RENTD: The heart of the Volcker Rule has been saved
RENTD: The heart of the Volcker Rule
Understanding the potential implications of RENTD
The requirement to analyze and calculate reasonably expected near-term demand (RENTD) of clients, customers, and counterparties (CCCs) is one of the most complex aspects of the final regulation implementing the Volcker Rule. Considerable attention and debate about RENTD has occurred in the two-plus years since the Volcker Rule became effective, culminating in a series of Volcker related recommendations in the US Treasury Department’s recently issued report on regulations governing banks and credit unions. Included within the report were recommendations specifically directed at the RENTD construct as an impediment to banks having sufficient flexibility to be effective market-makers and consequently as an important factor leading to meaningfully lower levels of liquidity in the secondary capital markets.
- Volcker 2.0 and the RENTD requirement
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Volcker 2.0 and the RENTD requirement: What’s changed?
On May 30, 2018, the Federal Reserve Board approved a 373 page notice of proposed rulemaking (the “proposal”) to amend the regulations implementing the Volcker Rule (the Rule), a centerpiece of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The proposal aims to simplify and tailor the compliance requirements of the Rule, which was finalized back in December 2013 to prevent banks from engaging in proprietary trading and from owning hedge funds or private equity funds. Much attention has been directed toward understanding the implications of the new proposal and chief among them is the RENTD requirement. Initial coverage of the proposed revisions focused on the increased flexibility and ease of compliance offered by the replacement of the demonstrable analysis standard with a risk-limit based presumption of compliance:
The Agencies believe that this approach (limit based presumption of compliance) would allow for a clearer application of these exemptions, and would provide firms with more flexibility and certainty in conducting market making-related activities.
While the proposed revisions may move the underwriting and market-making exemptions in this direction, our view is that the change to a risk-limit approach to meeting the RENTD requirement retains many key structural features of the original implementing regulations and may result in continued uncertainty with regard to whether an organization is conducting its market-making and underwriting activities in a manner consistent with each exemption’s compliance requirements. In particular, the rebuttable presumption of compliance requires that limits be designed not to exceed RENTD of CCCs and then tasks the Agencies with assessing that design. This paper, Volcker 2.0 and the RENTD requirement: What’s changed, takes a deeper look at this new rebuttable presumption of compliance and asks a simple question, “How will Agencies assess design of the risk limits?”
Market-making RENTD overview
Subsequent to the issuance of the Treasury’s report, on August 2, 2017, the Office of the Comptroller of the Currency (OCC) issued a notice and request for comment on whether certain aspects of the regulation implementing the Volcker Rule should be revised to “better accomplish the purposes of the statute,” while decreasing the compliance burden on banking entities and fostering economic growth. The OCC is seeking comment on a variety of topics, including about seeking input on streamlining and simplifying existing exclusions and exemptions and specific questions on whether the concept of the Market Maker Inventory (MMI) was a helpful approach to determining whether trading desk market-making activities were appropriate. Within the context of the current reexamination of the Volcker Rule and how it could be potentially modified, this paper provides thoughts on conceptual and operational challenges related to market-making RENTD and the related limits.
RENTD—The heart of the Volcker Rule
Proprietary trading as defined in the Volcker Rule is permitted only under specific exemptions, including market-making activities (“Section 4 exemptions”). In order to rely on the market-making exemption, a banking entity must meet a number of requirements, including: “Establishment and enforcement of a compliance program targeted to the activity; limits on positions, inventory, and risk exposure addressing the requirement that activities be designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties; limits on the duration of holdings and positions; defined escalation procedures to change or exceed limits; analysis justifying established limits; internal controls and independent testing of compliance with limits; senior management accountability and limits on incentive compensation.”
The objective of the compliance program and, in particular, the required limits, is to identify trading activity that may constitute impermissible proprietary trading and provide evidence that subsequent escalation, investigation, and resolution have occurred on a timely basis. Instances of impermissible proprietary trading must be reported to senior management and the appropriate regulatory agency or agencies. While the requirement seems clearly stated, establishing a compliance program that can differentiate between acceptable market-making activities and impermissible proprietary trading can be challenging. A key to achieving the required level of trading activity differentiation rests with a banking entity’s RENTD methodology and implementation of the related limits.
Anchoring market-making activities to CCC demand is the core of the Volcker Rule’s compliance philosophy; the exemptions are intended to support these trading activities as long as they are being employed to provide liquidity and beneficial customer service to the capital markets. Trading activities beyond what is required to provide market-making services to CCCs and mitigate the resulting risk, would be deemed impermissible unless otherwise exempted or excluded. Given the linkage to CCC demand, RENTD is positioned within the context of the rule to be the constraining factor on the trading desk’s overall trading activity:
A banking entity must have a reasonable basis for the limits it establishes for a trading desk and must have a robust procedure for analyzing, establishing, and monitoring limits, as well as appropriate escalation procedures…The limits established by a banking entity should generally reflect the amount and types of inventory and risk that a trading desk holds to meet the reasonably expected near term demands of clients, customers, or counterparties. As discussed above, while the trading desk’s market-maker inventory is directly limited by the reasonably expected near term demands of customers, the positions managed by the trading desk outside of its market-maker inventory are similarly constrained by the near term demand requirement because they must be designed to manage the risks of the market-maker inventory in accordance with the desk’s risk management procedures. As a result, the trading desk’s risk management positions and aggregate financial exposure are also limited by the current and reasonably expected near term demands of customers.
Given the prominent role that RENTD plays in setting limits that are designed to detect potentially impermissible proprietary trading, having a robust and reasonable methodology for calculating RENTD and deriving the related limits is essential to achieving an effective compliance regime. The key question remains, however, as to how a banking entity or qualified independent party (“QIP”) would go about assessing whether a trading desk’s RENTD methodology and related limits are “reasonable and robust.”
Conclusion: RENTD requirements
Considerable uncertainty remains regarding how regulators will finally interpret the RENTD requirement and what practices will be deemed acceptable from a compliance perspective. Despite the uncertainty, the RENTD requirement is present in the original statutory language and it plays a central role in achieving the broad regulatory objective of eliminating impermissible proprietary trading within financial institutions covered by the Volcker Rule. The key questions that are currently being asked and debated relate to the practical aspects of operationalizing this requirement.
As discussed in the report, interpretation, and application of the RENTD requirement requires many trading desk-specific determinations and the ability to apply critical new data attributes at the individual trade level. While these attributes can be retroactively mapped into historical data sets using common reference fields (e.g., product and counterparty related fields), our experience suggests that doing so introduces considerable data quality issues that undermine the effectiveness of the demonstrable analysis. Firms should be seeking ways to embed the business rules and resulting attributes in their upstream trade capture and risk measurement processes so that sub-portfolio level risk exposures aligned with the Volcker Rule requirements are being produced on a daily basis within the production systems of the firms. This approach maximizes operational integrity and efficiency and gives trading desks the best chance to achieve the desired balance of market-making activities and risk mitigation.
To do this, many firms impacted by the rule should take a more thoughtful and diligent approach in both their interpretation of the requirements and the subsequent implementation of a compliance program. While the issues of interpretation and application can be complex in specific situations, they are by no means impossible to implement, and with the right methodology and operational approach, much of it can be automated and incorporated into the daily risk management routines of most firms.
To learn more about RENTD compliance, download the full report, RENTD: The heart of the Volcker Rule.