Agencies approve final rule to simplify and tailor the “Volcker Rule”

September 9, 2019 | Financial services

Agencies approve final rule to simplify and tailor the "Volcker Rule"

On August 20, 2019, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) signed the final rule (Revisions to Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds) amending the Volcker Rule to simplify and reduce the compliance requirements (Amendments).¹ The Volcker Rule was finalized in December 2013 (2013 Rule) to prevent banks from engaging in impermissible proprietary trading and from owning hedge funds or private equity funds.² The FDIC, OCC, Federal Reserve Board (FRB), Commodity Futures Trading Commission (CFTC), and Securities and Exchange Commission (SEC) (collectively 'Agencies') jointly released proposed amendments to the 2013 Rule in July 2018.^3,4

The Amendments are effective January 1, 2020, but banking entities will have until January 1, 2021, to become compliant or voluntarily choose to opt-in earlier.

Key takeaways:

• Tailored regulatory impact: The agencies created a three-tiered approach to apply the compliance program to banking entities based on the size of their trading assets and liabilities in lines with efforts for tailored regulatory impact. The final rule increased the threshold for “significant” trading activity from $10 billion to $20 billion based on the average gross sum of trading assets and liabilities over the previous consecutive four quarters as measured on the last day of quarter-end.
• Resource and process optimization: As we await the remaining banking agencies (i.e. the FRB, CFTC, and SEC) to approve the Proposed Rule, banking entities must understand where they fall within the scope of applicability and the requirements across the simplified and six-pillar compliance programs. Given the reduced pressure in compliance requirements, banking entities, especially those that are under the $1 billion “limited” trading threshold, can shift their focus towards reorganizing their resources. However, banking entities with "moderate" or "significant" trading assets and liabilities will benefit from an assessment on the maintenance or potential modifications of current processes around their respective compliance programs.
• RENTD requirements and limits unchanged: It is critical to note that the core "Reasonably Expected Near-term Demands of Clients, Customers and Counterparties" (RENTD) related requirement and limits remain and that regulators will be scrutinizing these limits as part of the ongoing exam process. As per our previous publications on RENTD and limit setting, the process of calculating RENTD and translating it into defensible limits used to establish the presumption of compliance will remain a critical exercise at most banking entities in the significant and moderate categories.
• Deferrals and additional rulemaking: The agencies intend to issue further rulemaking on fund-related issues, such as the definition and applicability of "covered funds" and "banking entity" and their potential exclusions at a later date.

Scope of applicability

The final rule formalized a three-tiered approach to compliance program requirements for banking entities based on their level of trading activity:

• Banking entities with “significant” trading assets and liabilities: Includes banking entities with consolidated trading assets and liabilities of at least $20 billion. For US banking entities this calculation is based on worldwide average gross trading assets and liabilities for each of the previous four quarters whereas for foreign banking organizations (FBOs), it is based on trading assets and liabilities of their combined US operations (CUSO) including its US branches, agencies, and subsidiaries. These entities are required to comply with the most extensive set of requirements under the Amendments, which include the six-pillar compliance program, an annual CEO attestation, and metrics reporting requirements.
• Banking entities with "moderate" trading assets and liabilities: Includes banking entities which have consolidated trading assets and liabilities equal to or above $1 billion but less than $20 billion. For FBOs, this is measured based on CUSO. These banking entities are subject to simplified compliance requirements.
• Banking entities with "limited" trading assets and liabilities: Includes banking entities with consolidated trading assets and liabilities of less than $1 billion. In contrast to the June 2018 proposed amendments, the calculation of trading assets and liabilities for the limited classification is based on the same scope as moderate: worldwide trading assets and liabilities for US banking entities and CUSO for FBOs. Banking entities meeting the limited threshold are assumed to operate under a presumption of compliance.
  

Key amendments: Proprietary trading

The Amendments contain several changes to the proprietary trading provisions, including the following:

• Changes to the short-term intent prong (purpose test): The definition of “trading account” is modified to increase clarity regarding the positions included in the definition. Per the 2013 Rule “trading account” was defined based on three main prongs:
  • Short-term intent prong⁵
  • Market risk capital prong⁶
  • Dealer prong⁷

The Amendments modify the short-term intent prong by eliminating the rebuttable presumation⁸ for financial instruments held for fewer than 60 days and by adding a rebuttable presumption for instruments held for 60 days or longer. The Amendments also provide a banking entity subject to the market risk capital rule prong, on a basis consistent with the 2013 Rule, is not otherwise subject to the short-term intent prong. A banking entity that is not subject to the market risk capital rule prong as an alternative and may elect to apply the market risk capital rule.

• Elimination of the accounting prong: The Amendments eliminated the accounting prong due to concerns that the accounting prong would have inappropriately scoped in many financial instruments and activities, regardless of the banking entity’s purpose for buying or selling the instrument. With the short-term intent prong being modified to provide more clarity and adding additional exclusions from the “proprietary trading” definition, the Agencies have decided to not adopt the accounting prong.
• Expansion of liquidity management exclusion: The Amendments modify the definition of proprietary trading to permit banking entities expanded usage of the liquidity management exclusion courtesy of permitted usage of a wider set of financial instruments. Under the Amendments, the purchase and sale of FX forwards, FX swaps, and physically-settled cross-currency swaps and non-deliverable cross-currency swaps are permitted in addition to securities permitted under the original exclusion.
• Additional exclusions to proprietary trading definitions: The Amendments now permit under specific circumstances usage of additional exclusions including correction of a bone fide trading errors, certain customer-driven swaps, hedges of mortgage servicing rights or assets, and purchases of financial instruments not meeting the definition of "trading asset or liabilities" under the applicable regulatory reporting forms.
• Changes to the underwriting and market-making exemption (related to RENTD): As amended, a banking entity’s purchase or sale of a financial instrument in connection with its underwriting or market making-related activities is presumed to be in compliance with the RENTD requirement if the banking entity has established and enforced internal risk limits at the trading desk level. The Amendments lighten the burden on reporting of limit breaches by eliminating the requirement to “promptly” report breaches to the relevant regulatory agency(ies). In lieu of immediate reporting to regulators, the Amendments require covered banking entities to maintain and make available upon request documentation of escalation and approval procedures followed to investigate and conclude on the underlying causes of limit breaches.
• Changes to the risk mitigation hedging exemption: For banking entities with significant trading assets and liabilities, the requirements for correlation analysis as well as the requirement that the hedging activity must “demonstrably reduce or otherwise significantly mitigate” one or more specific identifiable risks are eliminated. In addition, the Amendments remove enhanced documentation requirements for financial instruments commonly used by the trading desk to hedge risk. For banking entities with moderate or limited trading assets and liabilities, the requirements are further simplified in that the only requirement that applies is that the hedge is designed at inception to reduce or significantly mitigate one or more specific risks and is subject to ongoing calibration to ensure the hedge as designed mitigates its identified risk.
  

Key amendments: Covered funds

Below are key highlights from the Amendments pertaining to covered funds provisions:

• Declaration regarding forthcoming changes to the definition of covered funds: The Agencies plan to release a separate proposal relating to the definition of covered funds in the coming months.
• Banking entity status of foreign excluded funds: No changes have been made relating to the treatment of foreign excluded funds. The Agencies released a policy statement on July 17, 2019, extending the relief period for FBOs for a two year period ending on July 21, 2021. The Agencies will address foreign excluded funds in a separate proposed rulemaking.
• Underwriting and market making for the third party covered funds: As per the Amendments, a banking entity that does not organize or sponsor the covered fund would no longer need to include in its aggregate fund limit and capital deduction the value of any ownership interests of the covered fund acquired or retained under these exemptions.
• Expansion of the risk-mitigating hedging exemption: The Amendments restore the exemption from the original 2011 proposal that allows the banking entity to hold a covered fund interest as a risk-mitigating hedge when acting as an intermediary on behalf of a customer to facilitate the exposure by the customer to the profits and losses of the covered fund.⁹ In particular, these activities remain subject to the risk management requirements of the 2011 proposal.

Key amendments: Compliance program and metrics reporting

Unlike the 2013 rule where the size of the banking entity’s total consolidated assets was used as the measure to determine the type of compliance program that would be applicable, the Amendments focus solely on the size of the banking entity’s trading assets and liabilities. Key highlights of the Amendments include:

• Compliance program: Banking entities with “significant” trading assets and liabilities are required to implement a six-pillar compliance program and are required to report metrics. Banking entities with “moderate” trading assets and liabilities are required to implement a simplified and tailored compliance program by incorporating Volcker Rule compliance into their existing policies and procedures. Banking entities in the “limited” trading assets and liabilities category will benefit from presumed compliance and will have no obligation to demonstrate compliance on an ongoing basis.
• CEO attestation requirements: The annual CEO attestation requirements for all banking entities with significant trading assets and liabilities remain. The Amendments eliminate Appendix B of the 2013 Final Rule, which specified enhanced minimum standards for compliance programs of large banking entities with significant trading activities.
• Metrics reporting requirements: The Amendments adopted several changes with respect to metrics reporting including the following:
  • Removed requirements for reporting stressed value-at-risk in the risk and position limits and usage metrics and required banking entities to report within the internal limits information schedule an identifier indicating its corresponding risk factor attribution to facilitate review of the internal limit metric and its relation to gains and losses on the positions measured by that metric. It further requires firms to submit one consolidated internal limits information schedule for the entire banking entity’s covered trading activities, rather than multiple risks and position limits for different trading desks.
  • Removed the reporting requirement for risk factor sensitivities for all trading desks engaged in covered trading activities.
  • Banking entities will no longer be required to report volatility for the comprehensive profit and loss metric, but rather are required to provide certain information regarding the factors that explain the preponderance of the profit or loss changes due to risk factor changes when sub-attributing comprehensive profit or loss from existing positions to specific and other factors.
  • Existing metrics calculations were replaced or modified, including:
    • Replacing the customer-facing trade ratio with a new transaction volume metric
    • Replacing the inventory turnover with a new positions metric, and
    • Eliminating inventory aging metric for all desks and position types
  • Added requirements to provide qualitative and descriptive information with respect to each trading desk, quantitative measurements, and narrative statement;
  • Extended the time for reporting to 20 days after the calendar month-end (as opposed to 10 days per the 2013 Rule) for banks with trading assets and liabilities greater than $50 billion. The Agencies will continue to consider whether quantitative measurements should be publicly disclosed, considering the need to protect sensitive, confidential, and supervisory information on a firm-specific basis.
    

Key amendments specific to FBOs

The Amendments offer some relief to FBOs with respect to the Trading Outside the US (TOTUS) proprietary trading exemption and solely outside the US (SOTUS) covered funds exemption. Key changes include:

• TOTUS exemption: The Amendments remove or modify certain requirements from this exemption including:
  • Removes the prohibition on financing from US branch or affiliate (financing prong);
  • Removes the requirement that the purchase or sale not be with or through a US entity (counterparty prong); and
  • Modifies the requirement such that it allows some limited involvement by US personnel in the arranging or negotiating of a transaction.
• SOTUS exemption: Similar to the TOTUS exemption above, the Amendments remove the financing prohibition from SOTUS exemption. Additionally, the Amendments codify one of the Frequently Asked Questions (FAQs) (i.e. FAQ No. 13) issued by the Agencies staff in 2015 which allows SOTUS to be available for investing in covered funds so long as the FBO does not participate in the offer or sale of ownership interests to US residents.¹⁰

What’s next

According to Chairman of the FDIC Jelena McWilliams, the Amendments will provide "more clarity, certainty, and objectivity around the Volcker Rule, while tailoring the requirements to focus on those banks that conduct the overwhelming majority of trades."¹¹ She stated that there will be additional fine-tuning around restrictions associated with fund structure (including covered and excluded funds) through future proposed rulemaking in the coming months.

Deloitte will continue to follow further developments in this regard and will issue additional updates, as appropriate.

Endnotes

¹ FDIC, OCC, “Final Rule: Revisions to Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds,” accessed August 23, 2019.

² FDIC, OCC, FRB, SEC, CFTC, “Final Rule: Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds,” https://www.fdic.gov/news/board/2013/2013-12-10-notice-dis-a-regulatory-text.pdf, accessed August 23, 2019.

³ Deloitte, “Key highlights of the Volcker Rule proposal,” https://www2.deloitte.com/us/en/pages/regulatory/articles/key-highlights-of-the-volcker-rule-proposal.html, accessed August 23, 2019.

⁴ FDIC, OCC, FRB, SEC, CFTC, “Notice of Proposed Rulemaking: Proposed Revisions to Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds,” https://www.govinfo.gov/content/pkg/FR-2018-07-17/pdf/2018-13502.pdf, accessed August 23, 2019.

⁵ Short-term intent prong: Any account that is used by a banking entity to purchase or sell one or more financial instruments principally for the purpose of short-term resale, benefitting from short-term price movements, realizing short-term arbitrage profits, or hedging another trading account position.

⁶ Market risk capital prong: Trading positions that are both covered positions and trading positions for purposes of the federal banking agencies’ market risk capital rules, as well as hedges of covered position.

⁷ Dealer prong: Any account used by a banking entity that is a securities dealer, swap dealer, or security-based swap dealer that is licensed or registered, or required to be licensed or registered, as a dealer, swap dealer, or security-based swap dealer, to the extent the instrument is purchased or sold in connection with the activities that require the banking entity to be licensed or registered as such.

⁸ Rebuttable presumption: Purchase or sale of a financial instrument by a banking entity is for the trading account if the banking entity holds the financial instrument for fewer than 60 days or substantially transfer the risk of the financial instrument within 60 days of purchase (or sale).

⁹ FDIC, OCC, FRB, SEC, CFTC, “Notice of Proposed Rulemaking: Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds,” https://www.fdic.gov/regulations/laws/federal/2011/11proposednov7.pdf, accessed August 23, 2019.

¹⁰ FDIC, “FDIC Volcker FAQs as of September 25, 2015,” https://www.fdic.gov/regulations/reform/volcker/faq/FAQ.pdf, accessed August 23, 2019.

¹¹ FDIC, “Statement by Jelena McWilliams, Chairman, Federal Deposit Insurance Corporation, Final Rule: Revisions to Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds,” https://www.fdic.gov/news/news/speeches/spaug2019.pdf, accessed August 23, 2019.

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