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The Volcker Rule: A User’s Manual

Courtesy of ZeroHedge. View original post here.

Submitted by MacroAndCheese.

 

macroandcheese.org

 

The Volcker Rule, named for the former Chairman of the Federal Reserve credited with taming inflation in the early 1980s, is a specific section of the Dodd-Frank Act that was signed into law on July 21, 2010.  Although the Dodd-Frank Act is now law, the Volcker Rule is not slated to be implemented until July 21, 2012, on the two-year anniversary of the original bill.
 
This entry provides a brief overview of the Volcker Rule and its key statutes, including what entities are impacted, which bank trading activities will be prohibited, the measures that will be required for compliance, and the implementation timeline.   This explanation frequently references the original document itself, with specific citations sourced with the relevant page(s) provided in parentheses.  The original document can be found here:
 

  http://www.sec.gov/rules/proposed/2011/34-65545.pdf

 

 

What is the Volcker Rule?

 

The Volcker Rule (“VR”) is an addendum to the “Dodd-Frank Wall Street Reform and Consumer Protection Act.”  The VR runs 298 pages.  Its intent is to prohibit commercial banks from engaging in “proprietary trading” according to a limited, prescribed definition (see below).  The VR does not prohibit banks from trading altogether, although it will require banks to document all trades that are not “exempted,” and to demonstrate that these trades follow procedures as mandated.  The VR will be overseen by five separate government entities, including the Federal Reserve, SEC, CFTC, FDIC, and OCC (Office of the Comptroller of the Currency.)

 

 

What is the Dodd-Frank Act?

 

The Dodd-Frank Act (“DFA”) was enacted to carry out financial reform measures in response to the financial crisis and recession of 2007-2009.  The intent of the bill was to reform the financial system, including some consolidation of regulatory agencies, consumer protection measures, broader supervision of the financial system by the Federal Reserve, and increased supervision of hedge funds.  The Volcker Rule was added to the DFA at the request of President Barrack Obama.

 

 

What institutions are affected by the VR?

 

All banking institutions in the United States and their affiliates, including overseas bank branches, would be bound by the VR.  In addition, the VR would cover all foreign banks maintaining operations in the United States.  Non-bank financial institutions such as hedge funds or insurance companies would not be affected.  Brokerages and investment banks would also not be subject to the VR, although the largest of the investment banks such as Goldman Sachs and Morgan Stanley agreed to become banking institutions during the financial crisis and would now be covered.

 

 

What is the VR definition of “proprietary trading?”

 

The VR definition is as follows:

 

“Proprietary trading means engaging as principal for the trading account of the covered banking entity in any purchase or sale of one or more covered financial positions.  Proprietary trading does not include acting solely as agent, broker, or custodian for an affiliated third party.” (p. 390)

 

The VR goes on to provide a specific definition of “trading account,” namely an account that trades for “short-term resale; benefitting from…short-term price movements; realizing short-term arbitrage profits; and hedging…positions.”  The VR adds that positions held for 60 days or less will be generally deemed to be “trading” positions.  This definition effectively allows banks to maintain “investment accounts” for longer-term investments.  However, the VR permits regulators to designate any account as a “trading account” as they see fit.

 

The VR also defines “covered position” in a very specific manner, namely “(A) a security, including an option on a security; (B) a derivative, including an option on a derivative; (C) a contract of sale of a commodity for future delivery, or option on a contract of sale of a commodity for future delivery.”  The definition specifies that loans, commodities, and foreign exchange are excluded from the VR (p. 394). 

 

 

What activities are not “covered financial positions” and are therefore acceptable?

 

In addition to loan, commodity, and foreign exchange transactions, the VR also permits trading in government securities (including agencies, securities issued by individual states and cities, etc.), underwriting and market-making provided the transactions are affiliated with specific customer needs, and any trade in which the bank is acting as agent (broker) rather than as principal.

 

 

Does the VR impose other restrictions besides proprietary trading?

 

Yes, under the VR, US banks will not be allowed to own interests in hedge funds exceeding 3% of the total value of the equity, and will not be allowed to sponsor hedge or private equity funds.

 

The VR also prohibits transactions that represent a material conflict of interest between the bank and its clients, bank exposure to high-risk assets or trading strategies, or activities that jeopardize the “safety and soundness of the covered banking entity,” or the “financial stability of the United States.” (p.411)  None of backstop restrictions are defined in detail and are subject to the judgment of federal banking agencies.

 

 

How will banks comply with the VR?

 

Banks will be responsible for monitoring of and compliance with the VR.  As stated in the VR, the banks’ “written policies and procedures must clearly articulate and document a comprehensive explanation of how the mission and strategy of each trading unit, and its related risk levels, comply with this part.” (p. 487)  Additionally, banks are required to identify which activities are “covered,” and if so, to document in detail how covered transactions are being properly managed and monitored in accordance with the VR.

 

 

Why is compliance with the VR considered to be complicated?

 

Applying the VR in many cases is straightforward.  It will be possible for banks to trade US treasury bonds for their own account, for example, but not securities such as stocks or stock options.  However, due to the complexity of financial instruments and to the comprehensive nature of bank market-making activity, compliance will be challenging.

 

To distinguish market-making from proprietary trading, for example, regulators will apply five specific factors in making their determination.  These factors are:

 

  1. Risk-Management
  2. Source-of-Revenues
  3. Revenue Relative to Risk
  4. Customer-Facing Activity
  5. Payment of Fees, Commissions, and Spreads

 

The definitions and descriptions run 14 pages of the VR (pp. 450-464).  The application of these factors is quantitative in nature and requires extensive measurement and record-keeping on an ongoing basis.  Since regulators will be applying these rules to banking activities, the banks themselves will of course need to make their determination in the same manner.

 

 

What are the compliance measures to be implemented by banks?

 

As detailed in Appendix C of the VR, a minimal bank compliance program “requires that banking entities establish, maintain, and enforce an effective compliance program, consisting of written policies and procedures, internal controls, a management framework, independent testing, training, and recordkeeping.” (p.479)  Appendix C lays out in considerable detail what will be required and runs 23 pages, from pp. 479-502.  The VR holds senior and intermediate management accountable for the effective implementation of the program, and requires that the bank’s board of directors and CEO review the program for efficacy.

 

 

What is the VR timeline?

 

As mentioned, the VR implementation date is July 21, 2012.  Banks will be required to implement a full compliance program capable of monitoring all banking activities by that date.  However, there will be a two-year conformance period by which banks will be expected to bring their activities within compliance.  In other words, banks will have a two-year grace period during which they can bring their operations to conformity.  In addition, at the discretion of the Federal Reserve, individual banks may be granted three one-year extensions beyond the initial grace period.  Full implementation by all banks much be achieved by July 21, 2017.

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