The Volcker Rule s impact on infrastructure

The Volcker Rule s impact on infrastructure

The potential impact of the Volcker Rule s proprietary trading provisions on infrastructure for banking entities Section 619 of the Dodd-Frank s Wall Street Reform and Consumer Protection Act ( Dodd-Frank ), known informally as the Volcker Rule, recasts the landscape of financial transacting by amending the Bank Holding Company Act of 1956 with a new section entitled Prohibitions on Proprietary Trading and Certain Relationships with Hedge Funds and Private Equity Funds. Named after former Federal Reserve Board Chairman Paul A. Volcker, who proposed that Congress rein in the scope of bank investments to help mitigate future systemic risks, the Volcker Rule prohibits banking entities 1 from: Engaging in proprietary trading Acquiring or retaining any equity, partnership, or other ownership interest in or sponsoring a hedge fund or a private equity fund, with the exception of those offered in connection with bona fide trust, fiduciary, and investment advisory functions and then subject to de minimis investment limits 2 In addition, systemically important nonbank financial companies that engage in proprietary trading, or take or retain an equity, partnership, or other ownership interest in or sponsor a hedge fund or private equity fund, may be subject by rule to additional capital requirements and quantitative limits, including potential diversification requirements. On January 18, 2011, the Financial Stability Oversight Council (FSOC) published a study 3 about implementing the Volcker Rule, as required under Dodd-Frank. The report contains a number of recommendations for banking entities to follow. Final rules for implementation are due by October 18, 2011. Banking entities are expected to require significant investments in technology and infrastructure to comply with these final rules. Initial response to the Volcker Rule Following the passage of Dodd-Frank in July 2010, a number of banking entities either shuttered or announced plans to close their operationally distinct and dedicated proprietary trading operations. While much of the attention to date has been on dedicated proprietary operations, the scope of the Volcker Rule extends far beyond distinct proprietary trading desks and is likely to affect the core of how banking entities conduct their trading and securities operations going forward. Although the Volcker Rule allows banking entities to engage in so-called permitted activities such as marketmaking, underwriting, customer facilitation, hedging, and the trading of government securities it explicitly prohibits proprietary activities from being disguised as permitted activities. Banking entities will thus need to distinguish between permitted and prohibited activities. Constructing tests that definitively delineate the two may be quite difficult, due to differences across asset classes, differences in market practices, and changing market conditions. In its 79-page study, the FSOC makes several key recommendations. These include not only shutting down or ceasing propriety trading and divesting of speculative investments, but also implementing robust compliance regimes and quantitative metrics at the transacting desk level in addition to robust supervisory review and oversight by the U.S. regulatory agencies ("Agencies") to help ensure that impermissible activities are not disguised as permitted ones. 1 Defined as a firm that benefits from federal insurance on customer deposits (and/or has access to the discount window) under Section 619 (h) (1) of the Dodd-Frank Act. 2 Such investments may not represent more than 3% of the total ownership interest of such fund after one year from the fund s establishment, and all aggregated investments of the banking entity in such funds may not represent more than 3% of the Tier 1 capital of the banking entity. 3 Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds, the Financial Stability Oversight Council, January 2011. Referred to as the FSOC study throughout the remainder of this document. http://www.treasury.gov/initiatives/documents/volcker%20sec%20%20619%20study%20final%20 1%2018%2011%20rg.pdf 2

Permitted and proprietary trading activity Meeting the requirements of the Volcker Rule, especially as envisioned by the FSOC recommendations, will require robust infrastructure and processes to monitor and comply. One of the challenges for banking entities will be the need to unambiguously distinguish permitted versus proprietary trading activities. Proprietary trading The Volcker Rule defines proprietary trading as a transaction in which the banking entity uses its own capital to assume principal risk in order to benefit from near-term price movements. Such transactions are typically "trader-initiated, as opposed to being customer-initiated. The Volcker Rule covers an expansive list of transactions and instruments. Specifically, it covers any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative, or contract or any other security or financial instrument that the appropriate Federal banking agencies, the Securities and Exchange Commission (SEC) or Commodity Futures Trading Commission (CFTC) may determine. 4 The FSOC study discusses several indicators to help banking entities determine which activities are considered proprietary trading. According to the study, some of the indicators that would characterize activities as bright line proprietary trading include: The sole purpose of the transaction is for generating profits from trading strategies No formal market-making responsibilities or customer exposure exists Compensation structures are similar to those of hedge fund managers and other managers of private pools of capital In summary, when all of the above conditions are present, it would seem relatively easy to identify the activity as proprietary trading this is particularly the case when such activities are conducted in an operationally distinct unit. However, making a definitive call becomes more difficult when evaluating whether other forms of trading activities are being used to benefit from short-term price movements or from speculation. Dodd-Frank casts a wide net as to which instruments are covered and the list can be expanded at any time, based on views by the Agencies. 4 The Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub.L. 111-203, H.R. 4173), page 255, http://www.gpo.gov/fdsys/pkg/bills-111hr4173enr/pdf/bills-111hr4173enr.pdf The Volcker Rule's Impact on Infrastructure 3

Permitted activities On the other side of the spectrum, the Volcker Rule allows banking entities to engage in permitted trading activity. These include the aforementioned market-making, underwriting activities, hedging, transacting in government securities, and certain other activities that are identified in Dodd-Frank. Such activities are recognized by Congress as important with respect to the effective functioning of robust and liquid capital markets and for facilitating financial intermediation. To the extent that they can be conducted in a manner that is consistent with the principles of safety and soundness, they are permissible in the context of entities that have the support of federal deposit insurance and discount window access. However, if these activities cannot be conducted safely as determined by the federal regulators, then the U.S. regulatory agencies have the authority to claw them back or subject them to a so-called prudential backstop (see sidebar) and thereby disallow them or impose other actions, such as higher capital charges. The FSOC study suggests that additional governance, controls, and metrics may need to be designed and implemented to support compliance with these limitations. The study itself is less prescriptive in this area, as there is significant judgment required in this regard. Suffice it to state that the requirements could be significant, and it may be worth reading the discussion in the study on this topic. The prudential backstop There is an additional limitation called the prudential backstop that is codified in Dodd-Frank. This limitation specifies that no transaction, class of transactions, or activity may be deemed a permitted activity 5 if it would: Involve or result in a material conflict of interest between the banking entity and its clients, customers, or counterparties Result, directly or indirectly, in a material exposure by the banking entity to high-risk assets or high-risk trading strategies Pose a threat to the safety or soundness of the banking entity Pose a threat to the financial stability of the United States Transacting in government securities and conducting hedging activities, on the other hand, are not subject to the requirement that the transactions be customerinitiated. However, these activities are still subject to the prudential backstop and, if they are deemed too risky, they can be disallowed. Moreover, they also have their own unique attributes, of which banking entities will need to be mindful in order to demonstrate conformance with the Volcker Rule. The characteristic that typically defines market-making and underwriting as permitted is that the activity be done on behalf of customer, as opposed to speculation for price gain, and not to exceed the reasonable near-term demands of clients, customers, or counterparties. 5 IBID. Page 251. 4

The gray area between activities Permitted trades can evidence outwardly similar characteristics to proprietary trading, even if they are pursued for different reasons. The core difference has to do with the assumption of risk, particularly in the case of market-making on behalf of customers, or in the case of hedging. Consider the example of a banking entity that, acting in its capacity as a market-maker, purchases a security from a seller where, in turn, there is no ready buyer for that particular issue. It is not uncommon that a buyer and seller cannot be readily matched. The corporate bond market is a case in point. Overall, it is a highly fragmented market. With more than 40,000 corporate bond issues in the U.S. market alone, it is reasonable that there are times when a ready match cannot be made. In the absence of a perfect hedge (which brings its own unique subtleties and complexities to evaluate compliance under the Volcker Rule), the banking entity is exposed to counterparty risk and the risk of price movement on the underlying security. While this occurs, the banking entity s capital is used to support these risks, as is the case when conducting proprietary trading. Assume that when the banking entity can finally liquidate the position, it realizes a gain on the price of the underlying security/position. The question then becomes, Is this proprietary trading? Did the banking entity intentionally hold the instrument to benefit from near-term price movements? Additional factors which may make distinction between permitted versus proprietary activities more complex include the fact that: Each asset class (such as equities, commodities, and derivatives) is unique and has its own characteristics Liquidity and fragmentation differ across asset classes The degree of market stress can change the holding periods that are needed to readily match buyers and sellers Hedging can be used to neutralize the risk of price movements on the position. However, hedging also presents complications in the context of the Volcker Rule because: The hedge may not be one-for-one It may create basis risk It may be effected at a centralized desk and on a portfolio basis (which makes a great deal of sense from an enterprise-wide perspective), but which could make it more difficult to demonstrate that the strategy was undertaken to neutralize the risk of the particular position To recap, the purpose of the Volcker Rule is to constrain risk-taking of banking entities. A key concern of the Volcker Rule is that proprietary and speculative trading activities and investments may be disguised as permitted activities. Dodd-Frank takes a firm stance that evasion in any form will not be permitted. The Volcker Rule's Impact on Infrastructure 5

What the FSOC recommends To achieve the objectives of the Volcker Rule, the FSOC recommends that banking entities employ a four-part implementation and supervisory framework or program. The recommended program puts the onus of compliance on the banking entity and also tasks the Agencies with conducting robust supervisory oversight and enforcement: 1. Programmatic compliance for banking entities: The FSOC study recommends that banking entities be required to develop an effective, comprehensive 6 program designed to ensure compliance with the Volcker Rule, and that only permitted activities are transacted. This may include, among other things, internal policies, procedures and controls, independent testing, and public attestation of compliance with the Volcker Rule by the chief executive officer (CEO) that compliance standards are continually being met. 2. Analysis of reporting and quantitative metrics by banking entities: The recommendation here is that banking entities be required to analyze and report various quantitative metrics to the Agencies to help them identify impermissible proprietary trading. 3. Supervisory review and oversight by the agencies: The FSOC also recommends that the Agencies engage in review and oversight of the banking entities trading operations and test their internal controls. This would typically take place through a combination of on-site examination, review of quantitative metrics, and monitoring. 4. Enforcement procedures by the agencies for violations: Dodd-Frank requires that impermissible trading activities be discontinued. Beyond termination of such activities, the Agencies are encouraged to consider strong supervisory consequences and penalties for violations, including increased capital charges, reductions in risk limits, supervisory or enforcement actions, and / or monetary penalties. Timing of Volcker Rule implementation A final five-year extension for illiquid investments in HF/PE to fulfill pre-may 1, 2010, contractual obligations Effective date of final Federal Reserve Bank rule for bringing activities, investments, and relationships into conformance July 21,2012 2012 April 1, 2011 Rulemaking Study Jan 18, 2011 FSOC study issued Transition period Possible conformance period extensions Conformance period existing activities July 21, 2014 Oct 18, 2011 Final agency rules* (operational requirements) Up to three one-year extensions 2014 Volcker Rule effective date** 2022 Possible illiquid HF/PE investment extension July 21, 2017 End of conformance period * Agencies are required, no later than nine months after the completion of the FSOC study, to adopt rules to implement the Volker Rule and must consider the recommendations of the FSOC in developing and adopting such regulations. ** Effective date for the prohibitions and restrictions of the Volker Rule is the earlier of July 21, 2012, or 12 months after the issuance of final Agency Rules. 6 The FSOC study, page 31. 6

The Agencies are working hard to release a Notice of Proposed Rulemaking and to allow the industry time to comment. Dodd-Frank requires the rules to be finalized no longer than nine months after the completion of the FSOC study, or by or before October 18, 2011. It is anticipated that there will be close coordination among the Agencies for a cohesive program. The relative focus by each Agency is likely to be consistent with the functional responsibilities of each, with the: Banking Agencies creating the rules around the activities conducted in banks and the Federal Reserve taking the lead on consolidated supervision at the bank holdingcompany level The SEC creating the rules for activities conducted in broker-dealers (e.g., market-making and underwriting that are typically conducted in broker dealers) The CFTC creating the rules for activities conducted under Futures Commission Merchants licenses, which, when conducted within banking entities, are typically conducted within broker-dealers While it remains to be seen exactly which requirements will be put forth in the Rulemakings, the combination of the strong wording in Dodd-Frank and FSOC study seems to foreshadow that a relatively strict compliance regime will be forthcoming. Compliance with the Volcker Rule will likely require significant investment in infrastructure. Potential infrastructure requirements In thinking about what it will take to comply with the Volcker Rule, it is helpful to visualize what a potential framework might look like (see illustration below). The FSOC study refers to the characteristics of trading activities as indicia. Consistent with the indicia-based evaluation that banking entities would need to apply in determining whether a type of activity is permitted, the FSOC study suggests that the Agencies mandate that banking entities produce and maintain at the business and desk level a comprehensive description of the mission and strategy for all permitted trading activity. Policies and procedures to detect propietary trading Pre-Execution Execution Post Execution Establish authorized activities, risks, products and instruments Review of proposed or new business activities and transactions that were not previously approved to establish permissibility Adherence to qualitative and quantitative limits on transacting activities Identification and evidencing of transactions as customer initiated Ongoing monitoring of the types and levels of risk Ongoing monitoring of the magnitude and sources of returns Compliance and exception reporting Issue escalation & resolution Subcertification of compliance Supervisory oversight Evidence of compliance monitoring & internal reviews Independant testing of the compliance regime Board review and CEO certification The Volcker Rule's Impact on Infrastructure 7

The study specifies that this may include again at the business and desk level: A description of the compensation policy for those engaged in risk-taking activities The types and levels of risk that are necessary to execute the articulated mission, as well as a rationale for why the risk types and levels specified for that trading unit or desk are appropriate and necessary in light of the Volcker Rule The mandate of each trading unit or profit center A description of how revenues are generated and positions are hedged An enumeration of activities engaged in by the trading unit Detail of the types of customers served A description of the activity typical of the customer base A listing of the types of products approved for transactions In addition to potentially requiring this for existing transacting activities, these requirements would need to be met for any new products. Quantitative metrics Beyond the indicia-based tests and requirements to document the mission and strategy for all permitted activities, the FSOC study further recommends four categories of metrics which can help to identify instances of impermissible proprietary trading that might otherwise be conducted as part of or in tandem with permissible activities. Presumably, banking entities would be required to analyze these metrics on an ongoing basis. The study also recommends that banking entities report these metrics to regulatory agencies for the purpose of facilitating Agency review of the banking entity itself, as well as to facilitate horizontal comparisons across different banking entities. The four categories of metrics are: 1. Revenue-based metrics These would attempt to measure daily revenue associated with specific activities as compared to historical revenue and similar data for other banking entities. This appears to be based on the notion that revenues and losses for market-making and certain other permitted activities are principally derived from both spreads and price movement in the inventory held, while impermissible proprietary trading revenue is generated principally from price movements. An analysis of revenue may allow a determination that a particular trade or activity was proprietary in nature. 2. Revenue-to-risk metrics These would attempt to measure revenue generated per unit of risk assumed, as permitted activities are likely to have greater revenue-to-risk ratios than impermissible proprietary trading. 8

3. Inventory metrics These are designed to measure the rate of inventory turnover and aging in a firm s portfolio and would attempt to show whether a banking entity s market making-related activities are intended to meet reasonably expected near-term demand. For example, inventory turnover compares the asset value that is transacted each day to the value of assets that are held in inventory. A market maker that retains risk well 7 in excess of customer demand is more likely to be holding an impermissible proprietary position in that risk. 4. Customer-flow metrics These evaluate the volume of customer-initiated orders on a market-making desk against those orders that are initiated by a trader for the purpose of building inventory or hedging. Significant trader-initiated order volume, rather than customer-initiated order volume, could indicate that impermissible proprietary activity has occurred. These metrics are more easily applied to some activities than others, with a significant distinction as to how readily they could be applied to cash market instrument activity versus derivative activity, books, or desks that transact in both types of instruments, or to particular markets or activities. In fact, the FSOC s study specifically notes these limitations in application, but believes that quantitative metrics are still likely to be a useful tool in implementing the Volcker Rule, and recommends that they be used in combination with and tailored to individual activities, products, or classes of financial instruments. The study includes a detailed summary of the specific types of metrics that the FSOC believes the Agencies may find useful to consider. Revenue based Current and historical trend comparison of revenues over a period to revenues for other periods. Revenue trends Profitable trading days/trading days Profit and loss (P&L) decomposed (attributed) to its primary and subprimary components -Commissions - -Fees - -- Changes in valuation -Carry - Inventory -- New business -- Inception P&L -Other/adjustments - Inventory metrics calibrated to each asset class/product and assessed in relation to observed customer demand. Inventory turnover Inventory ageing "Factor based" measures of inventory turnover that relate to key drivers of valuation for less liquid or more complex financial instruments Risk/revenue to risk Metrics intended to measure the source of risk, and the revenue generated per unit of risk assumed, on both a current and historical trend basis. Sharpe ratios to measure level of excess return earned for every unit of risk taken Revenue to value at risk Risk attribution Value at risk Stress risk Customer flow Designation and record keeping of customer-initiated transactions, and metrics to evaluate the volume of customer-initiated orders rather than trader -initiated orders. Customer-initiated trade ratio Customer-initiated flow to inventory Revenue to customer-initiated flow 7 The FSOC study, page 39. The Volcker Rule's Impact on Infrastructure 9

Infrastructure implications of the quantitative metrics So what might the additional control and infrastructure implications of these issues be? Applying the four categories of metrics at the level of detail implied by the study will likely place significant demands upon financial institutions. First, the potential requirement to distinguish between customer-initiated versus firm-initiated transactions is not typically something that banking entities do today. Second, other measures of inventory turnover particularly for derivatives may not be prepared by most banking companies either. Integrating these metrics into operations may not be a simple exercise. Third, many of these metrics specifically, the revenue and revenue-to-risk metrics will likely require a deeper understanding of the sources of return and the sources of risk for distinct business activities. While it might be possible to determine these metrics at the activity or book level by leveraging the daily profit and loss calculation and risk attribution that many banking entities perform, in practice, at many banks, the upstream T-0 controls designed to ensure accuracy and these daily profit and loss and risk attribution processes may need to be enhanced and standardized across the different trading areas and desks to accomplish this task. The potential requirements of the Volcker Rule together with Basel II, II.5 and III, interagency guidance on sound compensation practices, and the systemic risk and derivatives titles of Dodd-Frank, are motivating banks to consider ways to enhance their infrastructure. As much as any other regulation, the Volcker Rule is likely to drive to the heart of what a firm can do and, just as importantly, how activities may need to be assessed and monitored pre-trade, at the time of trade, and on an ex-post ongoing basis. The potential application of this rule will likely add urgency for firms to: Improve front-office systems and processes to better support profit and loss and risk attribution Improve data quality, and reduce downstream adjustments and data remediation Reduce the use of spreadsheets and end-user-developed applications Develop a means to apply the four new categories of metrics to all of their desks Other methodologies and processes that might be affected include the new transaction/product approval as a banking entity would need to consider: Evaluating the proposed activity in relation to the tests of indicia Documenting the mission and strategy in accordance with the study recommendations Determining that the banking entity can support the relevant metrics and ongoing monitoring that the new transactions or activities would be subject to all prior to approval The requirements of the Volcker Rule may also be a driver for companies to better define and control their book structure. It is likely that there will be other ancillary effects that arise from applying the Volcker Rule, some of which may only be identified once the final rulemaking is completed and implementation begins. 10

Programmatic compliance regime for large complex banking entities The FSOC study recommends that Agencies require that banking entities implement robust compliance regimes to monitor compliance with the Volker Rule. It also recommends that Agencies strongly consider imposing obligations on the board of directors and CEOs of banking entities to ensure that they are effectively engaged in and accountable for compliance with the prohibition on impermissible proprietary trading. In this regard, the FSOC recommends that this compliance regime include public attestation of the regime s effectiveness by CEOs. The proposed public attestation requirement seems similar in nature to what was required under the Sarbanes- Oxley Act on corporate governance. Board mandates and CEO attestations likely raise the bar as to the standard to which companies will be held. Supporting the recommended compliance regime for Volcker may include developing standards both for design and operating effectiveness, ongoing compliance monitoring and evaluation, reporting and escalation procedures, as well as processes, including subcertifications, to support the CEO and board certifications. The FSOC study also recommends an independent testing requirement for programmatic compliance. These requirements could be similar to those that the banking agencies have established with respect to the Bank Secrecy Act and anti-money laundering compliance. Independent testing could be conducted by a banking entity s internal audit department, outside auditors, consultants, or other qualified independent parties that would be potentially permitted under the final rules. Supporting this compliance regime will likely be onerous for all banking entities. However, banking entities with large trading volumes and across a variety of asset classes may need to develop automated workflow and reporting to support their compliance monitoring and tracking. Such workflow and reporting could: Provide a means to monitor, review, and evidence the review of transacting activities and the four categories of metrics described earlier Support required manager- and executive-level supervision and oversight of transacting activities potentially required under the rule Enable the escalation and routing of exceptions and instances of potential prohibited activities Support compliance reporting metrics for certifications Provide evidence of the compliance program to Agencies Looking ahead While it remains to be seen exactly which requirements will be promulgated in the final rulemaking, the combination of the strong wording in Dodd-Frank and the FSOC study suggest that strict requirements will be forthcoming. Compliance with the prohibitions on proprietary trading is expected to be quite demanding on banking entities because many trading systems are not currently designed to manage and measure trading activities to distinguish between proprietary versus permitted activities. As a result, significant investment in infrastructure is likely to be required. Another challenge for compliance is the speed with which banking entities may be required to comply. The effective date of the Final Rules is anticipated to be July 21, 2012. 8 If the Final Rules are published in October 2011, this leaves only nine short months to reflect the final requirements and to put controls in place which prevent the organization from conducting new proprietary trades and to start to develop a plan relative to the final requirements to wind down impermissible activities, investments, and relationships during the conformance period. 8 Effective date for the prohibitions and restrictions of the Volcker Rule is the earlier of July 21, 2012, or 12 months after the issuance of final Agency Rules. The Volcker Rule's Impact on Infrastructure 11

For further information about this subject, please contact: Kim Olson Principal Deloitte & Touche LLP kolson@deloitte.com Tel: +1 212 436 5976 Kim Olson is a principal with Deloitte & Touche LLP and specializes in advising and delivering solutions to financial institutions on risk management, capital adequacy, internal control remediation, and regulatory compliance. Her career includes significant experience in industry and as a banking supervisor. Bob Maxant Partner Deloitte & Touche LLP rmaxant@deloitte.com Tel: +1 212 436 7046 Bob Maxant is a partner with Deloitte & Touche LLP. He has substantial professional services and industry experience in the areas of risk, finance and treasury processes controls, and technology. His area of focus at clients and in industry has included all cash market and derivative asset classes: fixed income, including mortgage and asset backed securities; foreign exchange; energy and other commodities; and equities. This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte, its affiliates, and related entities shall not be responsible for any loss sustained by any person who relies on this publication. About Deloitte Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting. Copyright 2011 Deloitte Development LLC. All rights reserved. Member of Deloitte Touche Tohmatsu Limited