On December 10, 2013, the SEC adopted a long-awaited final rule¹ implementing Section 619 of the Dodd-Frank Act.² Known as the “Volcker rule,” the final rule was developed jointly with the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Commodity Futures Trading Commission (collectively “the agencies”). More than 18,000 comment letters were submitted in response to the proposed rule.

The final rule outlines requirements that prohibit or restrict banking entities (with certain exceptions) from (1) engaging in proprietary trading (as defined in the final rule) of certain types of financial instruments and (2) having certain interests in, or relationships with, a hedge fund or private equity fund. In addition, the nearly 1,000-page final rule defines numerous key terms that constituents believed were unclear.

Proprietary Trading Prohibition

The Volcker rule prohibits banking entities from engaging in short-term proprietary trading of certain securities, derivatives, commodity futures, and options on these instruments. Exceptions to the prohibition against proprietary trading by banking entities include the following:

• Banking entities can continue market-making activities for their own accounts when trading U.S. government, agency, state, and municipal obligations.
• A banking entity acting as an underwriter (i.e., to distribute securities in private or public offerings) would be exempt from this prohibition if its securities position is related to the offering and is reasonably designed not to exceed the expected near-term customer and counterparty demand.
• Hedging activities that significantly mitigate specific identifiable risks associated with a banking entity’s individual or aggregated securities positions would be exempt from the prohibition. However, a banking entity would be required to (1) perform analysis in support of its hedging strategy and (2) assess the effectiveness of the hedging relationship on an ongoing basis.
• Foreign banking entities and their affiliates would not be prohibited from engaging in limited proprietary trading activities if the entity’s trading decisions and risks associated with such activities are held and managed outside the United States.
• Foreign banks are not prohibited from conducting cleared transactions with unaffiliated market intermediaries.

The final rule also requires trading desks of banking entities that are engaged in market-making activities to maintain inventory of securities at a level that reasonably aligns with the expected near-term demands of customers and counterparties. In determining what inventory should be maintained at the trading-desk level, banking entities will need to consider the historical demand for securities held in inventory, market factors, and their compliance with risk management procedures described in the final rule.

Covered Funds

The final rule imposes limits on the ability of banking entities to sponsor or invest in hedge funds or private equity funds (referred to as “covered funds”). A covered fund is any issuer that would be an investment company under the Investment Company Act of 1940 and any fund that is excluded from regulation as an investment company under either Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act. Covered funds also include certain foreign funds and commodity pools.

Compliance Requirements

Entities affected by the Volcker rule are required to implement internal programs to monitor and ensure compliance with the prohibitions and restrictions of Section 619 of the Dodd-Frank Act. The final rule prescribes such compliance requirements on the basis of the size of the banking entity and the volume of its trading activities. For instance, larger banking entities are required to establish a more detailed compliance program, including a “CEO attestation,” while smaller entities are permitted to establish a “simplified compliance regime.” Banking entities with significant trading operations are required to report certain quantitative measurements about their trading activity to appropriate federal regulatory agencies.

Transition and Next Steps

The Volcker rule will be effective on April 1, 2014; the Federal Reserve Board has extended the conformance period by approximately one year to July 21, 2015. In addition, the final rule requires banking entities to comply with its reporting requirements (e.g., certain quantitative measurement reporting) on a phased-in basis from June 30, 2014, through December 31, 2016; the phase-in dates are dependent on the size of the banking entities’ trading assets and liabilities. The agencies will also review data they collect before September 30, 2015, and “revise the collection requirement” as needed.

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1 SEC Final Rule, Prohibitions and Restrictions on Proprietary Trading and Certain Interests In, and Relationships With, Hedge Funds and Private Equity Funds.

2 The Dodd-Frank Wall Street Reform and Consumer Protection Act.