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Volcker Rule

A proposal that bans banks from indulging in high risk speculative trading that endangers the deposits of average customers is being fiercely opposed by most banking institutions in the USA. The proposal which is on its way to its final draft is meeting with all kinds of resistance. The Volcker rule named after Paul Volcker, a former Federal Reserve chairman no less, who proposed a complete ban on proprietary trading by banks.

The ban of proprietary trading was not carried through, and banks are allowed to invest in hedge funds and private equity funds. The import of the rule is that while banks themselves were government insured against risk, to allow them to trade in high risk, high speculation instruments, sometimes against the best interests of its clients would result in systemic failure. An area of contention has been the method to differentiate between market making and speculation. This has not been easy to define and has resulted in some delay in the completion of the final draft. It is most likely that the proposal will have different methods for market making different types of securities. The team drafting the proposal currently has Treasury under secretary of domestic finance Mary. J. Miller heading it and lawyers from the Federal Reserve, SEC, FDIC, FTCC and OCC.

Given below are details from the Commodities Futures Trading Commission document regarding the prohibitions and restrictions of proprietary trading.

“Section 619 of the Dodd-Frank Act, among other things, generally prohibits two activities of banking entities.

  • It prohibits federally insured depository institutions, bank holding companies, and their subsidiaries or affiliates (banking entities) from engaging in short-term proprietary trading of any security, derivative, and certain other financial instruments for a banking entity’s own account, subject to certain exemptions.
  • It prohibits owning, sponsoring, or having certain relationships with a hedge fund or private equity fund, subject to certain exemptions.

Section 619 also prohibits banking entities from entering into any transaction or engaging in any activity that would:

  • Involve or result in a material conflict of interest,
  • Result in a material exposure to high-risk assets or high-risk trading strategies,
  • Pose a threat to the safety and soundness of the banking entity,
  • Pose a threat to the financial stability of the United States.

To implement Section 619, the Commission is considering a proposal that would clarify the scope of the section’s prohibitions and, consistent with statutory authority, provide certain exemptions.

The Commission’s proposal to implement Section 619 is substantively similar to the joint rule proposal issued by the Board of Governors of the Federal Reserve System (the Board); the Office of the Comptroller of the Currency, Treasury (OCC), the Federal Deposit Insurance Corporation (FDIC); and the Securities and Exchange Commission (SEC) in October of 2011 (the Joint Volcker Rule).  The Commission’s proposal also includes several additional questions asking whether certain provisions of the Joint Volcker Rule are applicable to CFTC-regulated banking entities.

The Commission’s proposal to implement the so-called “Volcker Rule” requirements is substantively similar to the Joint Volcker Rule.  Under the proposed rule, banking entities would be required to establish an internal compliance program that is designed to ensure and monitor compliance with the prohibitions and restrictions of Section 619, and the implementing regulations.  The internal compliance program would be subject to oversight by the banking entity’s board of directors and the appropriate federal supervisory agency.

The proposal also requires firms with significant trading operations to report to the appropriate federal supervisory agency certain quantitative measurements designed to assist the supervisory agency and banking entities in identifying prohibited proprietary trading from permitted activities.

The proposal also exempts transactions in certain instruments from the prohibition on proprietary trading, including obligations of:

  • The U.S. government or a U.S. government agency,
  • The government-sponsored enterprises,
  • State and local governments.

Additionally, the proposal would exempt activities such as:

  • Market making;
  • Underwriting;
  • Risk-mitigating hedging.

Notwithstanding the general prohibition on investments in, and certain relationships with, hedge funds and private equity funds, the statute contains several exemptions.  The proposal, for example, would exempt:

  • Organizing and offering a hedge fund or private equity fund under certain conditions, including limiting
  • Investments in such funds to a de minimis amount.
  • Making risk-mitigating hedging investments.
  • Making investments in certain non-U.S. funds.

This proposed rule also includes regulatory commentary intended to assist banking entities in distinguishing permitted market making-related activities from prohibited proprietary trading activities, and in identifying permitted activities in hedge funds and private equity funds.  It also includes a number of elements intended to reduce the effect of the proposal on smaller, less-complex banking entities.  For example, the proposal limits the extent to which smaller banking entities are required to report quantitative measurements.”

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