anticipatory hedging, although such hedging must come within the requirements of the exemption. See Supplementary Information at The Supplementary Information notes that hedging may occur across affiliates, but reserves the right of the appropriate supervisory agency to place limits on inter-affiliate hedging. See Supplementary Information at

17 Page 9 Hedging Strategies not Identified in Policies and Procedures: Hedges that are effected through a financial instrument, exposure, technique or strategy that is not specifically identified in applicable policies and procedures. o Contemporaneously with the establishment of one of these positions, the banking entity must document: the specific, identifiable risk(s) designed to be reduced; the specific risk-mitigating strategy being employed; and the trading desk or other business unit that is establishing and responsible for the hedge. The Final Rule as adopted is not substantially different from the Proposed Rule. A few key distinctions are highlighted below. Compliance Program: The compliance program requirement has been developed, with the Final Rule providing additional detail as to the required components of the compliance program. New components include that (i) position and aging limits be applied to hedging positions, and (ii) correlation analysis be undertaken as part of the analysis of hedging positions. Correlation: The Proposed Rule included a requirement that a permitted hedging transaction is reasonably correlated, based upon the facts and circumstances of the underlying and hedging positions and the risks and liquidity of those positions, to the risk or risks [the hedging transaction] is intended to hedge or otherwise mitigate. This requirement would have tied the applicability of the exemption to the performance of the risk mitigation transaction over its lifetime as measured by correlation. The Final Rule modifies this requirement in two respects (in addition to the introduction of a requirement that the compliance program include correlation analysis): o o First, the Final Rule requires that the hedge demonstrably reduce or otherwise significantly mitigate specific identifiable risk, without focusing on correlation in isolation. The Agencies explained that [t]his change acknowledges that hedges need not simply be correlated to underlying positions, and that hedging activities should be consciously designed to reduce or mitigate identifiable risks. 31 Second, the Final Rule provides that the determination of whether an activity or strategy is risk-reducing or mitigating must, in the first instance, be made at inception of the hedging activity. Enhanced Documentation: The Proposed Rule applied enhanced documentation requirements with respect to hedging transactions that are undertaken at a level of organization that is different than the level of organization establishing or responsible for the positions, contracts, or other holdings the risks of which [the hedge transaction is] designed to reduce. 32 The Final Rule elaborates that enhanced documentation requirements apply in any of the circumstances discussed above. 31 Supplementary Information at Proposed Rule 5(c).