United States: Final Regulation Implementing the Volcker Rule

Keywords: Volcker Rule, financial regulators, joint final regulation, financial reform, private fund, banking obligations

The US federal financial regulators recently approved the much-anticipated joint final regulation implementing the Volcker Rule, a key element of the 2010 Dodd-Frank financial reform legislation, which is intended to curtail the proprietary trading and private fund activities of US and non-US banking groups. The final regulation represents, in certain respects, a significant improvement upon the proposal released in fall 2011, particularly as it relates to limiting the extraterritorial impact of the regulation on non-US banking organizations. On the other hand, the final regulation leaves important questions from the proposal unresolved and creates new issues of its own, not least among them the manner in which Volcker Rule compliance will be supervised and enforced for complex banking organizations subject to the jurisdiction of multiple US regulators.

This report summarizes the final regulation, including a banking entity's obligations in advance of the termination of the Volcker Rule conformance period, now scheduled for July 2015, and highlights select issues of concern for many financial services firms.


On December 10, 2013, the five US federal financial regulators (the "Agencies") approved joint final regulations (the "Final Regulation") implementing Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), commonly referred to as the Volcker Rule.1 Section 619 added a new Section 13 to the Bank Holding Company Act of 1956 (the "BHCA") that generally prohibits any banking entity from engaging in proprietary trading and from acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with a hedge fund or a private equity fund, subject to exemptions for certain permitted activities.

Over 70 pages in rule text and nearly 900 pages of supplementary information (the "Preamble"), the Final Regulation made numerous changes to the regulations proposed in October 2011 (the "Proposal"), which was subject to an unprecedented number of comment letters.2 These changes address many of the concerns raised in the comment letters, while leaving some questions unanswered and raising a number of new issues. In many respects the Final Regulation is an improvement over the Proposal. For example, the Final Regulation substantially mitigates concerns about the extraterritorial impact of the Volcker Rule, and adopts a more flexible approach to certain key exemptions. On the other hand, some changes will result in a regulation that is potentially more restrictive than the Proposal, such as the requirement for hedging to be tied to "specific, identifiable" risks with ongoing "recalibration" and extensive documentation requirements. This Legal Report provides an initial assessment of the Final Regulation and notes a number of new interpretive issues that will likely need to be clarified by further guidance.

At this early juncture, it is evident that the Final Regulation will place a substantial compliance burden on many banking entities. Moreover, it is not yet clear how the Agencies will ultimately implement the authority to supervise and examine certain banking entities. For example, the CFTC has stated in its release that it will be the primary regulator for registered swap dealers, whereas many swap dealers will already be subject to the primary jurisdiction of one of the other Agencies, such as the OCC in the case of national banks and the FRB in the case of foreign banks.3

Fortunately, there will be a period of time in which to resolve some of this uncertainty. While the Final Regulation has a technical "effective date" of April 1, 2014, no specific provisions of the Volcker Rule will actually go into effect on that date. Rather, as result of an FRB order issued in connection with the approval of the Final Regulation, the Volcker Rule conformance period has been extended for all banking entities until July 21, 2015 (although certain banking entities with large trading operations will be required to begin reporting trading metrics during the conformance period). The key requirement for all banking entities during the conformance period will be to continue making good faith efforts to be in a position to comply with the Final Regulation by the end of the conformance period. The FRB order includes two specific additions to this general good faith conformance obligation: (i) a directive to "promptly" shut down stand-alone prop trading desks and (ii) a directive "not to expand activities and make investments during the conformance period with an expectation that additional time to conform those activities or investments will be granted."4

This Legal Report addresses the following topics: the scope of the Final Regulation, in particular the definition of "banking entity" (pages 2-4); the prohibition on proprietary trading and the exemptions thereto (pages 4-14); the prohibition on covered fund activities and the exemptions thereto (pages 14-32); the "Super 23A" prohibition on covered transactions with certain covered funds (pages 33-34); the limitations on permitted activities, including conflicts of interest (pages 34-35); and the extensive compliance program requirements that banking entities are required to implement by the end of the conformance period, including metrics reporting obligations for entities with significant trading activities (pages 35-43).


The Volcker Rule applies to every "banking entity," which is defined in Section _.2(c)(1) of the Final Regulation as:5

  1. Any Insured Depository Institution. This includes any bank, thrift, industrial loan company, or other entity the deposits of which are insured by the FDIC.
  2. Any Company That Controls an Insured Depository Institution. This includes any bank holding company ("BHC"), any savings and loan holding company ("SLHC"), and any foreign bank or company that has a US insured depository institution subsidiary.
  3. Any Company Treated as a BHC for purposes of the International Banking Act of 1978 (the "IBA"). This includes any foreign bank that has a US branch, agency, or commercial lending company subsidiary and the parent company of such a foreign bank.
  4. Any Affiliate or Subsidiary of the Foregoing. This includes any company, on a global basis, that controls, is controlled by or is under common control with the foregoing, as defined in the BHCA.6 Thus, it includes, wherever located, broker-dealers, insurance companies, commodities and derivatives firms, investment advisers, investment funds, and any other entity that is affiliated with one of the foregoing entities.

The Final Regulation does not apply to financial groups that do not contain a US depository institution or a foreign bank with a US branch or agency.

Exclusion of Covered Funds. Section _.2(c)(2) of the Final Regulation excludes from the definition of banking entity any covered fund that is not itself an insured depository institution, a company that controls an insured depository institution, or a company treated as a BHC under the IBA. Accordingly, covered funds controlled by a banking entity are not prohibited by the Volcker Rule from engaging in proprietary trading or covered fund activities (e.g., investing in other covered funds in a fund of funds structure).

Non-Covered Funds as Banking Entities. A fund that is not a covered fund, including any entity that is excluded from the definition of covered fund by Section _.10(c) of the Final Regulation (discussed below, pages 17-21), would be a banking entity subject to all of the restrictions of the Volcker Rule if it is affiliated with a banking entity for BHCA purposes. The Preamble confirms that SEC-registered investment companies and SEC-regulated business development companies would not be considered subsidiaries or affiliates of a banking entity "solely by virtue of being advised or organized, sponsored and managed by a banking entity in accordance with the BHCA."7 It also notes FRB precedents that certain director/officer interlocks with and investments in less than 25 percent of the voting shares of such SEC-regulated funds would not constitute control. However, to the extent that other entities covered by the Section _.10(c) exclusions may be controlled by a banking entity, these excluded entities—which might include, for example, securitization vehicles and asset-backed commercial paper ("ABCP") conduits that are bank affiliates—would themselves be prohibited from engaging in proprietary trading or covered fund activities unless a specific Volcker Rule exemption is available.

Exclusion of Merchant Banking Investments. A portfolio company held pursuant to merchant banking authority under the BHCA is not a covered fund, nor is any "portfolio concern" controlled by a small business investment company ("SBIC") as defined in the Small Business Investment Act of 1958, unless such portfolio entities trigger any of the first three definitions of banking entity listed above.8

Nonbank Financial Companies Supervised by the FRB. Section 13 of the BHCA authorizes the FRB to impose additional capital requirements, quantitative limits and other restrictions with respect to proprietary trading and covered fund activities on nonbank financial companies that are not "banking entities," but that become subject to FRB supervision upon designation by the Financial Stability Oversight Council (the "FSOC") as systemically important financial institutions ("SIFIs"). The Final Regulation does not address the extent to which the Volcker Rule restrictions might be applied to SIFIs.


Prohibition on Proprietary Trading

Section 13 of the BHCA broadly prohibits any banking entity from engaging in proprietary trading. Section _.3(a) of the Final Regulation defines "proprietary trading" as "engaging as principal for the trading account of the banking entity in any purchase or sale of one or more financial instruments."9 In rejecting many of the requests in the comment letters that the proposed definitions of proprietary trading, trading account, and financial instrument be narrowed, the Agencies generally take the view that these concerns are best addressed in the context of the exclusions and exemptions from proprietary trading.

Definition of "Financial Instrument"

The Final Regulation replaces the term "covered financial position" used in the Proposal with the term "financial instrument," but defines it in substantially the same manner. A financial instrument includes any security, any derivative,10 any contract of sale of a commodity for future delivery, and any option on any of the foregoing instruments. The definition of financial instrument specifically excludes loans (including any leases, extensions of credit, or secured or unsecured receivables that are not securities or derivatives), certain commodities (i.e., those defined as excluded commodities under the Commodity Exchange Act of 1936 (the "CEA")), and foreign exchange or currency. In this context, "foreign exchange or currency" is not further defined or interpreted by the Agencies.

Definition of "Trading Account"

Substantially as proposed, Section _.3(b) of the Final Regulation adopts a three-pronged definition of "trading account," and an activity need only fall within one prong of the definition to constitute proprietary trading.

Intent Test. The Final Regulation first defines the trading account as any account used to buy or sell a financial product principally for the purposes of short-term resale, benefitting from short-term price movements, realizing short-term arbitrage profits, or hedging positions resulting from any of the above transactions.

Capital Rule Test. The trading account also includes any account used for the purchase or sale of a financial instrument that is both a "covered position" for purposes of the US market risk capital rule and a "trading position" (including hedges of those positions). This test applies to any banking entity that is, or that has an affiliate that is, an insured depository institution, BHC, or SLHC that calculates risk-based capital ratios under the market risk rule.

Status Test. The trading account also includes any account used for the purchase or sale of financial instruments by a banking entity that is licensed or registered, or required to be licensed or registered, as a dealer, swap dealer, or security-based swap dealer, and the purchase or sale is being made in connection with the entity's dealing activities. This prong also applies to banking entities engaged in business as a dealer, swap dealer, or security-based swap dealer outside of the United States.

Rebuttable Presumption. The purchase of a financial instrument by a banking entity is presumed to be for its trading account if the banking entity holds the position for fewer than sixty days or substantially transfers the risk of the position within sixty days of the purchase. A banking entity may rebut the presumption by demonstrating that it did not purchase the financial instrument principally for any of the short-term trading purposes described above in connection with the trading account "intent test." There is no opposite presumption for positions held longer than sixty days.

Excluded Activities

Section _.3(d) of the Final Regulation expressly excludes the following activities from the definition of proprietary trading:

Repurchase and Reverse Repurchase Transactions. The proprietary trading ban does not apply to a repurchase or reverse repurchase agreement in which a banking entity has simultaneously agreed, in writing, to both purchase and sell a stated asset, at stated prices, on stated dates or on demand, with the same counterparty. The Agencies agree that repos are the equivalent of secured loans. The collateral or position that is being financed by a repo, however, is not excluded from the definition of proprietary trading.

Securities Lending and Borrowing. Securities lending and borrowing transactions are not proprietary trading, provided that the banking entity lends or borrows a security temporarily to or from another party pursuant to a written securities lending agreement, under which the lender retains the economic interest of an owner of such security and has the right to terminate the transaction and to recall the loaned security on terms agreed by the parties. The same rationale and limits apply to securities borrowing and lending transactions as to repos.

Liquidity Management. Securities transactions conducted in accordance with a documented liquidity management plan are also excluded from the definition of proprietary trading, provided that the plan:

  1. Specifically contemplates and authorizes the particular securities to be used for liquidity management purposes, the amount, types, and risks of the securities that are consistent with liquidity management, and the liquidity circumstances in which the particular securities may be used;
  2. Requires that any purchase or sale of securities under the plan be principally for the purpose of managing the liquidity of the banking entity, and not for prohibited short-term trading purposes;
  3. Requires that any securities purchased or sold for liquidity management purposes be highly liquid and limited to securities that the banking entity does not reasonably expect to give rise to appreciable profits or losses as a result of short-term price movements;
  4. Limits securities purchased or sold for liquidity management purposes to an amount that is consistent with the banking entity's near-term funding needs, as estimated and documented pursuant to methods specified in the plan;
  5. Includes written policies and procedures, internal controls, analysis, and independent testing to ensure compliance; and
  6. Is consistent with supervisory requirements, guidance, and expectations regarding liquidity management applicable to the banking entity.

In a footnote, the Agencies state that they plan to construe "near-term funding needs" in a manner consistent with applicable laws, regulations and issuances related to liquidity risk management including liquidity coverage ratio requirements.11 They also declined the request of commenters to expand the exclusion to cover asset-liability management activities more generally.

Clearing Organization Transactions. Purchases and sales of financial instruments by a banking entity that is a derivatives clearing organization ("DCO") or a clearing agency are excluded from the definition of proprietary trading, under the rationale that the banking entity provides clearing as a service to third parties and not to profit from short-term resale or short-term price movements.

Clearing Activities. A banking entity may engage in "excluded clearing activities" if the banking entity is a member of a DCO, clearing agency or designated financial market utility. Excluded clearing activities include purchases and sales by a banking entity arising in connection with errors, defaults, or threatened defaults by one or more participants in the clearing process of a DCO, clearing agency, or designated financial market utility.

Trading as Agent, Broker or Custodian. A banking entity purchasing and selling financial instruments solely as an agent, broker, or custodian is not engaged in proprietary trading. The Preamble provides that this exclusion includes agency, brokerage, and custodial transactions on behalf of an affiliate, but notes that the exclusion does not exempt an affiliate on whose behalf transactions are carried out from complying with the Volcker Rule (i.e., to the extent such affiliate is engaged in proprietary trading as principal).

Trading in Satisfaction of Delivery Obligations. The Final Regulation adds an exclusion that permits a banking entity to purchase or sell a financial instrument (i) to satisfy an existing delivery obligation of the banking entity or its customers in connection with delivery, clearing, or settlement activity or (ii) to satisfy an obligation of the banking entity in connection with a judicial, administrative, self-regulatory organization, or arbitration proceeding.

Trading on Behalf of Employee Benefit Plans. The Final Regulation permits a banking entity to purchase and sell financial instruments through a deferred compensation, stock-bonus, profit-sharing, or pension plan of the banking entity, if the banking entity is acting as trustee acting for the benefit of persons who were or are employees of the banking entity.

Debt Collection Activities. The Final Regulation permits a banking entity to purchase or sell a financial instrument if the banking entity effects the sale or purchase in the ordinary course of collecting a debt previously contracted in good faith, so long as the banking entity divests itself of the financial instrument as soon as practicable and in compliance with its regulator's maximum retention period.

Permitted Trading Activities

Permitted Market-Making Activities

The Final Regulation makes substantial revisions to the Proposal in exempting market-making-related activities from the prohibition on proprietary trading. The Agencies have discarded lengthy guidance from the Proposal discussing indicia of market-making in favor of streamlined rule text. Under Section _.4(b) of the Final Regulation, a trading desk, which may operate across one or more legal entities, must "routinely stand ready" to trade and be "willing and available" to quote and otherwise enter into trades "through market cycles" on a basis appropriate given the liquidity, maturity, and market depth of the financial instruments for which it acts as market-maker. This exemption does not require trade-by-trade analyses, but instead a banking entity must monitor (i) "financial exposure"—i.e., the aggregate risks of financial instruments and any associated loans, commodities, or foreign exchange or currency held as part of its market-making-related activities—and (ii) for each trading desk, its "market-maker inventory." Consistent with the Proposal, the amount, types, and risks of the financial investments in the market-maker inventory must be designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties based on, among other things, demonstrable analysis of historical demand.

In another change from the Proposal, the Final Regulation permits market-making related hedging under Section _.4(b) without requiring a banking entity to separately comply with the risk-mitigating hedging exemption set forth in Section _.5. Moreover, the Proposal would have required market-making to generate revenues primarily from fees, commissions, bid/ask spreads, or other income not attributable to appreciation in value in covered financial positions (or hedges thereto), which a number of comment letters had identified as problematic for certain types of market-making activities. This revenue requirement has not been incorporated in the Final Regulation, although compensation arrangements for market-making personnel must be designed so that they do not reward or incentivize prohibited proprietary trading.

Compliance Obligations. A banking entity relying on the market-making exemption must establish and maintain an appropriate compliance program as required by subpart D of the Final Regulation (discussed below, pages 35-43) that (i) addresses the conditions noted above, including identification of the financial instruments that the trading desk is permitted to buy and sell as market-maker and the products and strategies it may use for risk management purposes; (ii) sets limits for each trading desk based on the desk's market-making activities; (iii) implements controls and ongoing monitoring for compliance with the limits; and (iv) establishes authorization procedures for any trade that would exceed the limits. These compliance requirements generally apply at the "trading desk" level of an organization, and thus will potentially require tailoring depending upon the characteristics of a particular trading desk's activities.

Interdealer Limitation. The Final Regulation defines clients, customers, and counterparties in the context of the market-making exemption to exclude large trading desks of other banking entities—i.e., entities with $50 billion or more in total trading assets and liabilities—unless the trading desk documents why such an entity should be treated as a customer or the transactions are anonymously conducted on an exchange that permits trading on behalf of a broad range of market participants. The Agencies expressed concern that the market-making exemption could be used to facilitate interdealer trading, activities which will "bear some scrutiny" by the Agencies going forward.

Clarifications in the Preamble. The Agencies note that, if a banking entity's primary dealer activities for a sovereign government fall outside of the underwriting exemption in Section _.4(a) of the Final Regulation, discussed below, the sovereign government and its central bank are each a client, customer, or counterparty for purposes of applying the market-making exemption. Further, the Agencies also state that the market-making exemption generally may be used by so-called "authorized participants" who create and redeem shares of, and engage in various trading activities in connection with, exchange-traded funds ("ETFs"). Commenters had been unsure whether such ETF transactions would be exempt under the proposed market-making or underwriting exemptions.

Permitted Underwriting Activities

Section _.4(a) of the Final Regulation adopts the underwriting exemption from the proprietary trading prohibition substantially as proposed, but the scope of the exemption has been broadened to apply to members of an underwriting syndicate and selling group members (rather than a single, lead underwriter), smaller offerings based on a change to the definition of "distribution," and selling security holders (in addition to issuers). The exemption also now permits banking entities to engage in stabilizing activities and to retain unsold allotments.

In brief, a banking entity may permissibly engage in proprietary trading activities under the underwriting exemption if:

  1. It is acting as an "underwriter" for a "distribution" of securities of an issuer or selling security holder;
  2. Its trading desk's "underwriting position" is related to the distribution;
  3. The amount and type of the securities of the trading desk's underwriting position are designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties;
  4. Reasonable efforts are made to sell or otherwise reduce the underwriting position within a reasonable period, taking into account the liquidity, maturity, and depth of the market for the relevant type of security;
  5. The banking entity establishes and maintains a compliance program that addresses various underwriting-related requirements;
  6. Compensation arrangements for relevant personnel are designed not to reward or incentivize prohibited proprietary trading; and
  7. The banking entity is licensed or registered to engage in the underwriting activity.

Although the Final Regulation still defines the term "distribution" by reference to the SEC's concept of "special selling efforts and selling methods" from Regulation M, it does not require compliance with the "magnitude" requirement from that same regulation. Accordingly, the exemption is now available for distributions of smaller size than those historically meeting the Regulation M definition of distribution. The Agencies also note that offerings that qualify as distributions include, among others, private placements in which resales may be made in reliance on the SEC's Rule 144A or other available exemptions, as well as commercial paper being offered as a security.

Compliance Obligations. As under the market-making exemption, a banking entity relying on the underwriting exemption must establish and maintain an appropriate compliance program as required by subpart D of the Final Regulation that (i) addresses the conditions noted above; (ii) sets limits for each trading desk based on the desk's underwriting activities; (iii) implements controls and ongoing monitoring for compliance with the limits; and (iv) establishes authorization procedures for any trade that would exceed the limits.

Permitted Risk-Mitigating Hedging Activities

Section _.5 of the Final Regulation implements the exemption for risk-mitigating hedging activities, which generally permits a banking entity to trade financial instruments in order to hedge specific risks to the banking entity arising in connection with the individual or aggregated positions, contracts, or other holdings of the banking entity. The Final Regulation circumscribes the risk-mitigating hedging exemption originally described in the Proposal and imposes significant additional documentation and compliance-oriented obligations. However, the retention of the reference to hedging of "aggregated position" indicates that some degree of portfolio hedging remains permissible, provided that the risks being hedged are sufficiently identifiable and other specific requirements of the exemption (e.g., related to documentation) are satisfied.

Under the Final Regulation, in order for a position to qualify as permitted hedging, the putative hedge must, from inception, demonstrably (via some type of analysis) reduce or mitigate the specific identifiable risks of specific identifiable positions or aggregated positions.12 In contrast, the Proposal only required that a hedge be reasonably correlated to a risk or risks being mitigated. In any event, a hedge must not itself give rise to any significant new or additional risk that is not contemporaneously hedged, and banking entities are required to engage in ongoing recalibration of hedging activities to ensure continuing compliance with the conditions of this exemption. Compensation arrangements for risk-mitigating hedging personnel must be designed so that they do not reward or incentivize prohibited proprietary trading.

These new conditions reflect the Agencies' view that hedging should be connected to "identifiable" positions and risks, as opposed to being conducted on a macro basis. Notably, the Agencies state that it would be inconsistent with Congressional intent to permit hedging 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."13 Accordingly, the Preamble provides that the hedging exemption may not be used for "scenario hedging," "revenue hedging" or general asset-liability management.

In at least one aspect, the Final Regulation liberalizes the proposed exemption. Anticipatory hedging remains permissible if conducted in accordance with the conditions noted above, but now such hedging need not be conducted "slightly" before a banking entity becomes exposed to a specific, identifiable risk. The Agencies effectively agreed with commenters' concerns that this now-deleted modifier was potentially unduly limiting.

Compliance Obligations. A banking entity relying on the risk-mitigating hedging exemption is subject to compliance obligations similar to those that apply for underwriting and market-making, including establishing and maintaining a compliance program as required by subpart D of the Final Regulation. The Final Regulation imposes additional documentation requirements for hedges that are created or maintained (i) to hedge aggregated positions across two or more trading desks, (ii) in a financial instrument not previously listed among the products used for hedging by the hedging trading desk, or (iii) at a different trading desk from the trading desk that established the underlying positions creating the risks being hedged. These additional records must be maintained for a period no less than five years.

Permitted Trading Activities of Foreign Banking Entities

The Final Regulation modifies the proposed exemption for trading activities conducted by foreign banking entities solely outside of the United States ("SOTUS"). In response to comments, some key aspects of the Proposal have been revised or eliminated, including the definition of "resident of the United States" and the requirement that a transaction be executed wholly outside the United States in order to be covered by the exemption. Under Section _.6(e) of the Final Regulation, foreign banking entities may engage in "foreign trading activities" under the following conditions:

  1. The banking entity is not organized, or directly or indirectly controlled by another banking entity that is organized, under US law;
  2. The banking entity engages in the transaction pursuant to the authority in Section 4(c)(9) or Section 4(c)(13) of the BHCA;
  3. The banking entity is either a qualifying foreign banking organization ("QFBO") under Regulation K or, if it is a not a foreign banking organization under Regulation K, it meets at least two of three tests showing a foreign predominance in its operations;14
  4. The banking entity, including any personnel of the banking entity arranging, negotiating or executing the purchase or sale, or deciding to make the purchase or sale, is not located in the United States;
  5. The transaction, including any related risk-mitigating hedging, is not accounted for as principal on the books of any US-located or US-organized branch or affiliate of the foreign banking entity;
  6. No financing for the banking entity's purchase or sale is directly or indirectly provided by any US-located or US-organized branch or affiliate; and
  7. The banking entity's purchase or sale is not conducted with or through any US entity, except as discussed below.

Permissible US Counterparties. A foreign banking entity is permitted to trade with the foreign operations of a US entity, such as the non-US branch of a US bank, provided that no personnel of the counterparty that are located in the United States are involved in the arrangement, negotiation, or execution of the transaction. In addition, a foreign banking entity is permitted to trade with any unaffiliated US market intermediary acting as principal, provided that the trade is promptly cleared and settled through a clearing agency or DCO. The exemption also permits a foreign banking entity to trade with an unaffiliated US market intermediary acting as agent, if the transaction is anonymously conducted on an exchange or similar trading facility and is promptly cleared and settled through a clearing agency or DCO.15

Permitted Trading in US Government Obligations

Section _.6(a) of the Final Regulation permits a banking entity to purchase and sell, anywhere in the world, obligations issued or guaranteed by the United States or an agency thereof, Ginnie Mae, Fannie Mae, Freddie Mac, Farmer Mac, a Federal Home Loan Bank, or a Farm Credit System Institution. This represents an expansion of the proposed exemption because it permits trading in obligations guaranteed but not issued by the United States. The Final Regulation also permits a banking entity to purchase and sell obligations of any US state or any political subdivision thereof, including municipal securities. The Final Regulation does not permit a banking entity to buy or sell derivatives referencing US government obligations in reliance on this exemption.

Permitted Trading in Foreign Government Obligations

Many foreign governments and other foreign entities filed comment letters requesting that an exemption for foreign sovereign obligations be adopted similar to the exemption for US government obligations. Section _.6(b) of the Final Regulation includes a new exemption to address these concerns. As detailed below, separate exemptions have been adopted for the US operations of foreign banking entities and certain foreign affiliates of US banking entities.

US Operations of a Foreign Banking Entity. Under Section _.6(b)(1) of the Final Regulation, a banking entity organized under, or directly or indirectly controlled by a banking entity organized under, the laws of a foreign sovereign may purchase and sell obligations issued or guaranteed by the entity's "home country" foreign sovereign or any agency or political subdivision of the foreign sovereign. The exemption is not available to any banking entity (i) that is directly or indirectly controlled by a top-tier banking entity organized under US law or (ii) that is an insured depository institution. Although the exemption in Section _.6(b) is not by its terms limited solely to US operations of foreign banking entities, the Preamble indicates that trading in foreign sovereign obligations by the non-US operations of a foreign banking entity would be conducted pursuant to the foreign trading exemption set forth in Section _.6(e) of the Final Regulation (discussed above, pages 11-12) rather than the Section _.6(b)(1) exemption.16 Thus, these exemptions when read together appear to be intended to permit a foreign banking entity to trade in home-country government obligations in almost all circumstances.

Foreign Affiliates of a US Banking Entity. Section _.6(b)(2) of the Final Regulation permits a foreign affiliate of a US banking entity to purchase or sell an obligation of, or issued or guaranteed by, a foreign sovereign or any agency or political subdivision of a foreign sovereign if (i) the foreign affiliate is a foreign bank under FRB's Regulation K or is regulated by the foreign sovereign as a securities dealer; (ii) the financial instrument is issued by the entity's "host country" foreign sovereign, or by a political subdivision of the host country foreign sovereign (including any multinational central bank of which the foreign sovereign is a member); and (iii) the financial instrument is owned by the foreign affiliate and is not financed by an affiliate located in the United States or organized under US law. The Section _.6(b)(2) exemption does not appear to be available to foreign branches of US banks.

Permitted Trading on Behalf of Customers

Section _.6(c) of the Final Regulation permits banking entities to purchase and sell financial instruments on behalf of, or for the account of, customers in two separate ways:

In a Fiduciary Capacity. A banking entity is permitted to purchase or sell a financial instrument if it (i) is acting as a trustee or in a similar fiduciary capacity; (ii) is conducting the transaction on behalf of, or for the account of, a customer; and (iii) does not have or retain beneficial ownership of the financial instrument.

As a Riskless Principal. A banking entity is permitted to purchase or sell a financial instrument as a riskless principal (i) after receiving an order to purchase or sell from a client and (ii) if it does so to offset a contemporaneous sale to or purchase from the customer.

Permitted Trading by Regulated Insurance Companies

Section _.6(d) of the Final Regulation permits a banking entity that is an insurance company or an affiliate of an insurance company to purchase or sell financial instruments for (i) the general account of the insurance company or (ii) a separate account established by the insurance company. The purchase or sale must be made in compliance with applicable insurance company investment laws of the jurisdiction in which the insurance company is domiciled. The exemption is not available if the federal banking agencies have determined, after consultation with the FSOC and the relevant insurance commissioners, that the insurance company investment laws of the jurisdiction in question are insufficient to protect the safety and soundness of the banking entity or the financial stability of the United States.

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Originally published December 18, 2013


1 The Agencies are the Board of Governors of the Federal Reserve System (the "FRB"), the Federal Deposit Insurance Corporation (the "FDIC"), the Office of the Comptroller of the Currency (the "OCC"), the Securities and Exchange Commission (the "SEC") and the Commodity Futures Trading Commission (the "CFTC"). The FRB, FDIC, OCC, and SEC issued a joint release, and the CFTC issued a separate release with text that, with exceptions noted herein, is generally identical to the joint release. The joint release is available here, and the CFTC's release is available here. Page number references in the Legal Report are to the pre-Federal Register publication draft of the joint Agency release, unless otherwise indicated. The rule text, which is common to all of the Agencies, is available here.

2 For a discussion of the Proposal, see our Legal Report available here.

3 See CFTC release at 12.

4 FRB, "Order Approving Extension of Conformance Period," available here (emphasis added).

5 Citations in this Legal Report to the text of the Final Regulation adopt the convention employed in the pre-Federal Register publication draft, which is to refer to sections with a "_" preceding the subsection designation, e.g., "Section _.2(c)(1)." Each Agency will ultimately use its own section designation based on where the Final Regulation appears in its section of the Code of Federal Regulations. The subsection numbers should be consistent for all of the Agencies.

6 Under the BHCA, one company generally is deemed to control another if it (i) owns, controls, or has the power to vote 25 percent or more of the outstanding shares of any class of voting securities of the other company; (ii) controls in any manner the election of a majority of the directors, trustees, or general partners of the other company; or (iii) has the power to exercise, directly or indirectly, a "controlling influence" over the management or policies of the other company, as determined by FRB after notice and opportunity for hearing.

7 Preamble at page 497.

8 In addition, the Final Regulation excludes the FDIC acting in a corporate capacity or as a conservator or receiver.

9 The Final Regulation defines what is a "purchase" and "sale" for a variety of financial instruments. For example, with respect to a derivative, purchases and sales include the execution, termination (prior to scheduled maturity), assignment, exchange, or similar conveyance of, or extinguishing of rights or obligations under, as derivative, as context may require.

10 The definition of "derivative" in the Final Regulation is substantively unchanged from the Proposal. Among other things, it excludes any "identified banking product" as defined in the Legal Certainty for Bank Products Act of 2000. The Agencies declined to adopt the suggestion of many commenters that foreign exchange swaps and forwards that are generally exempt from the definition of "swap" under Title VII of the Dodd-Frank Act also be excluded from the definition of "derivative" and, thus, be treated as non-financial instruments for Volcker Rule purposes.

11 See Preamble at Footnote 242.

12 A specific identifiable risk may include market risk, counterparty or other credit risk, currency or foreign exchange risk, interest rate risk, commodity price risk, basis risk, or other similar risk.

13 Preamble at 346.

14 The three tests, of which a non-QFBO banking entity must satisfy at least two to be eligible for the foreign banking entity exemption, are (i) whether the banking entity holds more than 50 percent of its assets outside of the United States; (ii) whether the banking entity derives more than 50 percent of its revenue from business outside of the United States; and (iii) whether the banking entity derives more than 50 percent of its net income from business outside of the United States.

15 An unaffiliated market intermediary is defined as (i) a broker, dealer, or security-based swap dealer registered with the SEC or exempt from registration or (ii) a swap dealer or futures commission merchant registered with the CFTC or exempt from registration.

16 Provided that the requirements of the Section _.6(e) exemption are satisfied, a foreign banking entity is permitted to trade in the obligations of any foreign sovereign under that exemption (i.e., in addition to any other financial instrument), so trading would not be limited to "home country" sovereign obligations as under Section _.6(b)(1). This would include, for example, the trading of German Bunds by the Frankfurt branch of a Japanese bank. We also note that trading by a foreign banking entity under Section _.6(e) is not subject to mandatory metrics reporting obligations under Appendix A of the Final Regulation, which do apply to trading under Section _.6(b)(1) (as well as trading pursuant to the market-making, underwriting, hedging, and US Government obligations exemptions).

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Mayer Brown is a global legal services provider comprising legal practices that are separate entities (the "Mayer Brown Practices"). The Mayer Brown Practices are: Mayer Brown LLP and Mayer Brown Europe – Brussels LLP, both limited liability partnerships established in Illinois USA; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales (authorized and regulated by the Solicitors Regulation Authority and registered in England and Wales number OC 303359); Mayer Brown, a SELAS established in France; Mayer Brown JSM, a Hong Kong partnership and its associated entities in Asia; and Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. "Mayer Brown" and the Mayer Brown logo are the trademarks of the Mayer Brown Practices in their respective jurisdictions.

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This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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