[Federal Register Volume 79, Number 21 (Friday, January 31, 2014)]
[Rules and Regulations]
[Pages 5535-5806]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2013-31511]



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Vol. 79

Friday,

No. 21

January 31, 2014

Part II





Department of the Treasury





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Office of the Comptroller of the Currency





Board of Governors of the Federal Reserve System





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Federal Deposit Insurance Corporation





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Securities and Exchange Commission





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12 CFR Parts 44, 248, and 351

17 CFR Part 255





 Prohibitions and Restrictions on Proprietary Trading and Certain 
Interests in, and Relationships With, Hedge Funds and Private Equity 
Funds; Final Rule

Federal Register / Vol. 79, No. 21 / Friday, January 31, 2014 / Rules 
and Regulations

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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Part 44

[Docket No. OCC-2011-0014]
RIN 1557-AD44

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

12 CFR Part 248

[Docket No. R-1432]
RIN 7100 AD82

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Part 351

RIN 3064-AD85

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 255

[Release No. BHCA-1; File No. S7-41-11]
RIN 3235-AL07


Prohibitions and Restrictions on Proprietary Trading and Certain 
Interests in, and Relationships With, Hedge Funds and Private Equity 
Funds

AGENCY: Office of the Comptroller of the Currency, Treasury (``OCC''); 
Board of Governors of the Federal Reserve System (``Board''); Federal 
Deposit Insurance Corporation (``FDIC''); and Securities and Exchange 
Commission (``SEC'').

ACTION: Final rule.

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SUMMARY: The OCC, Board, FDIC, and SEC (individually, an ``Agency,'' 
and collectively, ``the Agencies'') are adopting a rule that would 
implement section 13 of the BHC Act, which was added by section 619 of 
the Dodd-Frank Wall Street Reform and Consumer Protection Act (``Dodd-
Frank Act''). Section 13 contains certain prohibitions and restrictions 
on the ability of a banking entity and nonbank financial company 
supervised by the Board to engage in proprietary trading and have 
certain interests in, or relationships with, a hedge fund or private 
equity fund.

DATES: The final rule is effective April 1, 2014.

FOR FURTHER INFORMATION CONTACT:
    OCC: Ursula Pfeil, Counsel, or Deborah Katz, Assistant Director, 
Legislative and Regulatory Activities Division, (202) 649-5490; Ted 
Dowd, Assistant Director, or Roman Goldstein, Senior Attorney, 
Securities and Corporate Practices Division, (202) 649-5510; Kurt 
Wilhelm, Director for Financial Markets Group, (202) 649-6360; 
Stephanie Boccio, Technical Expert for Credit and Market Risk Group, 
(202) 649-6360, Office of the Comptroller of the Currency, 250 E Street 
SW., Washington, DC 20219.
    Board: Christopher M. Paridon, Counsel, (202) 452-3274, or Anna M. 
Harrington, Senior Attorney, Legal Division, (202) 452-6406; Mark E. 
Van Der Weide, Deputy Director, Division of Bank Supervision and 
Regulation, (202) 452-2263; or Sean D. Campbell, Deputy Associate 
Director, Division of Research and Statistics, (202) 452-3760, Board of 
Governors of the Federal Reserve System, 20th and C Streets NW., 
Washington, DC 20551.
    FDIC: Bobby R. Bean, Associate Director, bbean@fdic.gov, or Karl R. 
Reitz, Chief, Capital Markets Strategies Section, kreitz@fdic.gov, 
Capital Markets Branch, Division of Risk Management Supervision, (202) 
898-6888; Michael B. Phillips, Counsel, mphillips@fdic.gov, or Gregory 
S. Feder, Counsel, gfeder@fdic.gov, Legal Division, Federal Deposit 
Insurance Corporation, 550 17th Street NW., Washington, DC 20429.
    SEC: Josephine J. Tao, Assistant Director, Angela R. Moudy, Branch 
Chief, John Guidroz, Branch Chief, Jennifer Palmer or Lisa Skrzycki, 
Attorney Advisors, Office of Trading Practices, Catherine McGuire, 
Counsel, Division of Trading and Markets, (202) 551-5777; W. Danforth 
Townley, Attorney Fellow, Jane H. Kim, Brian McLaughlin Johnson or 
Marian Fowler, Senior Counsels, Division of Investment Management, 
(202) 551-6787; David Beaning, Special Counsel, Office of Structured 
Finance, Division of Corporation Finance, (202) 551-3850; John Cross, 
Office of Municipal Securities, (202) 551-5680; or Adam Yonce, 
Assistant Director, or Matthew Kozora, Financial Economist, Division of 
Economic and Risk Analysis, (202) 551-6600, U.S. Securities and 
Exchange Commission, 100 F Street NE., Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Background
II. Notice of Proposed Rulemaking
III. Overview of Final Rule
    A. General Approach and Summary of Final Rule
    B. Proprietary Trading Restrictions
    C. Restrictions on Covered Fund Activities and Investments
    D. Metrics Reporting Requirement
    E. Compliance Program Requirement
IV. Final Rule
    A. Subpart B--Proprietary Trading Restrictions
    1. Section ----.3: Prohibition on Proprietary Trading and 
Related Definitions
    a. Definition of ``Trading Account''
    b. Rebuttable Presumption for the Short-Term Trading Account
    c. Definition of ``Financial Instrument''
    d. Proprietary Trading Exclusions
    1. Repurchase and Reverse Repurchase Arrangements and Securities 
Lending
    2. Liquidity Management Activities
    3. Transactions of Derivatives Clearing Organizations and 
Clearing Agencies
    4. Excluded Clearing-Related Activities of Clearinghouse Members
    5. Satisfying an Existing Delivery Obligation
    6. Satisfying an Obligation in Connection With a Judicial, 
Administrative, Self-Regulatory Organization, or Arbitration 
Proceeding
    7. Acting Solely as Agent, Broker, or Custodian
    8. Purchases or Sales Through a Deferred Compensation or Similar 
Plan
    9. Collecting a Debt Previously Contracted
    10. Other Requested Exclusions
    2. Section ----.4(a): Underwriting Exemption
    a. Introduction
    b. Overview
    1. Proposed Underwriting Exemption
    2. Comments on Proposed Underwriting Exemption
    3. Final Underwriting Exemption
    c. Detailed Explanation of the Underwriting Exemption
    1. Acting as an Underwriter for a Distribution of Securities
    a. Proposed Requirements That the Purchase or Sale Be Effected 
Solely in Connection With a Distribution of Securities for Which the 
Banking Entity Acts as an Underwriter and That the Covered Financial 
Position be a Security
    i. Proposed Definition of ``Distribution''
    ii. Proposed Definition of ``Underwriter''
    iii. Proposed Requirement That the Covered Financial Position Be 
a Security
    b. Comments on the Proposed Requirements That the Trade Be 
Effected Solely in Connection With a Distribution for Which the 
Banking Entity Is Acting as an Underwriter and That the Covered 
Financial Position Be a Security
    i. Definition of ``Distribution''
    ii. Definition of ``Underwriter''
    iii. ``Solely in Connection With'' Standard
    c. Final Requirement That the Banking Entity Act as an 
Underwriter for a Distribution of Securities and the Trading Desk's 
Underwriting Position Be Related to Such Distribution
    i. Definition of ``Underwriting Position''
    ii. Definition of ``Trading Desk''
    iii. Definition of ``Distribution''
    iv. Definition of ``Underwriter''
    v. Activities Conducted ``in Connection With'' a Distribution
    2. Near Term Customer Demand Requirement

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    a. Proposed Near Term Customer Demand Requirement
    b. Comments Regarding the Proposed Near Term Customer Demand 
Requirement
    c. Final Near Term Customer Demand Requirement
    3. Compliance Program Requirement
    a. Proposed Compliance Program Requirement
    b. Comments on the Proposed Compliance Program Requirement
    c. Final Compliance Program Requirement
    4. Compensation Requirement
    a. Proposed Compensation Requirement
    b. Comments on the Proposed Compensation Requirement
    c. Final Compensation Requirement
    5. Registration Requirement
    a. Proposed Registration Requirement
    b. Comments on Proposed Registration Requirement
    c. Final Registration Requirement
    6. Source of Revenue Requirement
    a. Proposed Source of Revenue Requirement
    b. Comments on the Proposed Source of Revenue Requirement
    c. Final Rule's Approach to Assessing Source of Revenue
    3. Section ----.4(b): Market-Making Exemption
    a. Introduction
    b. Overview
    1. Proposed Market-Making Exemption
    2. Comments on the Proposed Market-Making Exemption
    a. Comments on the Overall Scope of the Proposed Exemption
    b. Comments Regarding the Potential Market Impact of the 
Proposed Exemption
    3. Final Market-Making Exemption
    c. Detailed Explanation of the Market-Making Exemption
    1. Requirement to Routinely Stand Ready To Purchase And Sell
    a. Proposed Requirement To Hold Self Out
    b. Comments on the Proposed Requirement To Hold Self Out
    i. The Proposed Indicia
    ii. Treatment of Block Positioning Activity
    iii. Treatment of Anticipatory Market Making
    iv. High-Frequency Trading
    c. Final Requirement To Routinely Stand Ready To Purchase And 
Sell
    i. Definition of ``Trading Desk''
    ii. Definitions of ``Financial Exposure'' and ``Market-Maker 
Inventory''
    iii. Routinely Standing Ready To Buy and Sell
    2. Near Term Customer Demand Requirement
    a. Proposed Near Term Customer Demand Requirement
    b. Comments Regarding the Proposed Near Term Customer Demand 
Requirement
    i. The Proposed Guidance for Determining Compliance With the 
Near Term Customer Demand Requirement
    ii. Potential Inventory Restrictions and Differences Across 
Asset Classes
    iii. Predicting Near Term Customer Demand
    iv. Potential Definitions of ``Client,'' ``Customer,'' or 
``Counterparty''
    v. Interdealer Trading and Trading for Price Discovery or To 
Test Market Depth
    vi. Inventory Management
    vii. Acting as an Authorized Participant or Market Maker in 
Exchange-Traded Funds
    viii. Arbitrage or Other Activities That Promote Price 
Transparency and Liquidity
    ix. Primary Dealer Activities
    x. New or Bespoke Products or Customized Hedging Contracts
    c. Final Near Term Customer Demand Requirement
    i. Definition of ``Client,'' ``Customer,'' and ``Counterparty''
    ii. Impact of the Liquidity, Maturity, and Depth of the Market 
on the Analysis
    iii. Demonstrable Analysis of Certain Factors
    iv. Relationship to Required Limits
    3. Compliance Program Requirement
    a. Proposed Compliance Program Requirement
    b. Comments on the Proposed Compliance Program Requirement
    c. Final Compliance Program Requirement
    4. Market Making-Related Hedging
    a. Proposed Treatment of Market Making-Related Hedging
    b. Comments on the Proposed Treatment of Market Making-Related 
Hedging
    c. Treatment of Market Making-Related Hedging in the Final Rule
    5. Compensation Requirement
    a. Proposed Compensation Requirement
    b. Comments Regarding the Proposed Compensation Requirement
    c. Final Compensation Requirement
    6. Registration Requirement
    a. Proposed Registration Requirement
    b. Comments on the Proposed Registration Requirement
    c. Final Registration Requirement
    7. Source of Revenue Analysis
    a. Proposed Source of Revenue Requirement
    b. Comments Regarding the Proposed Source of Revenue Requirement
    i. Potential Restrictions on Inventory, Increased Costs for 
customers, and Other Changes To Market-Making Services
    ii. Certain Price Appreciation-Related Profits Are an Inevitable 
or Important Component of Market Making
    iii. Concerns Regarding the Workability of the Proposed Standard 
in Certain Markets or Asset Classes
    iv. Suggested Modifications to the Proposed Requirement
    v. General Support for the Proposed Requirement or for Placing 
Greater Restrictions on a Market Maker's Sources of Revenue
    c. Final Rule's Approach To Assessing Revenues
    8. Appendix B of the Proposed Rule
    a. Proposed Appendix B Requirement
    b. Comments on Proposed Appendix B
    c. Determination To Not Adopt Proposed Appendix B
    9. Use of Quantitative Measurements
    4. Section ----.5: Permitted Risk-Mitigating Hedging Activities
    a. Summary of Proposal's Approach to Implementing the Hedging 
Exemption
    b. Manner of Evaluating Compliance With the Hedging Exemption
    c. Comments on the Proposed Rule and Approach to Implementing 
the Hedging Exemption
    d. Final Rule
    1. Compliance Program Requirement
    2. Hedging of Specific Risks and Demonstrable Reduction Of Risk
    3. Compensation
    4. Documentation Requirement
    5. Section ----.6(a)-(b): Permitted Trading in Certain 
Government and Municipal Obligations
    a. Permitted Trading in U.S. Government Obligations
    b. Permitted Trading in Foreign Government Obligations
    c. Permitted Trading in Municipal Securities
    d. Determination To Not Exempt Proprietary Trading in 
Multilateral Development Bank Obligations
    6. Section ----.6(c): Permitted Trading on Behalf of Customers
    a. Proposed Exemption for Trading on Behalf of Customers
    b. Comments on the Proposed Rule
    c. Final Exemption for Trading on Behalf of Customers
    7. Section ----.6(d): Permitted Trading by a Regulated Insurance 
Company
    8. Section ----.6(e): Permitted Trading Activities of a Foreign 
Banking Entity
    a. Foreign Banking Entities Eligible for the Exemption
    b. Permitted Trading Activities of a Foreign Banking Entity
    9. Section ----.7: Limitations on Permitted Trading Activities
    a. Scope of ``Material Conflict of Interest''
    1. Proposed Rule
    2. Comments on the Proposed Limitation on Material Conflicts of 
Interest
    a. Disclosure
    b. Information Barriers
    3. Final Rule
    b. Definition of ``High-Risk Asset'' and ``High-Risk Trading 
Strategy''
    1. Proposed Rule
    2. Comments on Proposed Limitations on High-Risk Assets and 
Trading Strategies
    3. Final Rule
    c. Limitations on Permitted Activities That Pose a Threat to 
Safety and Soundness of the Banking Entity or the Financial 
Stability of the United States
    B. Subpart C--Covered Fund Activities and Investments
    1. Section ----.10: Prohibition on Acquisition or Retention of 
Ownership Interests in, and Certain Relationships With, a Covered 
Fund
    a. Prohibition Regarding Covered Fund Activities and Investments
    b. ``Covered Fund'' Definition
    1. Foreign Covered Funds
    2. Commodity Pools
    3. Entities Regulated Under the Investment Company Act
    c. Entities Excluded From Definition of Covered Fund
    1. Foreign Public Funds
    2. Wholly-Owned Subsidiaries
    3. Joint Ventures
    4. Acquisition Vehicles

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    5. Foreign Pension or Retirement Funds
    6. Insurance Company Separate Accounts
    7. Bank Owned Life Insurance Separate Accounts
    8. Exclusion for Loan Securitizations and Definition of Loan
    a. Definition of Loan
    b. Loan Securitizations
    i. Loans
    ii. Contractual Rights Or Assets
    iii. Derivatives
    iv. SUBIs and Collateral Certificates
    v. Impermissible Assets
    9. Asset-Backed Commercial Paper Conduits
    10. Covered Bonds
    11. Certain Permissible Public Welfare and Similar Funds
    12. Registered Investment Companies and Excluded Entities
    13. Other Excluded Entities
    d. Entities Not Specifically Excluded From the Definition of 
Covered Fund
    1. Financial Market Utilities
    2. Cash Collateral Pools
    3. Pass-Through REITS
    4. Municipal Securities Tender Option Bond Transactions
    5. Venture Capital Funds
    6. Credit Funds
    7. Employee Securities Companies
    e. Definition of ``Ownership Interest''
    f. Definition of ``Resident of the United States''
    g. Definition of ``Sponsor''
    2. Section ----.11: Activities Permitted in Connection With 
Organizing and Offering a Covered Fund
    a. Scope of Exemption
    1. Fiduciary Services
    2. Compliance With Investment Limitations
    3. Compliance With Section 13(f) of the BHC Act
    4. No Guarantees or Insurance of Fund Performance
    5. Limitation on Name Sharing With a Covered Fund
    6. Limitation on Ownership By Directors and Employees
    7. Disclosure Requirements
    b. Organizing and Offering an Issuing Entity of Asset-Backed 
Securities
    c. Underwriting and Market Making for a Covered Fund
    3. Section ----.12: Permitted Investment in a Covered Fund
    a. Proposed Rule
    b. Duration of Seeding Period for New Covered Funds
    c. Limitations on Investments in a Single Covered Fund (``Per-
Fund Limitation'')
    d. Limitation on Aggregate Permitted Investments in All Covered 
funds (``Aggregate Funds Limitation'')
    e. Capital Treatment of an Investment in a Covered Fund
    f. Attribution of Ownership Interests to a Banking Entity
    g. Calculation of Tier 1 Capital
    h. Extension of Time to Divest Ownership Interest in a Single 
Fund
    4. Section ----.13: Other Permitted Covered Fund Activities
    a. Permitted Risk-Mitigating Hedging Activities
    b. Permitted Covered Fund Activities and Investments Outside of 
the United States
    1. Foreign Banking Entities Eligible for the Exemption
    2. Activities or Investments Solely Outside of the United States
    3. Offered for Sale or Sold to a Resident of the United States
    4. Definition of ``Resident of the United States''
    c. Permitted Covered Fund Interests and Activities by a 
Regulated Insurance Company
    5. Section ----.14: Limitations on Relationships With a Covered 
Fund
    a. Scope of Application
    b. Transactions That Would Be a ``Covered Transaction''
    c. Certain Transactions and Relationships Permitted
    1. Permitted Investments and Ownerships Interests
    2. Prime Brokerage Transactions
    d. Restrictions on Transactions With Any Permitted Covered Fund
    6. Section ----.15: Other Limitations on Permitted Covered Fund 
Activities
    C. Subpart D and Appendices A and B--Compliance Program, 
Reporting, and Violations
    1. Section ----.20: Compliance Program Mandate
    a. Program Requirement
    b. Compliance Program Elements
    c. Simplified Programs for Less Active Banking Entities
    d. Threshold for Application of Enhanced Minimum Standards
    2. Appendix B: Enhanced Minimum Standards for Compliance 
Programs
    a. Proprietary Trading Activities
    b. Covered Fund Activities or Investments
    c. Enterprise-Wide Programs
    d. Responsibility and Accountability
    e. Independent Testing
    f. Training
    g. Recordkeeping
    3. Section ----.20(d) and Appendix A: Reporting and 
Recordkeeping Requirements Applicable to Trading Activities
    a. Approach to Reporting and Recordkeeping Requirements Under 
the Proposal
    b. General Comments on the Proposed Metrics
    c. Approach of the Final Rule
    d. Proposed Quantitative Measurements and Comments on Specific 
Metrics
    4. Section ----.21: Termination of Activities or Investments; 
Authorities for Violations
    V. Administrative Law Matters
    A. Use of Plain Language
    B. Paperwork Reduction Act Analysis
    C. Regulatory Flexibility Act Analysis
    D. OCC Unfunded Mandates Reform Act of 1995 Determination

I. Background

    The Dodd-Frank Act was enacted on July 21, 2010.\1\ Section 619 of 
the Dodd-Frank Act added a new section 13 to the Bank Holding Company 
Act of 1956 (``BHC Act'') (codified at 12 U.S.C. 1851) that generally 
prohibits any banking entity from engaging in proprietary trading or 
from acquiring or retaining an ownership interest in, sponsoring, or 
having certain relationships with a hedge fund or private equity fund 
(``covered fund''), subject to certain exemptions.\2\ New section 13 of 
the BHC Act also provides that a nonbank financial company designated 
by the Financial Stability Oversight Council (``FSOC'') for supervision 
by the Board (while not a banking entity under section 13 of the BHC 
Act) would be subject to additional capital requirements, quantitative 
limits, or other restrictions if the company engages in certain 
proprietary trading or covered fund activities.\3\
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    \1\ Dodd-Frank Wall Street Reform and Consumer Protection Act, 
Public Law 111-203, 124 Stat. 1376 (2010).
    \2\ See 12 U.S.C. 1851.
    \3\ See 12 U.S.C. 1851(a)(2) and (f)(4). The Agencies note that 
two of the three companies currently designated by FSOC for 
supervision by the Board are affiliated with insured depository 
institutions, and are therefore currently banking entities for 
purposes of section 13 of the BHC Act. The Agencies are continuing 
to review whether the remaining company engages in any activity 
subject to section 13 of the BHC Act and what, if any, requirements 
apply under section 13.
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    Section 13 of the BHC Act generally prohibits banking entities from 
engaging as principal in proprietary trading for the purpose of selling 
financial instruments in the near term or otherwise with the intent to 
resell in order to profit from short-term price movements.\4\ Section 
13(d)(1) expressly exempts from this prohibition, subject to 
conditions, certain activities, including:
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    \4\ See 12 U.S.C. 1851(a)(1)(A) and (B).
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     Trading in U.S. government, agency and municipal 
obligations;
     Underwriting and market making-related activities;
     Risk-mitigating hedging activities;
     Trading on behalf of customers;
     Trading for the general account of insurance companies; 
and
     Foreign trading by non-U.S. banking entities.\5\
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    \5\ See id. at 1851(d)(1).
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    Section 13 of the BHC Act also generally prohibits banking entities 
from acquiring or retaining an ownership interest in, or sponsoring, a 
hedge fund or private equity fund. Section 13 contains several 
exemptions that permit banking entities to make limited investments in 
hedge funds and private equity funds, subject to a number of 
restrictions designed to ensure that banking entities do not rescue 
investors in these funds from loss and are not themselves exposed to

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significant losses from investments or other relationships with these 
funds.
    Section 13 of the BHC Act does not prohibit a nonbank financial 
company supervised by the Board from engaging in proprietary trading, 
or from having the types of ownership interests in or relationships 
with a covered fund that a banking entity is prohibited or restricted 
from having under section 13 of the BHC Act. However, section 13 of the 
BHC Act provides that these activities be subject to additional capital 
charges, quantitative limits, or other restrictions.\6\
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    \6\ See 12 U.S.C. 1851(a)(2) and (d)(4).
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II. Notice of Proposed Rulemaking: Summary of General Comments

    Authority for developing and adopting regulations to implement the 
prohibitions and restrictions of section 13 of the BHC Act is divided 
among the Board, the Federal Deposit Insurance Corporation (``FDIC''), 
the Office of the Comptroller of the Currency (``OCC''), the Securities 
and Exchange Commission (``SEC''), and the Commodity Futures Trading 
Commission (``CFTC'').\7\ As required by section 13(b)(2) of the BHC 
Act, the Board, OCC, FDIC, and SEC in October 2011 invited the public 
to comment on proposed rules implementing that section's 
requirements.\8\ The period for filing public comments on this proposal 
was extended for an additional 30 days, until February 13, 2012.\9\ In 
January 2012, the CFTC requested comment on a proposal for the same 
common rule to implement section 13 with respect to those entities for 
which it is the primary financial regulatory agency and invited public 
comment on its proposed implementing rule through April 16, 2012.\10\ 
The statute requires the Agencies, in developing and issuing 
implementing rules, to consult and coordinate with each other, as 
appropriate, for the purposes of assuring, to the extent possible, that 
such rules are comparable and provide for consistent application and 
implementation of the applicable provisions of section 13 of the BHC 
Act.\11\
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    \7\ See 12 U.S.C. 1851(b)(2). Under section 13(b)(2)(B) of the 
BHC Act, rules implementing section 13's prohibitions and 
restrictions must be issued by: (i) The appropriate Federal banking 
agencies (i.e., the Board, the OCC, and the FDIC), jointly, with 
respect to insured depository institutions; (ii) the Board, with 
respect to any company that controls an insured depository 
institution, or that is treated as a bank holding company for 
purposes of section 8 of the International Banking Act, any nonbank 
financial company supervised by the Board, and any subsidiary of any 
of the foregoing (other than a subsidiary for which an appropriate 
Federal banking agency, the SEC, or the CFTC is the primary 
financial regulatory agency); (iii) the CFTC with respect to any 
entity for which it is the primary financial regulatory agency, as 
defined in section 2 of the Dodd-Frank Act; and (iv) the SEC with 
respect to any entity for which it is the primary financial 
regulatory agency, as defined in section 2 of the Dodd-Frank Act. 
See id.
    \8\ See 76 FR 68846 (Nov. 7, 2011) (``Joint Proposal'').
    \9\ See 77 FR 23 (Jan. 23, 2012) (extending the comment period 
to February 13, 2012).
    \10\ See 77 FR 8332 (Feb. 14, 2012) (``CFTC Proposal'').
    \11\ See 12 U.S.C. 1851(b)(2)(B)(ii). The Secretary of the 
Treasury, as Chairperson of the FSOC, is responsible for 
coordinating the Agencies' rulemakings under section 13 of the BHC 
Act. See id.
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    The proposed rules invited comment on a multi-faceted regulatory 
framework to implement section 13 consistent with the statutory 
language. In addition, the Agencies invited comments on the potential 
economic impacts of the proposed rule and posed a number of questions 
seeking information on the costs and benefits associated with each 
aspect of the proposal, as well as on any significant alternatives that 
would minimize the burdens or amplify the benefits of the proposal in a 
manner consistent with the statute. The Agencies also encouraged 
commenters to provide quantitative information and data about the 
impact of the proposal on entities subject to section 13, as well as on 
their clients, customers, and counterparties, specific markets or asset 
classes, and any other entities potentially affected by the proposed 
rule, including non-financial small and mid-size businesses.
    The Agencies received over 18,000 comments addressing a wide 
variety of aspects of the proposal, including definitions used by the 
proposal and the exemptions for market making-related activities, risk-
mitigating hedging activities, covered fund activities and investments, 
the use of quantitative metrics, and the reporting proposals. The vast 
majority of these comments were from individuals using a version of a 
short form letter to express support for the proposed rule. More than 
600 comment letters were unique comment letters, including from members 
of Congress, domestic and foreign banking entities and other financial 
services firms, trade groups representing banking, insurance, and the 
broader financial services industry, U.S. state and foreign 
governments, consumer and public interest groups, and individuals. To 
improve understanding of the issues raised by commenters, the Agencies 
met with a number of these commenters to discuss issues relating to the 
proposed rule, and summaries of these meetings are available on each of 
the Agency's public Web sites.\12\ The CFTC staff also hosted a public 
roundtable on the proposed rule.\13\ Many of the commenters generally 
expressed support for the broader goals of the proposed rule. At the 
same time, many commenters expressed concerns about various aspects of 
the proposed rule. Many of these commenters requested that one or more 
aspects of the proposed rule be modified in some manner in order to 
reflect their viewpoints and to better accommodate the scope of 
activities that they argued were encompassed within section 13 of the 
BHC Act. The comments addressed all major sections of the proposed 
rule.
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    \12\ See http://www.regulations.gov/#!docketDetail;D=OCC-2011-
0014 (OCC); http://www.federalreserve.gov/newsevents/reform_systemic.htm (Board); http://www.fdic.gov/regulations/laws/federal/2011/11comAD85.html (FDIC); http://www.sec.gov/comments/s7-41-11/s74111.shtml (SEC); and http://www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/DF_28_VolckerRule/index.htm (CFTC).
    \13\ See Commodity Futures Trading Commission, CFTC Staff to 
Host a Public Roundtable to Discuss the Proposed Volcker Rule (May 
24, 2012), available at http://www.cftc.gov/PressRoom/PressReleases/pr6263-12; transcript available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/transcript053112.pdf.
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    Section 13 of the BHC Act also required the FSOC to conduct a study 
(``FSOC study'') and make recommendations to the Agencies by January 
21, 2011 on the implementation of section 13 of the BHC Act. The FSOC 
study was issued on January 18, 2011. The FSOC study included a 
detailed discussion of key issues related to implementation of section 
13 and recommended that the Agencies consider taking a number of 
specified actions in issuing rules under section 13 of the BHC Act.\14\ 
The FSOC study also recommended that the Agencies adopt a four-part 
implementation and supervisory framework for identifying and preventing 
prohibited proprietary trading, which included a programmatic 
compliance regime requirement for banking entities, analysis and 
reporting of quantitative metrics by banking entities, supervisory 
review and oversight by the Agencies, and

[[Page 5540]]

enforcement procedures for violations.\15\ The Agencies carefully 
considered the FSOC study and its recommendations.
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    \14\ See Financial Stability Oversight Counsel, Study and 
Recommendations on Prohibitions on Proprietary Trading and Certain 
Relationships with Hedge Funds and Private Equity Funds (Jan. 18, 
2011), available at http://www.treasury.gov/initiatives/Documents/Volcker%20sec%20619%20study%20final%201%2018%2011%20rg.pdf. (``FSOC 
study''). See 12 U.S.C. 1851(b)(1). Prior to publishing its study, 
FSOC requested public comment on a number of issues to assist in 
conducting its study. See 75 FR 61,758 (Oct. 6, 2010). Approximately 
8,000 comments were received from the public, including from members 
of Congress, trade associations, individual banking entities, 
consumer groups, and individuals.
    \15\ See FSOC study at 5-6.
---------------------------------------------------------------------------

    In formulating this final rule, the Agencies carefully reviewed all 
comments submitted in connection with the rulemaking and considered the 
suggestions and issues they raise in light of the statutory 
restrictions and provisions as well as the FSOC study. The Agencies 
have sought to reasonably respond to all of the significant issues 
commenters raised. The Agencies believe they have succeeded in doing so 
notwithstanding the complexities involved. The Agencies also carefully 
considered different options suggested by commenters in light of 
potential costs and benefits in order to effectively implement section 
13 of the BHC Act. The Agencies made numerous changes to the final rule 
in response to the issues and information provided by commenters. These 
modifications to the rule and explanations that address comments are 
described in more detail in the section-by-section description of the 
final rule. To enhance uniformity in both rules that implement section 
13 and administration of the requirements of that section, the Agencies 
have been regularly consulting with each other in the development of 
this final rule.
    Some commenters requested that the Agencies repropose the rule and/
or delay adoption pending the collection of additional information.\16\ 
As described in part above, the Agencies have provided many and various 
types of opportunities for commenters to provide input on 
implementation of section 13 of the BHC Act and have collected 
substantial information in the process. In addition to the official 
comment process described above, members of the public submitted 
comment letters in advance of the official comment period for the 
proposed rules and met with staff of the Agencies to explain issues of 
concern; the public also provided substantial comment in response to a 
request for comment from the FSOC regarding its findings and 
recommendations for implementing section 13.\17\ The Agencies provided 
a detailed proposal and posed numerous questions in the preamble to the 
proposal to solicit and explore alternative approaches in many areas. 
In addition, the Agencies have continued to receive comment letters 
after the extended comment period deadline, which the Agencies have 
considered. Thus, the Agencies believe interested parties have had 
ample opportunity to review the proposed rules, as well as the comments 
made by others, and to provide views on the proposal, other comment 
letters, and data to inform our consideration of the final rules.
---------------------------------------------------------------------------

    \16\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); ABA 
(Keating); Chamber (Nov. 2011); Chamber (Nov. 2013); Members of 
Congress (Dec. 2011); IIAC; Real Estate Roundtable; Ass'n. of German 
Banks; Allen & Overy (Clearing); JPMC; Goldman (Prop. Trading); BNY 
Mellon et al.; State Street (Feb. 2012); ICI Global; Chamber (Feb. 
2012); Soci[eacute]t[eacute] G[eacute]n[eacute]rale; HSBC; Western 
Asset Mgmt.; Abbott Labs et al. (Feb. 2012); PUC Texas; Columbia 
Mgmt.; ICI (Feb. 2012); IIB/EBF; British Bankers' Ass'n.; ISDA (Feb. 
2012); Comm. on Capital Markets Regulation; Ralph Saul (Apr. 2012); 
BPC.
    \17\ See 75 FR 61,758 (Oct. 6, 2010).
---------------------------------------------------------------------------

    In addition, the Agencies have been mindful of the importance of 
providing certainty to banking entities and financial markets and of 
providing sufficient time for banking entities to understand the 
requirements of the final rule and to design, test, and implement 
compliance and reporting systems. The further substantial delay that 
would necessarily be entailed by reproposing the rule would extend the 
uncertainty that banking entities would face, which could prove 
disruptive to banking entities and the financial markets.
    The Agencies note, as discussed more fully below, that the final 
rule incorporates a number of modifications designed to address the 
issues raised by commenters in a manner consistent with the statute. 
The preamble below also discusses many of the issues raised by 
commenters and explains the Agencies' response to those comments.
    To achieve the purpose of the statute, without imposing unnecessary 
costs, the final rule builds on the multi-faceted approach in the 
proposal, which includes development and implementation of a compliance 
program at each banking entity engaged in trading activities or that 
makes investments subject to section 13 of the BHC Act; the collection 
and evaluation of data regarding these activities as an indicator of 
areas meriting additional attention by the banking entity and the 
relevant agency; appropriate limits on trading, hedging, investment and 
other activities; and supervision by the Agencies. To allow banking 
entities sufficient time to develop appropriate systems, the Agencies 
have provided for a phased-in schedule for the collection of data, 
limited data reporting requirements only to banking entities that 
engage in significant trading activity, and agreed to review the merits 
of the data collected and revise the data collection as appropriate 
over the next 21 months. Importantly, as explained in detail below, the 
Agencies have also reduced the compliance burden for banking entities 
with total assets of less than $10 billion. The final rule also 
eliminates compliance burden for firms that do not engage in covered 
activities or investments beyond investing in U.S. government 
obligations, agency guaranteed obligations, or municipal obligations.
    Moreover, the Agencies believe the data that will be collected in 
connection with the final rule, as well as the compliance efforts made 
by banking entities and the supervisory experience that will be gained 
by the Agencies in reviewing trading and investment activity under the 
final rule, will provide valuable insights into the effectiveness of 
the final rule in achieving the purpose of section 13 of the BHC Act. 
The Agencies remain committed to implementing the final rule, and 
revisiting and revising the rule as appropriate, in a manner designed 
to ensure that the final rule faithfully implements the requirements 
and purposes of the statute.\18\
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    \18\ If any provision of this rule, or the application thereof 
to any person or circumstance, is held to be invalid, such 
invalidity shall not affect other provisions or application of such 
provisions to other persons or circumstances that can be given 
effect without the invalid provision or application.
---------------------------------------------------------------------------

    Finally, the Board has determined, in accordance with section 13 of 
the BHC Act, to provide banking entities with additional time to 
conform their activities and investments to the statute and the final 
rule. The restrictions and prohibitions of section 13 of the BHC Act 
became effective on July 21, 2012.\19\ The statute provided banking 
entities a period of two years to conform their activities and 
investments to the requirement of the statute, until July 21, 2014. 
Section 13 also permits the Board to extend this conformance period, 
one year at a time, for a total of no more than three additional 
years.\20\ Pursuant to this authority and in connection with this 
rulemaking, the Board has in a separate action extended the conformance 
period for an additional year until July 21, 2015.\21\ The Board will 
continue to monitor developments to determine whether additional 
extensions of the conformance period are in the public interest, 
consistent with the statute. Accordingly, the Agencies do not believe 
that a reproposal or further delay is necessary or appropriate.
---------------------------------------------------------------------------

    \19\ See 12 U.S.C. 1851(c)(1).
    \20\ See 12 U.S.C. 1851(c)(2); See also, A Conformance Period 
for Entities Engaged in Prohibited Proprietary Trading or Private 
Equity Fund or Hedge Fund Activities, 76 FR 8265 (Feb. 14, 2011) 
(citing 156 Cong. Rec. S5898 (daily ed. July 15, 2010) (statement of 
Sen. Merkley)).
    \21\ See, Board Order Approving Extension of Conformance Period, 
available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20131210b1.pdf.
---------------------------------------------------------------------------

    Commenters have differing views on the overall economic impacts of 
section 13 of the BHC Act.

[[Page 5541]]

    Some commenters remarked that proprietary trading restrictions will 
have detrimental impacts on the economy such as: reduction in 
efficiency of markets, economic growth, and in employment due to a loss 
in liquidity.\22\ In particular, a commenter expressed concern that 
there may be high transition costs as non-banking entities replace some 
of the trading activities currently performed by banking entities.\23\ 
Another commenter focused on commodity markets remarked about the 
potential reduction in commercial output and curtailed resource 
exploration due to a lack of hedging counterparties.\24\ Several 
commenters stated that section 13 of the BHC Act will reduce access to 
debt markets--especially for smaller companies--raising the costs of 
capital for firms and lowering the returns on certain investments.\25\ 
Further, some commenters mentioned that U.S. banks may be competitively 
disadvantaged relative to foreign banks due to proprietary trading 
restrictions and compliance costs.\26\
---------------------------------------------------------------------------

    \22\ See, e.g., Oliver Wyman (Dec. 2011); Chamber (Dec. 2011); 
Thakor Study; Prof. Duffie; IHS.
    \23\ See Prof. Duffie.
    \24\ See IHS.
    \25\ See, e.g., Chamber (Dec. 2011); Thakor Study; Oliver Wyman 
(Dec. 2011); IHS.
    \26\ See, e.g., RBC; Citigroup (Feb. 2012); Goldman (Covered 
Funds).
---------------------------------------------------------------------------

    On the other hand, other commenters stated that restricting 
proprietary trading activity by banking entities may reduce systemic 
risk emanating from the financial system and help to lower the 
probability of the occurrence of another financial crisis.\27\ One 
commenter contended that large banking entities may have a moral hazard 
incentive to engage in risky activities without allocating sufficient 
capital to them, especially if market participants believe these 
institutions will not be allowed to fail.\28\ Commenters argued that 
large banking entities may engage in activities that increase the 
upside return at the expense of downside loss exposure which may 
ultimately be borne by Federal taxpayers \29\ and that subsidies 
associated with bank funding may create distorted economic 
outcomes.\30\ Furthermore, some commenters remarked that non-banking 
entities may fill much of the void in liquidity provision left by 
banking entities if banking entities reduce their current trading 
activities.\31\ Finally, some commenters mentioned that hyper-liquidity 
that arises from, for instance, speculative bubbles, may harm the 
efficiency and price discovery function of markets.\32\
---------------------------------------------------------------------------

    \27\ See, e.g., Profs. Admati & Pfleiderer; AFR (Nov. 2012); 
Better Markets (Dec. 2011); Better Markets (Feb. 2012); Occupy; 
Johnson & Prof. Stiglitz; Paul Volcker.
    \28\ See Occupy.
    \29\ See Profs. Admati & Pfleiderer; Better Markets (Feb. 2012); 
Occupy; Johnson & Prof. Stiglitz; Paul Volcker.
    \30\ See Profs. Admati & Pfleiderer; Johnson & Prof. Stiglitz.
    \31\ See AFR et al. (Feb. 2012); Better Markets (Apr. 16, 2012); 
David McClean; Public Citizen; Occupy.
    \32\ See Johnson & Prof. Stiglitz (citing Thomas Phillipon 
(2011)); AFR et al. (Feb. 2012); Occupy.
---------------------------------------------------------------------------

    The Agencies have taken these concerns into account in the final 
rule. As described below with respect to particular aspects of the 
final rule, the Agencies have addressed these issues by reducing 
burdens where appropriate, while at the same time ensuring that the 
final rule serves its purpose of promoting healthy economic activity. 
In that regard, the Agencies have sought to achieve the balance 
intended by Congress under section 13 of the BHC Act. Several comments 
suggested that a costs and benefits analysis be performed by the 
Agencies.\33\ On the other hand, some commenters \34\ correctly stated 
that a costs and benefits analysis is not legally required.\35\ 
However, the Agencies find certain of the information submitted by 
commenters concerning costs and benefits and economic effects to be 
relevant to consideration of the rule, and so have considered this 
information as appropriate, and, on the basis of these and other 
considerations, sought to achieve the balance intended by Congress in 
section 619 of the Dodd-Frank Act. The relevant comments are addressed 
therein.
---------------------------------------------------------------------------

    \33\ See SIFMA et al. (Covered Funds) (Feb. 2012); BoA; ABA 
(Keating); Chamber (Feb. 2012); Soci[eacute]t[eacute] 
G[eacute]n[eacute]rale; FTN; SVB; ISDA (Feb. 2012); Comm. on Capital 
Market Regulation; Real Estate Roundtable.
    \34\ See, e.g., Better Markets (Feb. 2012); Randel Pilo.
    \35\ For example, with respect to the CFTC, Section 15(a) of the 
CEA requires such consideration only when ``promulgating a 
regulation under this [Commodity Exchange] Act.'' This final rule is 
not promulgated under the CEA, but under the BHC Act. CEA section 
15(a), therefore, does not apply.
---------------------------------------------------------------------------

III. Overview of Final Rule

    The Agencies are adopting this final rule to implement section 13 
of the BHC Act with a number of changes to the proposal, as described 
further below. The final rule adopts a risk-based approach to 
implementation that relies on a set of clearly articulated 
characteristics of both prohibited and permitted activities and 
investments and is designed to effectively accomplish the statutory 
purpose of reducing risks posed to banking entities by proprietary 
trading activities and investments in or relationships with covered 
funds. As explained more fully below in the section-by-section 
analysis, the final rule has been designed to ensure that banking 
entities do not engage in prohibited activities or investments and to 
ensure that banking entities engage in permitted trading and investment 
activities in a manner designed to identify, monitor and limit the 
risks posed by these activities and investments. For instance, the 
final rule requires that any banking entity that is engaged in activity 
subject to section 13 develop and administer a compliance program that 
is appropriate to the size, scope and risk of its activities and 
investments. The rule requires the largest firms engaged in these 
activities to develop and implement enhanced compliance programs and 
regularly report data on trading activities to the Agencies. The 
Agencies believe this will permit banking entities to effectively 
engage in permitted activities, and the Agencies to enforce compliance 
with section 13 of the BHC Act. In addition, the enhanced compliance 
programs will help both the banking entities and the Agencies identify, 
monitor, and limit risks of activities permitted under section 13, 
particularly involving banking entities posing the greatest risk to 
financial stability.

A. General Approach and Summary of Final Rule

    The Agencies have designed the final rule to achieve the purposes 
of section 13 of the BHC Act, which include prohibiting banking 
entities from engaging in proprietary trading or acquiring or retaining 
an ownership interest in, or having certain relationships with, a 
covered fund, while permitting banking entities to continue to provide, 
and to manage and limit the risks associated with providing, client-
oriented financial services that are critical to capital generation for 
businesses of all sizes, households and individuals, and that 
facilitate liquid markets. These client-oriented financial services, 
which include underwriting, market making, and asset management 
services, are important to the U.S. financial markets and the 
participants in those markets. At the same time, providing appropriate 
latitude to banking entities to provide such client-oriented services 
need not and should not conflict with clear, robust, and effective 
implementation of the statute's prohibitions and restrictions.
    As noted above, the final rule takes a multi-faceted approach to 
implementing section 13 of the BHC Act. In particular, the final rule 
includes a framework that clearly describes the key characteristics of 
both prohibited and permitted

[[Page 5542]]

activities. The final rule also requires banking entities to establish 
a comprehensive compliance program designed to ensure compliance with 
the requirements of the statute and rule in a way that takes into 
account and reflects the banking entity's activities, size, scope and 
complexity. With respect to proprietary trading, the final rule also 
requires the large firms that are active participants in trading 
activities to calculate and report meaningful quantitative data that 
will assist both banking entities and the Agencies in identifying 
particular activity that warrants additional scrutiny to distinguish 
prohibited proprietary trading from otherwise permissible activities.
    As a matter of structure, the final rule is generally divided into 
four subparts and contains two appendices, as follows:
     Subpart A of the final rule describes the authority, 
scope, purpose, and relationship to other authorities of the rule and 
defines terms used commonly throughout the rule;
     Subpart B of the final rule prohibits proprietary trading, 
defines terms relevant to covered trading activity, establishes 
exemptions from the prohibition on proprietary trading and limitations 
on those exemptions, and requires certain banking entities to report 
quantitative measurements with respect to their trading activities;
     Subpart C of the final rule prohibits or restricts 
acquiring or retaining an ownership interest in, and certain 
relationships with, a covered fund, defines terms relevant to covered 
fund activities and investments, as well as establishes exemptions from 
the restrictions on covered fund activities and investments and 
limitations on those exemptions;
     Subpart D of the final rule generally requires banking 
entities to establish a compliance program regarding compliance with 
section 13 of the BHC Act and the final rule, including written 
policies and procedures, internal controls, a management framework, 
independent testing of the compliance program, training, and 
recordkeeping;
     Appendix A of the final rule details the quantitative 
measurements that certain banking entities may be required to compute 
and report with respect to certain trading activities;
     Appendix B of the final rule details the enhanced minimum 
standards for programmatic compliance that certain banking entities 
must meet with respect to their compliance program, as required under 
subpart D.

B. Proprietary Trading Restrictions

    Subpart B of the final rule implements the statutory prohibition on 
proprietary trading and the various exemptions to this prohibition 
included in the statute. Section ----.3 of the final rule contains the 
core prohibition on proprietary trading and defines a number of related 
terms, including ``proprietary trading'' and ``trading account.'' The 
final rule's definition of proprietary trading generally parallels the 
statutory definition and covers engaging as principal for the trading 
account of a banking entity in any transaction to purchase or sell 
specified types of financial instruments.\36\
---------------------------------------------------------------------------

    \36\ See final rule Sec.  ----.3(a).
---------------------------------------------------------------------------

    The final rule's definition of trading account also is consistent 
with the statutory definition.\37\ In particular, the definition of 
trading account in the final rule includes three classes of positions. 
First, the definition includes the purchase or sale of one or more 
financial instruments taken 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.\38\ For purposes of this part of the definition, the final 
rule also contains a rebuttable presumption that the purchase or sale 
of a financial instrument by a banking entity is for the trading 
account of the banking entity if the banking entity holds the financial 
instrument for fewer than 60 days or substantially transfers the risk 
of the financial instrument within 60 days of purchase (or sale).\39\ 
Second, with respect to a banking entity subject to the Federal banking 
agencies' Market Risk Capital Rules, the definition includes the 
purchase or sale of one or more financial instruments subject to the 
prohibition on proprietary trading that are treated as ``covered 
positions and trading positions'' (or hedges of other market risk 
capital rule covered positions) under those capital rules, other than 
certain foreign exchange and commodities positions.\40\ Third, the 
definition includes the purchase or sale of one or more financial 
instruments by a banking entity that is licensed or registered or 
required to be licensed or registered to engage in the business of 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 or is 
engaged in those businesses outside of the United States, to the extent 
the instrument is purchased or sold in connection with the activities 
of such business.\41\
---------------------------------------------------------------------------

    \37\ See final rule Sec.  ----.3(b).
    \38\ See final rule Sec.  ----.3(b)(1)(i).
    \39\ See final rule Sec.  ----.3(b)(2).
    \40\ See final rule Sec.  ----.3(b)(1)(ii).
    \41\ See final rule Sec.  ----.3(b)(1)(iii).
---------------------------------------------------------------------------

    The definition of proprietary trading also contains clarifying 
exclusions for certain purchases and sales of financial instruments 
that generally do not involve the requisite short-term trading intent, 
such as the purchase and sale of financial instruments arising under 
certain repurchase and reverse repurchase arrangements or securities 
lending transactions and securities acquired or taken for bona fide 
liquidity management purposes.\42\
---------------------------------------------------------------------------

    \42\ See final rule Sec.  ----.3(d).
---------------------------------------------------------------------------

    In Section ----.3, the final rule also defines a number of other 
relevant terms, including the term ``financial instrument.'' This term 
is used to define the scope of financial instruments subject to the 
prohibition on proprietary trading. Consistent with the statutory 
language, such financial instruments include securities, derivatives, 
commodity futures, and options on such instruments, but do not include 
loans, spot foreign exchange or spot physical commodities.\43\
---------------------------------------------------------------------------

    \43\ See final rule Sec.  ----.3(c).
---------------------------------------------------------------------------

    In Section ----.4, the final rule implements the statutory 
exemptions for underwriting and market making-related activities. For 
each of these permitted activities, the final rule defines the exempt 
activity and provides a number of requirements that must be met in 
order for a banking entity to rely on the applicable exemption. As more 
fully discussed below, these include 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. In 
addition, the final rule requires firms with significant market-making 
or underwriting activities to report data involving several metrics 
that may be used by the banking entity and the Agencies to identify 
trading activity that may warrant more detailed compliance review.
    These requirements are generally designed to ensure that the 
banking

[[Page 5543]]

entity's trading activity is limited to underwriting and market making-
related activities and does not include prohibited proprietary 
trading.\44\ These requirements are also intended to work together to 
ensure that banking entities identify, monitor and limit the risks 
associated with these activities.
---------------------------------------------------------------------------

    \44\ See final rule Sec.  ----.4(a), (b).
---------------------------------------------------------------------------

    In Section ----.5, the final rule implements the statutory 
exemption for risk-mitigating hedging. As with the underwriting and 
market-making exemptions, Sec.  ----.5 of the final rule contains a 
number of requirements that must be met in order for a banking entity 
to rely on the exemption. These requirements are generally designed to 
ensure that the banking entity's hedging activity is limited to risk-
mitigating hedging in purpose and effect.\45\ Section ----.5 also 
requires banking entities to document, at the time the transaction is 
executed, the hedging rationale for certain transactions that present 
heightened compliance risks.\46\ As with the exemptions for 
underwriting and market making-related activity, these requirements 
form part of a broader implementation approach that also includes the 
compliance program requirement and the reporting of quantitative 
measurements.
---------------------------------------------------------------------------

    \45\ See final rule Sec.  ----.5.
    \46\ See final rule Sec.  ----.5(c).
---------------------------------------------------------------------------

    In Section ----.6, the final rule implements statutory exemptions 
for trading in certain government obligations, trading on behalf of 
customers, trading by a regulated insurance company, and trading by 
certain foreign banking entities outside of the United States. Section 
----.6(a) of the final rule describes the government obligations in 
which a banking entity may trade, which include U.S. government and 
agency obligations, obligations and other instruments of specified 
government sponsored entities, and State and municipal obligations.\47\ 
Section ----.6(b) of the final rule permits trading in certain foreign 
government obligations by affiliates of foreign banking entities in the 
United State and foreign affiliates of a U.S. banking entity 
abroad.\48\ Section ----.6(c) of the final rule describes permitted 
trading on behalf of customers and identifies the types of transactions 
that would qualify for the exemption.\49\ Section ----.6(d) of the 
final rule describes permitted trading by a regulated insurance company 
or an affiliate thereof for the general account of the insurance 
company, and also permits those entities to trade for a separate 
account of the insurance company.\50\ Finally, Sec.  ----.6(e) of the 
final rule describes trading permitted outside of the United States by 
a foreign banking entity.\51\ The exemption in the final rule clarifies 
when a foreign banking entity will qualify to engage in such trading 
pursuant to sections 4(c)(9) or 4(c)(13) of the BHC Act, as required by 
the statute, including with respect to a foreign banking entity not 
currently subject to the BHC Act. As explained in detail below, the 
exemption also provides that the risk as principal, the decision-
making, and the accounting for this activity must occur solely outside 
of the United States, consistent with the statute.
---------------------------------------------------------------------------

    \47\ See final rule Sec.  ----.6(a).
    \48\ See final rule Sec.  ----.6(b).
    \49\ See final rule Sec.  ----.6(c).
    \50\ See final rule Sec.  ----.6(d).
    \51\ See final rule Sec.  ----.6(e).
---------------------------------------------------------------------------

    In Section ----.7, the final rule prohibits a banking entity from 
relying on any exemption to the prohibition on proprietary trading if 
the permitted activity would involve or result in a material conflict 
of interest, result in a material exposure to high-risk assets or high-
risk trading strategies, or pose a threat to the safety and soundness 
of the banking entity or to the financial stability of the United 
States.\52\ This section also describes the terms material conflict of 
interest, high-risk asset, and high-risk trading strategy for these 
purposes.
---------------------------------------------------------------------------

    \52\ See final rule Sec.  ----.7.
---------------------------------------------------------------------------

C. Restrictions on Covered Fund Activities and Investments

    Subpart C of the final rule implements the statutory prohibition 
on, directly or indirectly, acquiring and retaining an ownership 
interest in, or having certain relationships with, a covered fund, as 
well as the various exemptions to this prohibition included in the 
statute. Section ----.10 of the final rule contains the core 
prohibition on covered fund activities and investments and defines a 
number of related terms, including ``covered fund'' and ``ownership 
interest.'' \53\ The definition of covered fund contains a number of 
exclusions for entities that may rely on exclusions from the Investment 
Company Act of 1940 contained in section 3(c)(1) or 3(c)(7) of that Act 
but that are not engaged in investment activities of the type 
contemplated by section 13 of the BHC Act. These include, for example, 
exclusions for wholly owned subsidiaries, joint ventures, foreign 
pension or retirement funds, insurance company separate accounts, and 
public welfare investment funds. The final rule also implements the 
statutory rule of construction in section 13(g)(2) and provides that a 
securitization of loans, which would include loan securitization, 
qualifying asset backed commercial paper conduit, and qualifying 
covered bonds, is not covered by section 13 or the final rule.\54\
---------------------------------------------------------------------------

    \53\ See final rule Sec.  ----.10(b).
    \54\ The Agencies believe that most securitization transactions 
are currently structured so that the issuing entity with respect to 
the securitization is not an affiliate of a banking entity under the 
BHC Act. However, with respect to any securitization that is an 
affiliate of a banking entity and that does not meet the 
requirements of the loan securitization exclusion, the related 
banking entity will need to determine how to bring the 
securitization into compliance with this rule.
---------------------------------------------------------------------------

    The definition of ``ownership interest'' in the final rule provides 
further guidance regarding the types of interests that would be 
considered to be an ownership interest in a covered fund.\55\ As 
described in this Supplementary Information, these interests may take 
various forms. The definition of ownership interest also explicitly 
excludes from the definition ``restricted profit interest'' that is 
solely performance compensation for services provided to the covered 
fund by the banking entity (or an employee or former employee thereof), 
under certain circumstances.\56\ Section ----.10 of the final rule also 
defines a number of other relevant terms, including the terms ``prime 
brokerage transaction,'' ``sponsor,'' and ``trustee.''
---------------------------------------------------------------------------

    \55\ See final rule Sec.  ----.10(d)(6).
    \56\ See final rule Sec.  ----.10(b)(6)(ii).
---------------------------------------------------------------------------

    Section ----.11 of the final rule implements the exemption for 
organizing and offering a covered fund provided for under section 
13(d)(1)(G) of the BHC Act. Section ----.11(a) of the final rule 
outlines the conditions that must be met in order for a banking entity 
to organize and offer a covered fund under this authority. These 
requirements are contained in the statute and are intended to allow a 
banking entity to engage in certain traditional asset management and 
advisory businesses, subject to certain limits contained in section 13 
of the BHC Act.\57\ The requirements are discussed in detail in Part 
IV.B.2. of this Supplementary Information. Section ----.11 also 
explains how these requirements apply to covered funds that are issuing 
entities of asset-backed securities, as well as implements the 
statutory exemption for underwriting and market-making ownership 
interests of a covered fund, including explaining the limitations 
imposed on such activities under the final rule.
---------------------------------------------------------------------------

    \57\ See 156 Cong. Rec. S5889 (daily ed. July 15, 2010) 
(statement of Sen. Hagan).
---------------------------------------------------------------------------

    In Section ----.12, the final rule permits a banking entity to 
acquire and

[[Page 5544]]

retain, as an investment in a covered fund, an ownership interest in a 
covered fund that the banking entity organizes and offers or holds 
pursuant to other authority under Sec.  ----.11.\58\ This section 
implements section 13(d)(4) of the BHC Act and related provisions. 
Section 13(d)(4)(A) of the BHC Act permits a banking entity to make an 
investment in a covered fund that the banking entity organizes and 
offers, or for which it acts as sponsor, for the purposes of (i) 
establishing the covered fund and providing the fund with sufficient 
initial equity for investment to permit the fund to attract 
unaffiliated investors, or (ii) making a de minimis investment in the 
covered fund in compliance with applicable requirements. Section --
--.12 of the final rule implements this authority and related 
limitations, including limitations regarding the amount and value of 
any individual per-fund investment and the aggregate value of all such 
permitted investments. In addition, Sec.  ----.12 requires that the 
aggregate value of all investments in covered funds, plus any earnings 
on these investments, be deducted from the capital of the banking 
entity for purposes of the regulatory capital requirements, and 
explains how that deduction must occur. Section ----.12 of the final 
rule also clarifies how a banking entity must calculate its compliance 
with these investment limitations (including by deducting such 
investments from applicable capital, as relevant), and sets forth how a 
banking entity may request an extension of the period of time within 
which it must conform an investment in a single covered fund. This 
section also explains how a banking entity must apply the covered fund 
investment limits to a covered fund that is an issuing entity of asset 
backed securities or a covered fund that is part of a master-feeder or 
fund-of-funds structure.
---------------------------------------------------------------------------

    \58\ See final rule Sec.  ----.12.
---------------------------------------------------------------------------

    In Section ----.13, the final rule implements the statutory 
exemptions described in sections 13(d)(1)(C), (D), (F), and (I) of the 
BHC Act that permit a banking entity: (i) to acquire and retain an 
ownership interest in a covered fund as a risk-mitigating hedging 
activity related to employee compensation; (ii) in the case of a non-
U.S. banking entity, to acquire and retain an ownership interest in, or 
act as sponsor to, a covered fund solely outside the United States; and 
(iii) to acquire and retain an ownership interest in, or act as sponsor 
to, a covered fund by an insurance company for its general or separate 
accounts.\59\
---------------------------------------------------------------------------

    \59\ See final rule Sec.  ----.13(a)-(c).
---------------------------------------------------------------------------

    In Section ----.14, the final rule implements section 13(f) of the 
BHC Act and generally prohibits a banking entity from entering into 
certain transactions with a covered fund that would be a covered 
transaction as defined in section 23A of the Federal Reserve Act.\60\ 
Section ----.14(a)(2) of the final rule describes the transactions 
between a banking entity and a covered fund that remain permissible 
under the statute and the final rule. Section ----.14(b) of the final 
rule implements the statute's requirement that any transaction 
permitted under section 13(f) of the BHC Act (including a prime 
brokerage transaction) between the banking entity and a covered fund is 
subject to section 23B of the Federal Reserve Act,\61\ which, in 
general, requires that the transaction be on market terms or on terms 
at least as favorable to the banking entity as a comparable transaction 
by the banking entity with an unaffiliated third party.
---------------------------------------------------------------------------

    \60\ See 12 U.S.C. 371c; see also final rule Sec.  ----.14.
    \61\ 12 U.S.C. 371c-1.
---------------------------------------------------------------------------

    In Section ----.15, the final rule prohibits a banking entity from 
relying on any exemption to the prohibition on acquiring and retaining 
an ownership interest in, acting as sponsor to, or having certain 
relationships with, a covered fund, if the permitted activity or 
investment would involve or result in a material conflict of interest, 
result in a material exposure to high-risk assets or high-risk trading 
strategies, or pose a threat to the safety and soundness of the banking 
entity or to the financial stability of the United States.\62\ This 
section also describes material conflict of interest, high-risk asset, 
and high-risk trading strategy for these purposes.
---------------------------------------------------------------------------

    \62\ See final rule Sec.  ----.15.
---------------------------------------------------------------------------

D. Metrics Reporting Requirement

    Under the final rule, a banking entity that meets relevant 
thresholds specified in the rule must furnish the following 
quantitative measurements for each of its trading desks engaged in 
covered trading activity calculated in accordance with Appendix A:
     Risk and Position Limits and Usage;
     Risk Factor Sensitivities;
     Value-at-Risk and Stress VaR;
     Comprehensive Profit and Loss Attribution;
     Inventory Turnover;
     Inventory Aging; and
     Customer Facing Trade Ratio.
    The final rule raises the threshold for metrics reporting from the 
proposal to capture only firms that engage in significant trading 
activity, identified at specified aggregate trading asset and liability 
thresholds, and delays the dates for reporting metrics through a 
phased-in approach based on the size of trading assets and liabilities. 
Specifically, the Agencies have delayed the reporting of metrics until 
June 30, 2014 for the largest banking entities that, together with 
their affiliates and subsidiaries, have trading assets and liabilities 
the average gross sum of which equal or exceed $50 billion on a 
worldwide consolidated basis over the previous four calendar quarters 
(excluding trading assets and liabilities involving obligations of or 
guaranteed by the United States or any agency of the United States). 
Banking entities with $25 billion or more in trading assets and 
liabilities and banking entities with $10 billion or more in trading 
assets and liabilities would also be required to report these metrics 
beginning on April 30, 2016, and December 31, 2016, respectively.
    Under the final rule, a banking entity required to report metrics 
must calculate any applicable quantitative measurement for each trading 
day. Each banking entity required to report must report each applicable 
quantitative measurement to its primary supervisory Agency on the 
reporting schedule established in the final rule unless otherwise 
requested by the primary supervisory Agency for the entity. The largest 
banking entities with $50 billion in consolidated trading assets and 
liabilities must report the metrics on a monthly basis. Other banking 
entities required to report metrics must do so on a quarterly basis. 
All quantitative measurements for any calendar month must be reported 
no later than 10 days after the end of the calendar month required by 
the final rule unless another time is requested by the primary 
supervisory Agency for the entity except for a transitional six month 
period during which reporting will be required no later than 30 days 
after the end of the calendar month. Banking entities subject to 
quarterly reporting will be required to report quantitative 
measurements within 30 days of the end of the quarter, unless another 
time is requested by the primary supervisory Agency for the entity in 
writing.\63\
---------------------------------------------------------------------------

    \63\ See final rule Sec.  ----.20(d)(3). The final rule includes 
a shorter period of time for reporting quantitative measurements 
than was proposed for the largest banking entities. Like the monthly 
reporting requirement for these firms, this is intended to allow for 
more effective supervision of their large-scale trading operations.

---------------------------------------------------------------------------

[[Page 5545]]

E. Compliance Program Requirement

    Subpart D of the final rule requires a banking entity engaged in 
covered trading activities or covered fund activities to develop and 
implement a program reasonably designed to ensure and monitor 
compliance with the prohibitions and restrictions on covered trading 
activities and covered fund activities and investments set forth in 
section 13 of the BHC Act and the final rule.\64\ To reduce the overall 
burden of the rule, the final rule provides that a banking entity that 
does not engage in covered trading activities (other than trading in 
U.S. government or agency obligations, obligations of specified 
government sponsored entities, and state and municipal obligations) or 
covered fund activities and investments need only establish a 
compliance program prior to becoming engaged in such activities or 
making such investments.\65\ In addition, to reduce the burden on 
smaller banking entities, a banking entity with total consolidated 
assets of $10 billion or less that engages in covered trading 
activities and/or covered fund activities or investments may satisfy 
the requirements of the final rule by including in its existing 
compliance policies and procedures appropriate references to the 
requirements of section 13 and the final rule and adjustments as 
appropriate given the activities, size, scope and complexity of the 
banking entity.\66\
---------------------------------------------------------------------------

    \64\ See final rule Sec.  ----.20.
    \65\ See final rule Sec.  ----.20(f)(1).
    \66\ See final rule Sec.  ----.20(f)(2).
---------------------------------------------------------------------------

    For banking entities with total assets greater than $10 billion and 
less than $50 billion, the final rule specifies six elements that each 
compliance program established under subpart D must, at a minimum, 
include. These requirements focus on written policies and procedures 
reasonably designed to ensure compliance with the final rules, 
including limits on underwriting and market-making; a system of 
internal controls; clear accountability for compliance and review of 
limits, hedging, incentive compensation, and other matters; independent 
testing and audits; additional documentation for covered funds; 
training; and recordkeeping requirements.
    A banking entity with $50 billion or more total consolidated assets 
(or a foreign banking entity that has total U.S. assets of $50 billion 
or more) or that is required to report metrics under Appendix A is 
required to adopt an enhanced compliance program with more detailed 
policies, limits, governance processes, independent testing and 
reporting. In addition, the Chief Executive Officer of these larger 
banking entities must attest that the banking entity has in place a 
program reasonably designed to achieve compliance with the requirements 
of section 13 of the BHC Act and the final rule.
    The application of detailed minimum standards for these types of 
banking entities is intended to reflect the heightened compliance risks 
of large covered trading activities and covered fund activities and 
investments and to provide clear, specific guidance to such banking 
entities regarding the compliance measures that would be required for 
purposes of the final rule.

IV. Final Rule

A. Subpart B--Proprietary Trading Restrictions

1. Section ----.3: Prohibition on Proprietary Trading and Related 
Definitions
    Section 13(a)(1)(A) of the BHC Act prohibits a banking entity from 
engaging in proprietary trading unless otherwise permitted in section 
13.\67\ Section 13(h)(4) of the BHC Act defines proprietary trading, in 
relevant part, as engaging as principal for the trading account of the 
banking entity in any transaction to purchase or sell, or otherwise 
acquire or dispose of, a security, derivative, contract of sale of a 
commodity for future delivery, or other financial instrument that the 
Agencies include by rule.\68\
---------------------------------------------------------------------------

    \67\ 12 U.S.C. 1851(a)(1)(A).
    \68\ 12 U.S.C. 1851(h)(4).
---------------------------------------------------------------------------

    Section ----.3(a) of the proposed rule implemented section 
13(a)(1)(A) of the BHC Act by prohibiting a banking entity from 
engaging in proprietary trading unless otherwise permitted under 
Sec. Sec.  ----.4 through ----.6 of the proposed rule. Section --
--.3(b)(1) of the proposed rule defined proprietary trading in 
accordance with section 13(h)(4) of the BHC Act and clarified that 
proprietary trading does not include acting solely as agent, broker, or 
custodian for an unaffiliated third party. The preamble to the proposed 
rule explained that acting in these types of capacities does not 
involve trading as principal.\69\
---------------------------------------------------------------------------

    \69\ See Joint Proposal, 76 FR 68,857.
---------------------------------------------------------------------------

    Several commenters expressed concern about the breadth of the ban 
on proprietary trading.\70\ Some of these commenters stated that 
proprietary trading must be carefully and narrowly defined to avoid 
prohibiting activities that Congress did not intend to limit and to 
preclude significant, unintended consequences for capital markets, 
capital formation, and the broader economy.\71\ Some commenters 
asserted that the proposed definition could result in banking entities 
being unwilling to take principal risk to provide liquidity for 
institutional investors; could unnecessarily constrain liquidity in 
secondary markets, forcing asset managers to service client needs 
through alternative non-U.S. markets; could impose substantial costs 
for all institutions, especially smaller and mid-size institutions; and 
could drive risk-taking to the shadow banking system.\72\ Others urged 
the Agencies to determine that trading as agent, broker, or custodian 
for an affiliate was not proprietary trading.\73\
---------------------------------------------------------------------------

    \70\ See, e.g., Ass'n. of Institutional Investors (Feb. 2012); 
Capital Group; Comm. on Capital Markets Regulation; IAA; SIFMA et 
al. (Prop. Trading) (Feb. 2012); SVB; Chamber (Feb. 2012); 
Wellington.
    \71\ See Ass'n. of Institutional Investors (Feb. 2012); GE (Feb. 
2012); Invesco; Sen. Corker; Chamber (Feb. 2012).
    \72\ See Chamber (Feb. 2012).
    \73\ See Japanese Bankers Ass'n.
---------------------------------------------------------------------------

    Commenters also suggested alternative approaches for defining 
proprietary trading. In general, these approaches sought to provide a 
bright-line definition to provide increased certainty to banking 
entities\74\ or make the prohibition easier to apply in practice.\75\ 
One commenter stated the Agencies should focus on the economics of 
banking entities' transactions and ban trading if the banking entity is 
exposed to market risk for a significant period of time or is profiting 
from changes in the value of the asset.\76\ Several commenters, 
including individual members of the public, urged the Agencies to 
prohibit banking entities from engaging in any kind of proprietary 
trading and require separation of trading from traditional banking 
activities.\77\ After carefully considering comments, the Agencies are 
defining proprietary trading as engaging as principal for the trading 
account of the banking entity in any purchase or sale of one or more

[[Page 5546]]

financial instruments.\78\ The Agencies believe this effectively 
restates the statutory definition. The Agencies are not adopting 
commenters' suggested modifications to the proposed definition of 
proprietary trading or the general prohibition on proprietary trading 
because they generally appear to be inconsistent with Congressional 
intent. For instance, some commenters appeared to suggest an approach 
to defining proprietary trading that would capture only bright-line, 
speculative proprietary trading and treat the activities covered by the 
statutory exemptions as completely outside the rule.\79\ However, such 
an approach would appear to be inconsistent with Congressional intent 
because, for instance, it would not give effect to the limitations on 
permitted activities in section 13(d) of the BHC Act.\80\ For similar 
reasons, the Agencies are not adopting a bright-line definition of 
proprietary trading.\81\
---------------------------------------------------------------------------

    \74\ See, e.g., ABA (Keating); Ass'n. of Institutional Investors 
(Feb. 2012); BOK; George Bollenbacher; Credit Suisse (Seidel); NAIB 
et al.; SSgA (Feb. 2012); JPMC.
    \75\ See Public Citizen.
    \76\ See Sens. Merkley & Levin (Feb. 2012).
    \77\ See generally Occupy; Public Citizen; AFR et al. (Feb. 
2012). The Agencies received over fifteen thousand form letters in 
support of a rule with few exemptions, many of which expressed a 
desire to return to the regulatory scheme as governed by the Glass-
Steagall affiliation provisions of the U.S. Banking Act of 1933, as 
repealed through the Graham-Leach-Bliley Act of 1999. See generally 
Sarah McGee; Christopher Wilson; Michael Itlis; Barry Rein; Edward 
Bright. Congress rejected such an approach, however, opting instead 
for the more narrowly tailored regulatory approach embodied in 
section 13 of the BHC Act.
    \78\ See final rule Sec.  ----.3(a). The final rule also 
replaces all references to the proposed term ``covered financial 
position'' with the term ``financial instrument.'' This change has 
no substantive impact because the definition of ``financial 
instrument'' is substantially identical to the proposed definition 
of ``covered financial position.'' Consistent with this change, the 
final rule replaces the undefined verbs ``acquire'' or ``take'' with 
the defined terms ``purchase'' or ``sale'' and ``sell.'' See final 
rule Sec. Sec.  ----.3(c), ----.2(u), (x).
    \79\ See, e.g., Ass'n. of Institutional Investors (Feb. 2012); 
GE (Feb. 2012); Invesco; Sen. Corker; Chamber (Feb. 2012); JPMC.
    \80\ See 156 Cong. Rec. S5895-96 (daily ed. July 15, 2010) 
(statement of Sen. Merkley) (stating the statute ``permits 
underwriting and market-making-related transactions that are 
technically trading for the account of the firm but, in fact, 
facilitate the provision of near-term client-oriented financial 
services.'').
    \81\ See ABA (Keating); Ass'n. of Institutional Investors (Feb. 
2012); BOK; George Bollenbacher; Credit Suisse (Seidel); NAIB et 
al.; SSgA (Feb. 2012); JPMC.
---------------------------------------------------------------------------

    A number of commenters expressed concern that, as a whole, the 
proposed rule may result in certain negative economic impacts, 
including: (i) Reduced market liquidity; \82\ (ii) wider spreads or 
otherwise increased trading costs; \83\ (iii) higher borrowing costs 
for businesses or increased cost of capital; \84\ and/or (iv) greater 
market volatility.\85\ The Agencies have carefully considered 
commenters' concerns about the proposed rule's potential impact on 
overall market liquidity and quality. As discussed in more detail in 
Parts IV.A.2. and IV.A.3., the final rule will permit banking entities 
to continue to provide beneficial market-making and underwriting 
services to customers, and therefore provide liquidity to customers and 
facilitate capital-raising. However, the statute upon which the final 
rule is based prohibits proprietary trading activity that is not 
exempted. As such, the termination of non-exempt proprietary trading 
activities of banking entities may lead to some general reductions in 
liquidity of certain asset classes. Although the Agencies cannot say 
with any certainty, there is good reason to believe that to a 
significant extent the liquidity reductions of this type may be 
temporary since the statute does not restrict proprietary trading 
activities of other market participants.\86\ Thus, over time, non-
banking entities may provide much of the liquidity that is lost by 
restrictions on banking entities' trading activities. If so, 
eventually, the detrimental effects of increased trading costs, higher 
costs of capital, and greater market volatility should be mitigated.
---------------------------------------------------------------------------

    \82\ See, e.g., AllianceBernstein; Obaid Syed; Rep. Bachus et 
al.; EMTA; NASP; Sen. Hagan; Investure; Lord Abbett; Sumitomo Trust; 
EFAMA; Morgan Stanley; Barclays; BoA; Citigroup (Feb. 2012); STANY; 
ABA (Keating); ICE; ICSA; SIFMA (Asset Mgmt.) (Feb. 2012); Putnam; 
ACLI (Feb. 2012); Wells Fargo (Prop. Trading); Capital Group; RBC; 
Columbia Mgmt.; SSgA (Feb. 2012); Fidelity; ICI (Feb. 2012); ISDA 
(Feb. 2012); Comm. on Capital Markets Regulation; Clearing House 
Ass'n.; Thakor Study. See also CalPERS (acknowledging that the 
systemic protections afforded by the Volcker Rule come at a price, 
including reduced liquidity to all markets).
    \83\ See, e.g., AllianceBernstein; Obaid Syed; NASP; Investure; 
Lord Abbett; CalPERS; Credit Suisse (Seidel); Citigroup (Feb. 2012); 
ABA (Keating); SIFMA (Asset Mgmt.) (Feb. 2012); Putnam; Wells Fargo 
(Prop. Trading); Comm. on Capital Markets Regulation.
    \84\ See, e.g., Rep. Bachus et al.; Members of Congress (Dec. 
2011); Lord Abbett; Morgan Stanley; Barclays; BoA; Citigroup (Feb. 
2012); ABA (Abernathy); ICSA; SIFMA (Asset Mgmt.) (Feb. 2012); 
Chamber (Feb. 2012); Putnam; ACLI (Feb. 2012); UBS; Wells Fargo 
(Prop. Trading); Capital Group; Sen. Carper et al.; Fidelity; 
Invesco; Clearing House Ass'n.; Thakor Study.
    \85\ See, e.g., CalPERS (expressing the belief that a decline in 
banking entity proprietary trading will increase the volatility of 
the corporate bond market, especially during times of economic 
weakness or periods where risk taking declines, but noting that 
portfolio managers have experienced many different periods of market 
illiquidity and stating that the market will adapt post-
implementation (e.g., portfolio managers will increase their use of 
CDS to reduce economic risk to specific bond positions as the 
liquidation process of cash bonds takes more time, alternative 
market matching networks will be developed)); Morgan Stanley; 
Capital Group; Fidelity; British Bankers' Ass'n.; Invesco.
    \86\ See David McClean; Public Citizen; Occupy. In response to 
commenters who expressed concern about risks associated with 
proprietary trading activities moving to non-banking entities, the 
Agencies note that section 13's prohibition on proprietary trading 
and related exemptions apply only to banking entities. See, e.g., 
Chamber (Feb. 2012).
---------------------------------------------------------------------------

    To respond to concerns raised by commenters while remaining 
consistent with Congressional intent, the final rule has been modified 
to provide that certain purchases and sales are not proprietary trading 
as described in more detail below.\87\
---------------------------------------------------------------------------

    \87\ See final rule Sec.  ----.3(d).
---------------------------------------------------------------------------

a. Definition of ``Trading Account''
    As explained above, section 13 defines proprietary trading as 
engaging as principal ``for the trading account of the banking entity'' 
in certain types of transactions. Section 13(h)(6) of the BHC Act 
defines trading account as any account used for acquiring or taking 
positions in financial instruments principally for the purpose of 
selling in the near-term (or otherwise with the intent to resell in 
order to profit from short-term price movements), and any such other 
accounts as the Agencies may, by rule, determine.\88\
---------------------------------------------------------------------------

    \88\ See 12 U.S.C. 1851(h)(6).
---------------------------------------------------------------------------

    The proposed rule defined trading account to include three separate 
accounts. First, the proposed definition of trading account included, 
consistent with the statute, any account that is used by a banking 
entity to acquire or take one or more covered financial positions for 
short-term trading purposes (the ``short-term trading account'').\89\ 
The proposed rule identified four purposes that would indicate short-
term trading intent: (i) Short-term resale; (ii) benefitting from 
actual or expected short-term price movements; (iii) realizing short-
term arbitrage profits; or (iv) hedging one or more positions described 
in (i), (ii) or (iii). The proposed rule presumed that an account is a 
trading account if it is used to acquire or take a covered financial 
position (other than a position in the market risk rule trading account 
or the dealer trading account) that the banking entity holds for 60 
days or less.\90\
---------------------------------------------------------------------------

    \89\ See proposed rule Sec.  ----.3(b)(2)(i)(A).
    \90\ See proposed rule Sec.  ----.3(b)(2)(ii).
---------------------------------------------------------------------------

    Second, the proposed definition of trading account included, for 
certain entities, any account that contains positions that qualify for 
trading book capital treatment under the banking agencies' market risk 
capital rules other than positions that are foreign exchange 
derivatives, commodity derivatives or contracts of sale of a commodity 
for delivery (the ``market risk rule trading account'').\91\ ``Covered 
positions'' under the banking agencies' market-risk capital rules are 
positions that are generally held with the intent of sale in the short-
term.
---------------------------------------------------------------------------

    \91\ See proposed rule Sec. Sec.  ----.3(b)(2)(i)(B); --
--.3(b)(3).
---------------------------------------------------------------------------

    Third, the proposed definition of trading account included any 
account used by a banking entity that is a securities dealer, swap 
dealer, or

[[Page 5547]]

security-based swap dealer to acquire or take positions in connection 
with its dealing activities (the ``dealer trading account'').\92\ The 
proposed rule also included as a trading account any account used to 
acquire or take any covered financial position by a banking entity in 
connection with the activities of a dealer, swap dealer, or security-
based swap dealer outside of the United States.\93\ Covered financial 
positions held by banking entities that register or file notice as 
securities or derivatives dealers as part of their dealing activity 
were included because such positions are generally held for sale to 
customers upon request or otherwise support the firm's trading 
activities (e.g., by hedging its dealing positions).\94\
---------------------------------------------------------------------------

    \92\ See proposed rule Sec.  ----.3(b)(2)(i)(C).
    \93\ See proposed rule Sec.  ----.3(b)(2)(i)(C)(5).
    \94\ See Joint Proposal, 76 FR 68,860.
---------------------------------------------------------------------------

    The proposed rule also set forth four clarifying exclusions from 
the definition of trading account. The proposed rule provided that no 
account is a trading account to the extent that it is used to acquire 
or take certain positions under repurchase or reverse repurchase 
arrangements, positions under securities lending transactions, 
positions for bona fide liquidity management purposes, or positions 
held by derivatives clearing organizations or clearing agencies.\95\
---------------------------------------------------------------------------

    \95\ See proposed rule Sec.  ----.3(b)(2)(iii).
---------------------------------------------------------------------------

    Overall, commenters did not raise significant concerns with or 
objections to the short-term trading account. Several commenters argued 
that the definition of trading account should be limited to only this 
portion of the proposed definition of trading account.\96\ However, a 
few commenters raised concerns regarding the treatment of arbitrage 
trading under the proposed rule.\97\ Several commenters asserted that 
the proposed definition of trading account was too broad and covered 
trading not intended to be covered by the statute.\98\ Some of these 
commenters maintained that the Agencies exceeded their statutory 
authority under section 13 of the BHC Act in defining trading account 
to include the market risk rule trading account and dealer trading 
account, and argued that the definition should be limited to the short-
term trading account definition.\99\ Commenters argued, for example, 
that an overly broad definition of trading account may cause 
traditional bank activities important to safety and soundness of a 
banking entity to fall within the prohibition on proprietary trading to 
the detriment of banking organizations, customers, and financial 
markets.\100\ A number of commenters suggested modifying and narrowing 
the trading account definition to remove the implicit negative 
presumption that any position creates a trading account, or that all 
principal trading constitutes prohibited proprietary trading unless it 
qualifies for a narrowly tailored exemption, and to clearly exempt 
activities important to safety and soundness.\101\ For example, one 
commenter recommended that a covered financial position be considered a 
trading account position only if it qualifies as a GAAP trading 
position.\102\ A few commenters requested the Agencies define the 
phrase ``short term'' in the rule.\103\
---------------------------------------------------------------------------

    \96\ See ABA (Keating); JPMC.
    \97\ See AFR et al. (Feb. 2012); Paul Volcker; Credit Suisse 
(Seidel); ISDA (Feb. 2012); Japanese Bankers Ass'n.
    \98\ See ABA (Keating); Allen & Overy (on behalf of Large Int'l 
Banks with U.S. Operations); Am. Express; BoA; Goldman (Prop. 
Trading); ISDA (Feb. 2012); Japanese Bankers Ass'n.; JPMC; SIFMA et 
al. (Prop.Trading) (Feb. 2012); State Street (Feb. 2012).
    \99\ See ABA (Keating); JPMC; SIFMA et al. (Prop.Trading) (Feb. 
2012); State Street (Feb. 2012).
    \100\ See ABA (Keating); Credit Suisse (Seidel).
    \101\ See ABA (Keating); Ass'n. of Institutional Investors (Feb. 
2012); BoA; Capital Group; IAA; Credit Suisse (Seidel); ICI (Feb. 
2012); ISDA (Feb. 2012); NAIB et al.; SIFMA et al. (Prop.Trading) 
(Feb. 2012); SVB; Wellington.
    \102\ See ABA (Keating).
    \103\ See NAIB et al.; Occupy; but See Alfred Brock.
---------------------------------------------------------------------------

    Several commenters argued that the market risk rule should not be 
referenced as part of the definition of trading account.\104\ A few of 
these commenters argued instead that the capital treatment of a 
position be used only as an indicative factor rather than a dispositive 
test.\105\ One commenter thought that the market risk rule trading 
account was redundant because it includes only positions that have 
short-term trading intent.\106\ Commenters also contended that it was 
difficult to consider and comment on this aspect of the proposal 
because the market risk capital rules had not been finalized.\107\
---------------------------------------------------------------------------

    \104\ See ABA; BoA; Goldman (Prop. Trading); ISDA (Feb. 2012); 
JPMC; SIFMA et al. (Prop.Trading) (Feb. 2012).
    \105\ See BoA; SIFMA et al. (Prop.Trading) (Feb. 2012).
    \106\ See ISDA (Feb. 2012).
    \107\ See ABA (Keating); BoA; Goldman (Prop. Trading); ISDA 
(Feb. 2012); JPMC. The banking agencies adopted a final rule that 
amends their respective market risk capital rules on August 30, 
2012. See 77 FR 53,060 (Aug. 30, 2012). The Agencies continued to 
receive and consider comments on the proposed rule to implement 
section 13 of the BHC Act after that time.
---------------------------------------------------------------------------

    A number of commenters objected to the dealer trading account prong 
of the definition.\108\ Commenters asserted that this prong was an 
unnecessary and unhelpful addition that went beyond the requirements of 
section 13 of the BHC Act, and that it made the trading account 
determination more complex and difficult.\109\ In particular, 
commenters argued that the dealer trading account was too broad and 
introduced uncertainty because it presumed that dealers always enter 
into positions with short-term intent.\110\ Commenters also expressed 
concern about the difficulty of applying this test outside the United 
States and requested that, if this account is retained, the final rule 
be explicit about how it applies to a swap dealer outside the United 
States and treat U.S. swap dealers consistently.\111\
---------------------------------------------------------------------------

    \108\ See ABA (Keating); Allen & Overy (on behalf of Large Int'l 
Banks with U.S. Operations); Am. Express; Goldman (Prop. Trading); 
ISDA (Feb. 2012); Japanese Bankers Ass'n.; JPMC; SIFMA et al. 
(Prop.Trading) (Feb. 2012).
    \109\ See ABA (Keating); Allen & Overy (on behalf of Large Int'l 
Banks with U.S. Operations); JPMC; State Street (Feb. 2012); ISDA 
(Feb. 2012); SIFMA et al. (Prop.Trading) (Feb. 2012).
    \110\ See ABA (Keating); Am. Express; Goldman (Prop. Trading); 
ISDA (Feb. 2012); JPMC.
    \111\ See Allen & Overy (on behalf of Large Int'l Banks with 
U.S. Operations); Am. Express; JPMC.
---------------------------------------------------------------------------

    In contrast, other commenters contended that the proposed rule's 
definition of trading account was too narrow, particularly in its focus 
on short-term positions,\112\ or should be simplified.\113\ One 
commenter argued that the breadth of the trading account definition was 
critical because positions excluded from the trading account definition 
would not be subject to the proposed rule.\114\ One commenter supported 
the proposed definition of trading account.\115\ Other commenters 
believed that reference to the market-risk rule was an important 
addition to the definition of trading account. Some expressed the view 
that it should include all market risk capital rule covered positions 
and not just those requiring short-term trading intent.\116\
---------------------------------------------------------------------------

    \112\ See Sens. Merkley & Levin (Feb. 2012); Occupy.
    \113\ See, e.g., Public Citizen.
    \114\ See AFR et al. (Feb. 2012).
    \115\ See Alfred Brock.
    \116\ See AFR et al. (Feb. 2012).
---------------------------------------------------------------------------

    Certain commenters proposed alternate definitions. Several 
commenters argued against using the term ``account'' and instead 
advocated applying the prohibition on proprietary trading to trading 
positions.\117\ Foreign banks recommended applying the definition of 
trading account applicable to such banks in their home country, if the 
home country provided a clear definition of this term.\118\ These 
commenters argued that new definitions in the proposed rule, like 
trading account, would require foreign banking

[[Page 5548]]

entities to develop new and complex procedures and expensive 
systems.\119\
---------------------------------------------------------------------------

    \117\ See ABA (Keating); Goldman (Prop. Trading); NAIB et al.
    \118\ See Japanese Bankers Ass'n.; Norinchukin.
    \119\ See Japanese Bankers Ass'n.
---------------------------------------------------------------------------

    Commenters also argued that various types of trading activities 
should be excluded from the trading account definition. For example, 
one commenter asserted that arbitrage trading should not be considered 
trading account activity,\120\ while other commenters argued that 
arbitrage positions and strategies are proprietary trading and should 
be included in the definition of trading account and prohibited by the 
final rule.\121\ Another commenter argued that the trading account 
should include only positions primarily intended, when the position is 
entered into, to profit from short-term changes in the value of the 
assets, and that liquidity investments that do not have price changes 
and that can be sold whenever the banking entity needs cash should be 
excluded from the trading account definition.\122\
---------------------------------------------------------------------------

    \120\ See Alfred Brock.
    \121\ See AFR et al. (Feb. 2012); Paul Volcker.
    \122\ See NAIB et al. See infra Part IV.A.1.d.2. (discussing the 
liquidity management exclusion).
---------------------------------------------------------------------------

    After carefully reviewing the comments, the Agencies have 
determined to retain in the final rule the proposed approach for 
defining trading account that includes the short-term, market risk 
rule, and dealer trading accounts with modifications to address issues 
raised by commenters. The Agencies believe that this multi-prong 
approach is consistent with both the language and intent of section 13 
of the BHC Act, including the express statutory authority to include 
``any such other account'' as determined by the Agencies.\123\ The 
final definition effectuates Congress's purpose to generally focus on 
short-term trading while addressing commenters' desire for greater 
certainty regarding the definition of the trading account.\124\ In 
addition, the Agencies believe commenters' concerns about the scope of 
the proposed definition of trading account are substantially addressed 
by the refined exemptions in the final rule for customer-oriented 
activities, such as market making-related activities, and the 
exclusions from proprietary trading.\125\ Moreover, the Agencies 
believe that it is appropriate to focus on the economics of a banking 
entity's trading activity to help determine whether it is engaged in 
proprietary trading, as discussed further below.\126\
---------------------------------------------------------------------------

    \123\ 12 U.S.C. 1851(h)(6).
    \124\ In response to commenters' concerns about the meaning of 
account, the Agencies note the term ``trading account'' is a 
statutory concept and does not necessarily refer to an actual 
account. Trading account is simply nomenclature for the set of 
transactions that are subject to the final rule's restrictions on 
proprietary trading. See ABA (Keating); Goldman (Prop. Trading); 
NAIB et al.
    \125\ For example, several commenters' concerns about the 
potential impact of the proposed definition of trading account were 
tied to the perceived narrowness of the proposed exemptions. See ABA 
(Keating); Ass'n. of Institutional Investors (Feb. 2012); BoA; 
Capital Group; IAA; Credit Suisse (Seidel); ICI (Feb. 2012); ISDA 
(Feb. 2012); NAIB et al.; SIFMA et al. (Prop. Trading) (Feb. 2012); 
SVB; Wellington.
    \126\ See Sens. Merkley & Levin (Feb. 2012). However, as 
discussed in this SUPPLEMENTARY INFORMATION, the Agencies are not 
prohibiting any trading that involves profiting from changes in the 
value of the asset, as suggested by this commenter, because 
permitted activities, such as market making, can involve price 
appreciation-related revenues. See infra Part IV.A.3. (discussing 
the final market-making exemption).
---------------------------------------------------------------------------

    As explained above, the short-term trading prong of the definition 
largely incorporates the statutory provisions. This prong covers 
trading involving short-term resale, price movements, and arbitrage 
profits, and hedging positions that result from these activities. 
Specifically, the reference to short-term resale is taken from the 
statute's definition of trading account. The Agencies continue to 
believe it is also appropriate to include in the short-term trading 
prong an account that is used by a banking entity to purchase or sell 
one or more financial instruments principally for the purpose of 
benefitting from actual or expected short-term price movements, 
realizing short-term arbitrage profits, or hedging one or more 
positions captured by the short-term trading prong. The provisions 
regarding price movements and arbitrage focus on the intent to engage 
in transactions to benefit from short-term price movements (e.g., 
entering into a subsequent transaction in the near term to offset or 
close out, rather than sell, the risks of a position held by the 
banking entity to benefit from a price movement occurring between the 
acquisition of the underlying position and the subsequent offsetting 
transaction) or to benefit from differences in multiple market prices, 
including scenarios where movement in those prices is not necessary to 
realize the intended profit.\127\ These types of transactions are 
economically equivalent to transactions that are principally for the 
purpose of selling in the near term or with the intent to resell to 
profit from short-term price movements, which are expressly covered by 
the statute's definition of trading account. Thus, the Agencies believe 
it is necessary to include these provisions in the final rule's short-
term trading prong to provide clarity about the scope of the definition 
and to prevent evasion of the statute and final rule.\128\ In addition, 
like the proposed rule, the final rule's short-term trading prong 
includes hedging one or more of the positions captured by this prong 
because the Agencies assume that a banking entity generally intends to 
hold the hedging position for only so long as the underlying position 
is held.
---------------------------------------------------------------------------

    \127\ See Joint Proposal, 76 FR 68,857-68,858.
    \128\ As a result, the Agencies are not excluding arbitrage 
trading from the trading account definition, as suggested by at 
least one commenter. See, e.g., Alfred Brock.
---------------------------------------------------------------------------

    The remaining two prongs to the trading account definition apply to 
types of entities that engage actively in trading activities. Each 
prong focuses on analogous or parallel short-term trading activities. A 
few commenters stated these prongs were duplicative of the short-term 
trading prong, and argued the Agencies should not include these prongs 
in the definition of trading account, or should only consider them as 
non-determinative factors.\129\ To the extent that an overlap exists 
between the prongs of this definition, the Agencies believe they are 
mutually reinforcing, strengthen the rule's effectiveness, and may help 
simplify the analysis of whether a purchase or sale is conducted for 
the trading account.\130\
---------------------------------------------------------------------------

    \129\ See ISDA (Feb. 2012); JPMC; ABA (Keating); BoA; SIFMA et 
al. (Prop. Trading) (Feb. 2012).
    \130\ See Occupy.
---------------------------------------------------------------------------

    The market risk capital prong covers trading positions that are 
covered positions for purposes of the banking agency market-risk 
capital rules, as well as hedges of those positions. Trading positions 
under those rules are positions held by the covered entity ``for the 
purpose of short-term resale or with the intent of benefitting from 
actual or expected short-term price movements, or to lock-in arbitrage 
profits.'' \131\ This definition largely parallels the provisions of 
section 13(h)(4) of the BHC Act and mirrors the short-term trading 
account prong of both the proposed and final rules. Covered positions 
are trading positions under the rule that subject the covered entity to 
risks and exposures that must be actively managed and limited--a 
requirement consistent with the purposes of the section 13 of the BHC 
Act.
---------------------------------------------------------------------------

    \131\ 12 CFR part 225, Appendix E.
---------------------------------------------------------------------------

    Incorporating this prong into the trading account definition 
reinforces the consistency between governance of the types of positions 
that banking entities identify as ``trading'' for purposes of the 
market risk capital rules and those that are trading for purposes of 
the final rule under section 13 of the BHC Act. Moreover, this aspect 
of the final rule reduces the compliance burden on banking entities 
with substantial trading

[[Page 5549]]

activities by establishing a clear, bright-line rule for determining 
that a trade is within the trading account.\132\
---------------------------------------------------------------------------

    \132\ Accordingly, the Agencies are not using a position's 
capital treatment as merely an indicative factor, as suggested by a 
few commenters.
---------------------------------------------------------------------------

    After reviewing comments, the Agencies also continue to believe 
that financial instruments purchased or sold by registered dealers in 
connection with their dealing activity are generally held with short-
term intent and should be captured within the trading account. The 
Agencies believe the scope of the dealer prong is appropriate because, 
as noted in the proposal, positions held by a registered dealer in 
connection with its dealing activity are generally held for sale to 
customers upon request or otherwise support the firm's trading 
activities (e.g., by hedging its dealing positions), which is 
indicative of short-term intent.\133\ Moreover, the final rule includes 
a number of exemptions for the activities in which securities dealers, 
swap dealers, and security-based swap dealers typically engage, such as 
market making, hedging, and underwriting. Thus, the Agencies believe 
the broad scope of the dealer trading account is balanced by the 
exemptions that are designed to permit dealer entities to continue to 
engage in customer-oriented trading activities, consistent with the 
statute. This approach is designed to ensure that registered dealer 
entities are engaged in permitted trading activities, rather than 
prohibited proprietary trading.
---------------------------------------------------------------------------

    \133\ See Joint Proposal, 76 FR 68,860.
---------------------------------------------------------------------------

    The final rule adopts the dealer trading account substantially as 
proposed,\134\ with streamlining that eliminates the specific 
references to different types of securities and derivatives dealers. 
The final rule adopts the proposed approach to covering trading 
accounts of banking entities that regularly engage in the business of a 
dealer, swap dealer, or security-based swap dealer outside of the 
United States. In the case of both domestic and foreign entities, this 
provision applies only to financial instruments purchased or sold in 
connection with the activities that require the banking entity to be 
licensed or registered to engage in the business of dealing, which is 
not necessarily all of the activities of that banking entity.\135\ 
Activities of a banking entity that are not covered by the dealer prong 
may, however, be covered by the short-term or market risk rule trading 
accounts if the purchase or sale satisfies the requirements of 
Sec. Sec.  ----.3(b)(1)(i) or (ii).\136\
---------------------------------------------------------------------------

    \134\ See final rule Sec.  ----.3(b)(1)(iii).
    \135\ An insured depository institution may be registered as a 
swap dealer, but only the swap dealing activities that require it to 
be so registered are covered by the dealer trading account. If an 
insured depository institution purchases or sells a financial 
instrument in connection with activities of the insured depository 
institution that do not trigger registration as a swap dealer, such 
as lending, deposit-taking, the hedging of business risks, or other 
end-user activity, the financial instrument is included in the 
trading account only if the instrument falls within the statutory 
trading account under Sec.  ----.3(b)(1)(i) or the market risk rule 
trading account under Sec.  ----.3(b)(1)(ii) of the final rule.
    \136\ See final rule Sec. Sec.  ----.3(b)(1)(i) and (ii).
---------------------------------------------------------------------------

    A few commenters stated that they do not currently analyze whether 
a particular activity would require dealer registration, so the dealer 
prong of the trading account definition would require banking entities 
to engage in a new type of analysis.\137\ The Agencies recognize that 
banking entities that are registered dealers may not currently engage 
in such an analysis with respect to their current trading activities 
and, thus, this may represent a new regulatory requirement for these 
entities. If the regulatory analysis otherwise engaged in by banking 
entities is substantially similar to the dealer prong analysis required 
under the trading account definition, then any increased compliance 
burden could be small or insubstantial.\138\
---------------------------------------------------------------------------

    \137\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); 
Goldman (Prop. Trading).
    \138\ See, e.g., Goldman (Prop. Trading) (``For instance, a 
banking entity's market making-related activities with respect to 
credit trading may involve making a market in bonds (traded in a 
broker-dealer), single-name CDSs (in a security-based swap dealer) 
and CDS indexes (in a swap dealer). For regulatory or other reasons, 
these transactions could take place in different legal entities. . 
.'').
---------------------------------------------------------------------------

    In response to commenters' concerns regarding the application of 
this prong to banking entities acting as dealers in jurisdictions 
outside the United States,\139\ the Agencies continue to believe 
including the activities of a banking entity engaged in the business of 
a dealer, swap dealer, or security-based swap dealer outside of the 
United States, to the extent the instrument is purchased or sold in 
connection with the activities of such business, is appropriate. As 
noted above, dealer activity generally involves short-term trading. 
Further, the Agencies are concerned that differing requirements for 
U.S. and foreign dealers may lead to regulatory arbitrage. For foreign 
banking entities acting as dealers outside of the United States that 
are eligible for the exemption for trading conducted by foreign banking 
entities, the Agencies believe the risk-based approach to this 
exemption in the final rule should help address the concerns about the 
scope of this prong of the definition.\140\
---------------------------------------------------------------------------

    \139\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; Allen 
& Overy (on behalf of Large Int'l Banks with U.S. Operations).
    \140\ See final rule Sec.  ----.6(e).
---------------------------------------------------------------------------

    In response to one commenter's suggestion that the Agencies define 
the term trading account to allow a foreign banking entity to use of 
the relevant foreign regulator's definition of this term, where 
available, the Agencies are concerned such an approach could lead to 
regulatory arbitrage and otherwise inconsistent applications of the 
rule.\141\ The Agencies believe this commenter's general concern about 
the impact of the statute and rule on foreign banking entities' 
activities outside the United States should be substantially addressed 
by the exemption for trading conducted by foreign banking entities 
under Sec.  ----.6(e) of the final rule.
---------------------------------------------------------------------------

    \141\ See Japanese Bankers Ass'n.
---------------------------------------------------------------------------

    Finally, the Agencies have declined to adopt one commenter's 
recommendation that a position in a financial instrument be considered 
a trading account position only if it qualifies as a GAAP trading 
position.\142\ The Agencies continue to believe that formally 
incorporating accounting standards governing trading securities is not 
appropriate because: (i) The statutory proprietary trading provisions 
under section 13 of the BHC Act applies to financial instruments, such 
as derivatives, to which the trading security accounting standards may 
not apply; (ii) these accounting standards permit companies to 
classify, at their discretion, assets as trading securities, even where 
the assets would not otherwise meet the definition of trading 
securities; and (iii) these accounting standards could change in the 
future without consideration of the potential impact on section 13 of 
the BHC Act and these rules.\143\
---------------------------------------------------------------------------

    \142\ See ABA (Keating).
    \143\ See Joint Proposal, 76 FR 68,859.
---------------------------------------------------------------------------

b. Rebuttable Presumption for the Short-Term Trading Account
    The proposed rule included a rebuttable presumption clarifying when 
a covered financial position, by reason of its holding period, is 
traded with short-term intent for purposes of the short-term trading 
account. The Agencies proposed this presumption primarily to provide 
guidance to banking entities that are not subject to the market risk 
capital rules or are not covered dealers or swap entities and 
accordingly may not have experience evaluating short-term trading 
intent. In particular, Sec.  ----.3(b)(2)(ii) of the proposed rule 
provided that an account would be presumed to be a short-term trading 
account if it was used to acquire

[[Page 5550]]

or take a covered financial position that the banking entity held for a 
period of 60 days or less.
    Several commenters supported the rebuttable presumption, but 
suggested either shortening the holding period to 30 days or less,\144\ 
or extending the period to 90 days,\145\ to several months,\146\ or to 
one year.\147\ Some of these commenters argued that specifying an 
overly short holding period would be contrary to the statute, invite 
gamesmanship,\148\ and miss speculative positions held for longer than 
the specified period.\149\ Commenters also suggested turning the 
presumption into a safe harbor \150\ or into guidance.\151\
---------------------------------------------------------------------------

    \144\ See Japanese Bankers Ass'n.
    \145\ See Capital Group.
    \146\ See AFR et al. (Feb. 2012).
    \147\ See Sens. Merkley & Levin (Feb. 2012); Public Citizen 
(arguing that one-year demarks tax law covering short term capital 
gains).
    \148\ See Sens. Merkley & Levin (Feb. 2012).
    \149\ See Occupy.
    \150\ See Capital Group.
    \151\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------

    Other commenters opposed the inclusion of the rebuttable 
presumption for a number of reasons and requested that it be 
removed.\152\ For example, these commenters argued that the presumption 
had no statutory basis; \153\ was arbitrary; \154\ was not supported by 
data, facts, or analysis; \155\ would dampen market-making and 
underwriting activity; \156\ or did not take into account the nature of 
trading in different types of securities.\157\ Some commenters also 
questioned whether the Agencies would interpret rebuttals of the 
presumption consistently,\158\ and stressed the difficulty and 
costliness of rebutting the presumption,\159\ such as enhanced 
documentation or other administrative burdens.\160\ One foreign banking 
association also argued that requiring foreign banking entities to 
rebut a U.S. regulatory requirement would be costly and inappropriate 
given that the trading activities of the banking entity are already 
reviewed by home country supervisors.\161\ This commenter also 
contended that the presumption could be problematic for financial 
instruments purchased for long-term investment purposes that are closed 
within 60 days due to market fluctuations or other changed 
circumstances.\162\
---------------------------------------------------------------------------

    \152\ See ABA (Keating); Am. Express; Business Roundtable; 
Capital Group; ICI (Feb. 2012); Investure; JPMC; Liberty Global; 
STANY; Chamber (Feb. 2012).
    \153\ See ABA (Keating); JPMC; Chamber (Feb. 2012).
    \154\ See Am. Express; ICI (Feb. 2012).
    \155\ See ABA (Keating); Chamber (Feb. 2012).
    \156\ See AllianceBernstein; Business Roundtable; ICI (Feb. 
2012); Investure; Liberty Global; STANY. Because the rebuttable 
presumption does not impact the availability of the exemptions for 
underwriting, market making, and other permitted activities, the 
Agencies do not believe this provision creates any additional 
burdens on permissible activities.
    \157\ See Am. Express (noting that most foreign exchange forward 
transactions settle in less than one week and are used as commercial 
payment instruments, and not speculative trades); Capital Group.
    \158\ See ABA (Keating). As discussed below in Part IV.C., the 
Agencies expect to continue to coordinate their supervisory efforts 
related to section 13 of the BHC Act and to share information as 
appropriate in order to effectively implement the requirements of 
that section and the final rule.
    \159\ See ABA (Keating); AllianceBernstein; Capital Group; 
Japanese Bankers Ass'n.; Liberty Global; JPMC.
    \160\ See NAIB et al.; Capital Group.
    \161\ See Japanese Bankers Ass'n. As noted above, the Agencies 
believe concerns about the impacts of the definition of trading 
account on foreign banking entity trading activity outside of the 
United States are substantially addressed by the final rule's 
exemption for proprietary trading conducted by foreign banking 
entities in final rule Sec.  .6(e).
    \162\ Id.
---------------------------------------------------------------------------

    After carefully considering the comments received, the Agencies 
continue to believe the rebuttable presumption is appropriate to 
generally define the meaning of ``short-term'' for purposes of the 
short-term trading account, especially for small and regional banking 
entities that are not subject to the market risk capital rules and are 
not registered dealers or swap entities. The range of comments the 
Agencies received on what ``short-term'' should mean--from 30 days to 
one year--suggests that a clear presumption would ensure consistency in 
interpretation and create a level playing field for all banking 
entities with covered trading activities subject to the short-term 
trading account. Based on their supervisory experience, the Agencies 
find that 60 days is an appropriate cut off for a regulatory 
presumption.\163\ Further, because the purpose of the rebuttable 
presumption is to simplify the process of evaluating whether individual 
positions are included in the trading account, the Agencies believe 
that implementing different holding periods based on the type of 
financial instrument would insert unnecessary complexity into the 
presumption.\164\ The Agencies are not providing a safe harbor or a 
reverse presumption (i.e., a presumption for positions that are outside 
of the trading account), as suggested by some commenters, in 
recognition that some proprietary trading could occur outside of the 60 
day period.\165\
---------------------------------------------------------------------------

    \163\ See final rule Sec.  .3(b)(2). Commenters did not provide 
persuasive evidence of the benefits associated with a rebuttable 
presumption for positions held for greater or fewer than 60 days.
    \164\ See, e.g., Am. Express; Capital Group; Sens. Merkley & 
Levin (Feb. 2012).
    \165\ See Capital Group; AFR et al. (Feb. 2012); Sens. Merkley & 
Levin (Feb. 2012); Public Citizen; Occupy.
---------------------------------------------------------------------------

    Adopting a presumption allows the Agencies and affected banking 
entities to evaluate all the facts and circumstances surrounding 
trading activity in determining whether the activity implicates the 
purpose of the statute. For example, trading in a financial instrument 
for long-term investment that is disposed of within 60 days because of 
unexpected developments (e.g., an unexpected increase in the financial 
instrument's volatility or a need to liquidate the instrument to meet 
unexpected liquidity demands) may not be trading activity covered by 
the statute. To reduce the costs and burdens of rebutting the 
presumption, the Agencies will allow a banking entity to rebut the 
presumption for a group of related positions.\166\
---------------------------------------------------------------------------

    \166\ The Agencies believe this should help address commenters' 
concerns about the burdens associated with rebutting the 
presumption. See ABA (Keating); AllianceBernstein; Capital Group; 
Japanese Bankers Ass'n.; Liberty Global; JPMC; NAIB et al.; Capital 
Group.
---------------------------------------------------------------------------

    The final rule provides three clarifying changes to the proposed 
rebuttable presumption. First, in response to comments, the final rule 
replaces the reference to an ``account'' that is presumed to be a 
trading account with the purchase or sale of a ``financial 
instrument.'' \167\ This change clarifies that the presumption only 
applies to the purchase or sale of a financial instrument that is held 
for fewer than 60 days, and not the entire account that is used to make 
the purchase or sale. Second, the final rule clarifies that basis 
trades, in which a banking entity buys one instrument and sells a 
substantially similar instrument (or otherwise transfers the first 
instrument's risk), are subject to the rebuttable presumption.\168\ 
Third, in order to maintain consistency with definitions used 
throughout the final rule, the references to ``acquire'' or ``take'' a 
financial position have been replaced with references to ``purchase'' 
or ``sell'' a financial instrument.\169\
---------------------------------------------------------------------------

    \167\ See, e.g., ABA (Keating); Clearing House Ass'n.; JPMC.
    \168\ The rebuttable presumption covered these trades in the 
proposal, but the final rule's use of ``financial instrument'' 
rather than ``covered financial position'' necessitated clarifying 
this point in the rule text. See final rule Sec.  .3(b)(2). See also 
Public Citizen.
    \169\ The Agencies do not believe these revisions have a 
substantive effect on the operation or scope of the final rule in 
comparison to the statute or proposed rule.

---------------------------------------------------------------------------

[[Page 5551]]

c. Definition of ``Financial Instrument''
    Section 13 of the BHC Act generally prohibits proprietary trading, 
which is defined in section 13(h)(4) to mean engaging as principal for 
the trading account in any purchase or sale of any security, any 
derivative, any contract of sale of a commodity for future delivery, 
any option on any such security, derivative, or contract, or any other 
security or financial instruments that the Agencies may, by rule, 
determine.\170\ The proposed rule defined the term ``covered financial 
position'' to reference the instruments listed in section 13(h)(4), 
including: (i) A security, including an option on a security; (ii) a 
derivative, including an option on a derivative; or (iii) a contract of 
sale of a commodity for future delivery, or an option on such a 
contract.\171\ To provide additional clarity, the proposed rule also 
provided that, consistent with the statute, any position that is itself 
a loan, a commodity, or foreign exchange or currency was not a covered 
financial position.\172\
---------------------------------------------------------------------------

    \170\ See 12 U.S.C. 1851(h)(4).
    \171\ See proposed rule Sec.  .3(c)(3)(i).
    \172\ See proposed rule Sec.  .3(c)(3)(ii).
---------------------------------------------------------------------------

    The proposal also defined a number of other terms used in the 
definition of covered financial position, including commodity, 
derivative, loan, and security.\173\ These terms were generally defined 
by reference to the federal securities laws or the Commodity Exchange 
Act because these existing definitions are generally well-understood by 
market participants and have been subject to extensive interpretation 
in the context of securities, commodities, and derivatives trading.
---------------------------------------------------------------------------

    \173\ See proposed rule Sec.  .2(l), (q), (w); Sec.  .3(c)(1) 
and (2).
---------------------------------------------------------------------------

    As noted above, the proposed rule included derivatives within the 
definition of covered financial position. Derivative was defined to 
include any swap (as that term is defined in the Commodity Exchange 
Act) and security-based swap (as that term is defined in the Exchange 
Act), in each case as further defined by the CFTC and SEC by joint 
regulation, interpretation, guidance, or other action, in consultation 
with the Board pursuant to section 712(d) of the Dodd-Frank Act.\174\ 
The proposed rule also included within the definition of derivative 
certain other transactions that, although not included within the 
definition of swap or security-based swap, also appear to be, or 
operate in economic substance as, derivatives, and which if not 
included could permit banking entities to engage in proprietary trading 
that is inconsistent with the purpose of section 13 of the BHC Act. 
Specifically, the proposed definition also included: (i) Any purchase 
or sale of a nonfinancial commodity for deferred shipment or delivery 
that is intended to be physically settled; (ii) any foreign exchange 
forward or foreign exchange swap (as those terms are defined in the 
Commodity Exchange Act); \175\ (iii) any agreement, contract, or 
transaction in foreign currency described in section 2(c)(2)(C)(i) of 
the Commodity Exchange Act; \176\ (iv) any agreement, contract, or 
transactions in a commodity other than foreign currency described in 
section 2(c)(2)(D)(i) of the Commodity Exchange Act; \177\ and (v) any 
transactions authorized under section 19 of the Commodity Exchange 
Act.\178\ In addition, the proposed rule excluded from the definition 
of derivative (i) any consumer, commercial, or other agreement, 
contract, or transaction that the CFTC and SEC have further defined by 
joint regulation, interpretation, guidance, or other action as not 
within the definition of swap or security-based swap, and (ii) any 
identified banking product, as defined in section 402(b) of the Legal 
Certainty for Bank Products Act of 2000 (7 U.S.C. 27(b)), that is 
subject to section 403(a) of that Act (7 U.S.C. 27a(a)).
---------------------------------------------------------------------------

    \174\ See 7 U.S.C. 1a(47) (defining ``swap''); 15 U.S.C. 
78c(a)(68) (defining ``security-based swap'').
    \175\ 7 U.S.C. 1a(24), (25).
    \176\ 7 U.S.C. 2(c)(2)(C)(i).
    \177\ 7 U.S.C. 2(c)(2)(D)(i).
    \178\ 7 U.S.C. 23.
---------------------------------------------------------------------------

    Commenters expressed a variety of views regarding the definition of 
covered financial position, as well as other defined terms used in that 
definition. For instance, some commenters argued that the definition 
should be expanded to include transactions in spot commodities or 
foreign currency, even though those instruments are not included by the 
statute.\179\ Other commenters strongly supported the exclusion of spot 
commodity and foreign currency transactions as consistent with the 
statute, arguing that these instruments are part of the traditional 
business of banking and do not represent the types of instruments that 
Congress designed section 13 to address. These commenters argued that 
including spot commodities and foreign exchange within the definition 
of covered financial position in the final rule would put U.S. banking 
entities at a competitive disadvantage and prevent them from conducting 
routine banking operations.\180\ One commenter argued that the proposed 
definition of covered financial position was effective and recommended 
that the definition should not be expanded.\181\ Another commenter 
argued that an instrument be considered to be a spot foreign exchange 
transaction, and thus not a covered financial position, if it settles 
within 5 days of purchase.\182\ Another commenter argued that covered 
financial positions used in interaffiliate transactions should 
expressly be excluded because they are used for internal risk 
management purposes and not for proprietary trading.\183\
---------------------------------------------------------------------------

    \179\ See Sens. Merkley & Levin (Feb. 2012); Public Citizen; 
Occupy.
    \180\ See Northern Trust; Morgan Stanley; JPMC; Credit Suisse 
(Seidel); Am. Express; See also AFR et al. (Feb. 2012) (arguing that 
the final rule should explicitly exclude ``spot'' commodities and 
foreign exchange).
    \181\ See Alfred Brock.
    \182\ See Credit Suisse (Seidel).
    \183\ See GE (Feb. 2012).
---------------------------------------------------------------------------

    Some commenters requested that the final rule exclude additional 
instruments from the definition of covered financial position. For 
instance, some commenters requested that the Agencies exclude commodity 
and foreign exchange futures, forwards, and swaps, arguing that these 
instruments typically have a commercial and not financial purpose and 
that making them subject to the prohibitions of section 13 would 
negatively affect the spot market for these instruments.\184\ A few 
commenters also argued that foreign exchange swaps and forwards are 
used in many jurisdictions to provide U.S. dollar-funding for foreign 
banking entities and that these instruments should be excluded since 
they contribute to the stability and liquidity of the market for spot 
foreign exchange.\185\ Other commenters contended that foreign exchange 
swaps and forwards should be excluded because they are an integral part 
of banking entities' ability to provide trust and custody services to 
customers and are necessary to enable banking entities to deal in the 
exchange of currencies for customers.\186\
---------------------------------------------------------------------------

    \184\ See JPMC; BoA; Citigroup (Feb. 2012).
    \185\ See Govt. of Japan/Bank of Japan; Japanese Bankers Ass'n.; 
See also Norinchukin.
    \186\ See Northern Trust; Citigroup (Feb. 2012).
---------------------------------------------------------------------------

    One commenter argued that the inclusion of certain instruments 
within the definition of derivative, such as purchases or sales of 
nonfinancial commodities for deferred shipment or delivery that are 
intended to be physically settled, was inappropriate.\187\ This 
commenter alleged that these instruments are not derivatives but

[[Page 5552]]

should instead be viewed as contracts for purchase of specific 
commodities to be delivered at a future date. This commenter also 
argued that the Agencies do not have authority under section 13 to 
include these instruments as ``other securities or financial 
instruments'' subject to the prohibition on proprietary trading.\188\
---------------------------------------------------------------------------

    \187\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \188\ See id.
---------------------------------------------------------------------------

    Some commenters also argued that, because the CFTC and SEC had not 
yet finalized their definitions of swap and security-based swap, it was 
inappropriate to use those definitions as part of the proposed 
definition of derivative.\189\ One commenter argued that the definition 
of derivative was effective, although this commenter argued that the 
final rule should not cross-reference the definition of swap and 
security-based swap under the federal commodities and securities 
laws.\190\
---------------------------------------------------------------------------

    \189\ See SIFMA et al. (Prop.Trading) (Feb. 2012); ISDA (Feb. 
2012).
    \190\ See Alfred Brock.
---------------------------------------------------------------------------

    After carefully considering the comments received on the proposal, 
the final rule continues to apply the prohibition on proprietary 
trading to the same types of instruments as listed in the statute and 
the proposal, which the final rule defines as ``financial instrument.'' 
Under the final rule, a financial instrument is defined as: (i) A 
security, including an option on a security; \191\ (ii) a derivative, 
including an option on a derivative; or (iii) a contract of sale of a 
commodity for future delivery, or option on a contract of sale of a 
commodity for future delivery.\192\ The final rule excludes from the 
definition of financial instrument: (i) A loan; \193\ (ii) a commodity 
that is not an excluded commodity (other than foreign exchange or 
currency), a derivative, a contract of sale of a commodity for future 
delivery, or an option on a contract of sale of a commodity for future 
delivery; or (iii) foreign exchange or currency.\194\ An excluded 
commodity is defined to have the same meaning as in section 1a(19) of 
the Commodity Exchange Act.
---------------------------------------------------------------------------

    \191\ The definition of security under the final rule is the 
same as under the proposal. See final rule Sec.  ----.2(y).
    \192\ See final rule Sec.  .3(c)(1).
    \193\ The definition of loan, as well as comments received 
regarding that definition, is discussed in detail below in Part 
IV.B.1.c.8.a.
    \194\ See final rule Sec.  .3(c)(2).
---------------------------------------------------------------------------

    The Agencies continue to believe that these instruments and 
transactions, which are consistent with those referenced in section 
13(h)(4) of the BHC Act as part of the statutory definition of 
proprietary trading, represent the type of financial instruments which 
the proprietary trading prohibition of section 13 was designed to 
cover. While some commenters requested that this definition be expanded 
to include spot transactions \195\ or loans,\196\ the Agencies do not 
believe that it is appropriate at this time to expand the scope of 
instruments subject to the ban on proprietary trading.\197\ Similarly, 
while some commenters requested that certain other instruments, such as 
foreign exchange swaps and forwards, be excluded from the definition of 
financial instrument,\198\ the Agencies believe that these instruments 
appear to be, or operate in economic substance as, derivatives (which 
are by statute included within the scope of instruments subject to the 
prohibitions of section 13). If these instruments were not included 
within the definition of financial instrument, banking entities could 
use them to engage in proprietary trading that is inconsistent with the 
purpose and design of section 13 of the BHC Act.
---------------------------------------------------------------------------

    \195\ See Sens. Merkley & Levin (Feb. 2012); Public Citizen; 
Occupy.
    \196\ See Occupy.
    \197\ Several commenters supported the exclusion of spot 
commodity and foreign currency transactions as consistent with the 
statute. See Northern Trust; Morgan Stanley; State Street (Feb. 
2012); JPMC; Credit Suisse (Seidel); Am. Express; See also AFR et 
al. (Feb. 2012) (arguing that the final rule should explicitly 
exclude ``spot'' commodities and foreign exchange). One commenter 
stated that the proposed definition should not be expanded. See 
Alfred Brock. With respect to the exclusion for loans, the Agencies 
note this is generally consistent with the rule of statutory 
construction regarding the sale and securitization of loans. See 12 
U.S.C. 1851(g)(2).
    \198\ See JPMC; BAC; Citigroup (Feb. 2012); Govt. of Japan/Bank 
of Japan; Japanese Bankers Ass'n.; Northern Trust; See also 
Norinchukin.
---------------------------------------------------------------------------

    As under the proposal, loans, commodities, and foreign exchange or 
currency are not included within the scope of instruments subject to 
section 13. The exclusion of these types of instruments is intended to 
eliminate potential confusion by making clear that the purchase and 
sale of loans, commodities, and foreign exchange or currency--none of 
which are referred to in section 13(h)(4) of the BHC Act--are outside 
the scope of transactions to which the proprietary trading restrictions 
apply. For example, the spot purchase of a commodity would meet the 
terms of the exclusion, but the acquisition of a futures position in 
the same commodity would not qualify for the exclusion.
    The final rule also adopts the definitions of security and 
derivative as proposed.\199\ These definitions, which reference 
existing definitions under the federal securities and commodities laws, 
are generally well-understood by market participants and have been 
subject to extensive interpretation in the context of securities and 
commodities trading activities. While some commenters argued that it 
would be inappropriate to use the definition of swap and security-based 
swap because those terms had not yet been finalized pursuant to public 
notice and comment,\200\ the CFTC and SEC have subsequently finalized 
those definitions after receiving extensive public comment on the 
rulemakings.\201\ The Agencies believe that this notice and comment 
process provided adequate opportunity for market participants to 
comment on and understand those terms, and as such they are 
incorporated in the definition of derivative under this final rule.
---------------------------------------------------------------------------

    \199\ See final rule Sec. Sec.  ----.2(h), (y).
    \200\ See SIFMA et al. (Prop. Trading) (Feb. 2012); ISDA (Feb. 
2012).
    \201\ See CFTC and SEC, Further Definition of ``Swap,'' 
``Security-Based Swap,'' and ``Security-Based Swap Agreement''; 
Mixed swaps; Security Based Swap Agreement Recordkeeping, 78 FR 
48,208 (Aug. 13, 2012).
---------------------------------------------------------------------------

    While some commenters requested that foreign exchange swaps and 
forwards be excluded from the definition of derivative or financial 
instrument, the Agencies have not done so for the reasons discussed 
above. However, as explained below in Part IV.A.1.d., the Agencies note 
that to the extent a banking entity purchases or sells a foreign 
exchange forward or swap, or any other financial instrument, in a 
manner that meets an exclusion from proprietary trading, that 
transaction would not be considered to be proprietary trading and thus 
would not be subject to the requirements of section 13 of the BHC Act 
and the final rule. This includes, for instance, the purchase or sale 
of a financial instrument by a banking entity acting solely as agent, 
broker, or custodian, or the purchase or sale of a security as part of 
a bona fide liquidity management plan.
d. Proprietary Trading Exclusions
    The proposed rule contained four exclusions from the definition of 
trading account for categories of transactions that do not fall within 
the scope of section 13 of the BHC Act because they do not involve 
short-term trading activities subject to the statutory prohibition on 
proprietary trading. These exclusions covered the purchase or sale of a 
financial instrument under certain repurchase and reverse repurchase 
agreements and securities lending arrangements, for bona fide

[[Page 5553]]

liquidity management purposes, and by a clearing agency or derivatives 
clearing organization in connection with clearing activities.
    As discussed below, the final rule provides exclusions for the 
purchase or sale of a financial instrument under certain repurchase and 
reverse repurchase agreements and securities lending agreements; for 
bona fide liquidity management purposes; by certain clearing agencies, 
derivatives clearing organizations in connection with clearing 
activities; by a member of a clearing agency, derivatives clearing 
organization, or designated financial market utility engaged in 
excluded clearing activities; to satisfy existing delivery obligations; 
to satisfy an obligation of the banking entity in connection with a 
judicial, administrative, self-regulatory organization, or arbitration 
proceeding; solely as broker, agent, or custodian; through a deferred 
compensation or similar plan; and to satisfy a debt previously 
contracted. After considering comments on these issues, which are 
discussed in more detail below, the Agencies believe that providing 
clarifying exclusions for these non-proprietary activities will likely 
promote more cost-effective financial intermediation and robust capital 
formation. Overly narrow exclusions for these activities would 
potentially increase the cost of core banking services, while overly 
broad exclusions would increase the risk of allowing the types of 
trades the statute was designed to prohibit. The Agencies considered 
these issues in determining the appropriate scope of these exclusions. 
Because the Agencies do not believe these excluded activities involve 
proprietary trading, as defined by the statute and the final rule, the 
Agencies do not believe it is necessary to use our exemptive authority 
in section 13(d)(1)(J) of the BHC Act to deem these activities a form 
of permitted proprietary trading.
1. Repurchase and Reverse Repurchase Arrangements and Securities 
Lending
    The proposed rule's definition of trading account excluded an 
account used to acquire or take one or more covered financial positions 
that arise under (i) a repurchase or reverse repurchase agreement 
pursuant to which the banking entity had simultaneously agreed, in 
writing at the start of the transaction, to both purchase and sell a 
stated asset, at stated prices, and on stated dates or on demand with 
the same counterparty,\202\ or (ii) a transaction in which 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 interests of an owner of such security and 
has the right to terminate the transaction and to recall the loaned 
security on terms agreed to by the parties.\203\ Positions held under 
these agreements operate in economic substance as a secured loan and 
are not based on expected or anticipated movements in asset prices. 
Accordingly, these types of transactions do not appear to be of the 
type the statutory definition of trading account was designed to 
cover.\204\
---------------------------------------------------------------------------

    \202\ See proposed rule Sec.  ----.3(b)(2)(iii)(A).
    \203\ See proposed rule Sec.  ----.3(b)(2)(iii)(B). The language 
that described securities lending transactions in the proposed rule 
generally mirrored that contained in Rule 3a5-3 under the Exchange 
Act. See 17 CFR 240.3a5-3.
    \204\ See Joint Proposal, 76 FR 68,862.
---------------------------------------------------------------------------

    Several commenters expressed support for these exclusions and 
requested that the Agencies expand them.\205\ For example, one 
commenter requested clarification that all types of repurchase 
transactions qualify for the exclusion.\206\ Some commenters requested 
expanding this exclusion to cover all positions financed by, or 
transactions related to, repurchase and reverse repurchase 
agreements.\207\ Other commenters requested that the exclusion apply to 
all transactions that are analogous to extensions of credit and are not 
based on expected or anticipated movements in asset prices, arguing 
that the exclusion would be too limited in scope to achieve its 
objective if it is based on the legal form of the underlying 
contract.\208\ Additionally, some commenters suggested expanding the 
exclusion to cover transactions that are for funding purposes, 
including prime brokerage transactions, or for the purpose of asset-
liability management.\209\ Commenters also recommended expanding the 
exclusion to include re-hypothecation of customer securities, which can 
produce financing structures that, like a repurchase agreement, are 
functionally loans.\210\
---------------------------------------------------------------------------

    \205\ See generally ABA (Keating); Alfred Brock; Citigroup (Feb. 
2012); GE (Feb. 2012); Goldman (Prop. Trading); ICBA; Japanese 
Bankers Ass'n.; JPMC; Norinchukin; RBC; RMA; SIFMA et al. (Prop. 
Trading) (Feb. 2012); State Street (Feb. 2012); T. Rowe Price; UBS; 
Wells Fargo (Prop. Trading). See infra Part IV.A.d.10. for the 
discussion of commenters' requests for additional exclusions from 
the trading account.
    \206\ See SIFMA et al. (Prop.Trading) (Feb. 2012).
    \207\ See FIA; SIFMA et al. (Prop. Trading) (Feb. 2012).
    \208\ See Goldman (Prop. Trading); JPMC; UBS.
    \209\ See Goldman (Prop. Trading); UBS. For example, one 
commenter suggested that fully collateralized swap transactions 
should be exempted from the definition of trading account because 
they serve as funding transactions and are economically similar to 
repurchase agreements. See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \210\ See Goldman (Prop. Trading).
---------------------------------------------------------------------------

    In contrast, other commenters argued that there was no statutory or 
policy justification for excluding repurchase and reverse repurchase 
agreements from the trading account, and requested that this exclusion 
be removed from the final rule.\211\ Some of these commenters argued 
that repurchase agreements could be used for prohibited proprietary 
trading \212\ and suggested that, if repurchase agreements are excluded 
from the trading account, documentation detailing the use of liquidity 
derived from repurchase agreements should be required.\213\ These 
commenters suggested that unless the liquidity is used to secure a 
position for a willing customer, repurchase agreements should be 
regarded as a strong indicator of proprietary trading.\214\ As an 
alternative, commenters suggested that the Agencies instead use their 
exemptive authority pursuant to section 13(d)(1)(J) of the BHC Act to 
permit repurchase and reverse repurchase transactions so that such 
transactions must comply with the statutory limits on material 
conflicts of interests and high-risks assets and trading strategies, 
and compliance requirements under the final rule.\215\ These commenters 
urged the Agencies to specify permissible collateral types, haircuts, 
and contract terms for securities lending agreements and require that 
the investment of proceeds from securities lending transactions be 
limited to high-quality liquid assets in order to limit potential risks 
of these activities.\216\
---------------------------------------------------------------------------

    \211\ See AFR et al. (Feb. 2012); Occupy; Public Citizen; Sens. 
Merkley & Levin (Feb. 2012).
    \212\ See AFR et al. (Feb. 2012).
    \213\ See Public Citizen.
    \214\ See Public Citizen.
    \215\ See AFR et al. (Feb. 2012); Occupy.
    \216\ See AFR et al. (Feb. 2012); Occupy.
---------------------------------------------------------------------------

    After considering the comments received, the Agencies have 
determined to exclude repurchase and reverse repurchase agreements and 
securities lending agreements from the definition of proprietary 
trading under the final rule. The final rule defines these terms 
subject to the same conditions as were in the proposal. This 
determination recognizes that repurchase and reverse repurchase 
agreements and securities lending agreements excluded from the 
definition operate in economic substance as secured loans and do not in 
normal practice represent proprietary

[[Page 5554]]

trading.\217\ The Agencies will, however, monitor these transactions to 
ensure this exclusion is not used to engage in prohibited proprietary 
trading activities.
---------------------------------------------------------------------------

    \217\ Congress recognized that repurchase agreements and 
securities lending agreements are loans or extensions of credit by 
including them in the legal lending limit. See Dodd-Frank Act 
section 610 (amending 12 U.S.C. 84b). The Agencies believe the 
conditions of the final rule's exclusions for repurchase agreements 
and securities lending agreements identify those activities that do 
not in normal practice represent proprietary trading and, thus, the 
Agencies decline to provide additional requirements for these 
activities, as suggested by some commenters. See Public Citizen; AFR 
et al. (Feb. 2012); Occupy.
---------------------------------------------------------------------------

    To avoid evasion of the rule, the Agencies note that, in contrast 
to certain commenters' requests,\218\ only the transactions pursuant to 
the repurchase agreement, reverse repurchase agreement, or securities 
lending agreement are excluded. For example, the collateral or position 
that is being financed by the repurchase or reverse repurchase 
agreement is not excluded and may involve proprietary trading. The 
Agencies further note that if a banking entity uses a repurchase or 
reverse repurchase agreement to finance a purchase of a financial 
instrument, other transactions involving that financial instrument may 
not qualify for this exclusion.\219\ Similarly, short positions 
resulting from securities lending agreements cannot rely upon this 
exclusion and may involve proprietary trading.
---------------------------------------------------------------------------

    \218\ See Goldman (Prop. Trading); JPMC; UBS.
    \219\ See CFTC Proposal, 77 FR 8348.
---------------------------------------------------------------------------

    Additionally, the Agencies have determined not to exclude all 
transactions, in whatever legal form that may be construed to be an 
extension of credit, as suggested by commenters, because such a broad 
exclusion would be too difficult to assess for compliance and would 
provide significant opportunity for evasion of the prohibitions in 
section 13 of the BHC Act.
2. Liquidity Management Activities
    The proposed definition of trading account excluded an account used 
to acquire or take a position for the purpose of bona fide liquidity 
management, subject to certain requirements.\220\ The preamble to the 
proposed rule explained that bona fide liquidity management seeks to 
ensure that the banking entity has sufficient, readily-marketable 
assets available to meet its expected near-term liquidity needs, not to 
realize short-term profit or benefit from short-term price 
movements.\221\
---------------------------------------------------------------------------

    \220\ See proposed rule Sec.  ----.3(b)(2)(iii)(C).
    \221\ Id.
---------------------------------------------------------------------------

    To curb abuse, the proposed rule required that a banking entity 
acquire or take a position for liquidity management in accordance with 
a documented liquidity management plan that meets five criteria.\222\ 
Moreover, the Agencies stated in the preamble that liquidity management 
positions that give rise to appreciable profits or losses as a result 
of short-term price movements would be subject to significant Agency 
scrutiny and, absent compelling explanatory facts and circumstances, 
would be considered proprietary trading.\223\
---------------------------------------------------------------------------

    \222\ See proposed rule Sec.  ----.3(b)(2)(iii)(C)(1)-(5).
    \223\ See Joint Proposal, 76 FR 68,862.
---------------------------------------------------------------------------

    The Agencies received a number of comments regarding the exclusion. 
Many commenters supported the exclusion of liquidity management 
activities from the definition of trading account as appropriate and 
necessary. At the same time, some commenters expressed the view that 
the exclusion was too narrow and should be replaced with a broader 
exclusion permitting trading activity for asset-liability management 
(``ALM''). Commenters argued that two aspects of the proposed rule's 
definition of ``trading account'' would cause ALM transactions to fall 
within the prohibition on proprietary trading--the 60-day rebuttable 
presumption and the reference to the market risk rule trading 
account.\224\ For example, commenters expressed concern that hedging 
transactions associated with a banking entity's residential mortgage 
pipeline and mortgage servicing rights, and managing credit risk, 
earnings at risk, capital, asset-liability mismatches, and foreign 
exchange risks would be among positions that may be held for 60 days or 
less.\225\ These commenters contended that the exclusion for liquidity 
management and the activity exemptions for risk-mitigating hedging and 
trading in U.S. government obligations would not be sufficient to 
permit a wide variety of ALM activities.\226\ These commenters 
contended that prohibiting trading for ALM purposes would be contrary 
to the goals of enhancing sound risk management, the safety and 
soundness of banking entities, and U.S. financial stability,\227\ and 
would limit banking entities' ability to manage liquidity.\228\
---------------------------------------------------------------------------

    \224\ See ABA (Keating); BoA; CH/ABASA; JPMC. See supra Part 
IV.A.1.b. (discussing the rebuttable presumption under Sec.  ----
3.(b)(2) of the final rule); See also supra Part IV.A.1.a. 
(discussing the market risk rule trading account under Sec.  ----
3.(b)(1)(ii) of the final rule).
    \225\ See CH/ABASA; Wells Fargo (Prop. Trading).
    \226\ See CH/ABASA; JPMC; State Street (Feb. 2012); Wells Fargo 
(Prop. Trading). See also BaFin/Deutsche Bundesbank.
    \227\ See BoA; JPMC; RBC.
    \228\ See ABA (Keating); Allen & Overy (on behalf of Canadian 
Banks); JPMC; NAIB et al.; State Street (Feb. 2012); T. Rowe Price.
---------------------------------------------------------------------------

    Some commenters argued that the requirements of the exclusion would 
not provide a banking entity with sufficient flexibility to respond to 
liquidity needs arising from changing economic conditions.\229\ Some 
commenters argued the requirement that any position taken for liquidity 
management purposes be limited to the banking entity's near-term 
funding needs failed to account for longer-term liquidity management 
requirements.\230\ These commenters further argued that the 
requirements of the liquidity management exclusion might not be 
synchronized with the Basel III framework, particularly with respect to 
the liquidity coverage ratio if ``near-term'' is considered less than 
30 days.\231\
---------------------------------------------------------------------------

    \229\ See ABA (Keating); CH/ABASA; JPMC.
    \230\ See ABA (Keating); BoA; CH/ABASA; JPMC.
    \231\ See ABA (Keating); Allen & Overy (on behalf of Canadian 
Banks); BoA; CH/ABASA
---------------------------------------------------------------------------

    Commenters also requested clarification on a number of other issues 
regarding the exclusion. For example, one commenter requested 
clarification that purchases and sales of U.S. registered mutual funds 
sponsored by a banking entity would be permissible.\232\ Another 
commenter requested clarification that the deposits resulting from 
providing custodial services that are invested largely in high-quality 
securities in conformance with the banking entity's ALM policy would 
not be presumed to be ``short-term trading'' under the final rule.\233\ 
Commenters also urged that the final rule not prohibit interaffiliate 
transactions essential to the ALM function.\234\
---------------------------------------------------------------------------

    \232\ See T. Rowe Price.
    \233\ See State Street (Feb. 2012).
    \234\ See State Street (Feb. 2012); JPMC. See also Part 
IV.A.1.d.10. (discussing commenter requests to exclude inter-
affiliate transactions).
---------------------------------------------------------------------------

    In contrast, other commenters supported the liquidity management 
exclusion criteria \235\ and suggested tightening these requirements. 
For example, one commenter recommended that the rule require that 
investments made under the liquidity management exclusion consist only 
of high-quality liquid assets.\236\ Other commenters argued that the 
exclusion for liquidity management should be eliminated.\237\ One 
commenter argued that there was no need to provide a special exemption 
for liquidity management or ALM activities given the exemptions for

[[Page 5555]]

trading in government obligations and risk-mitigating hedging 
activities.\238\
---------------------------------------------------------------------------

    \235\ See AFR et al. (Feb. 2012); Occupy.
    \236\ See Occupy.
    \237\ See Sens. Merkley & Levin (Feb. 2012).
    \238\ See Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------

    After carefully reviewing the comments received, the Agencies have 
adopted the proposed exclusion for liquidity management with several 
important modifications. As limited below, liquidity management 
activity serves the important prudential purpose, recognized in other 
provisions of the Dodd-Frank Act and in rules and guidance of the 
Agencies, of ensuring banking entities have sufficient liquidity to 
manage their short-term liquidity needs.\239\
---------------------------------------------------------------------------

    \239\ See section 165(b)(1)(A)(ii) of the Dodd-Frank Act; 
Enhanced Prudential Standards, 77 FR 644 at 645 (Jan. 5, 2012), 
available at http://www.gpo.gov/fdsys/pkg/FR-2012-01-05/pdf/2011-33364.pdf; See also Enhanced Prudential Standards, 77 FR 76,678 at 
76,682 (Dec. 28, 2012), available at http://www.gpo.gov/fdsys/pkg/FR-2012-12-28/pdf/2012-30734.pdf.
---------------------------------------------------------------------------

    To ensure that this exclusion is not misused for the purpose of 
proprietary trading, the final rule imposes a number of requirements. 
First, the liquidity management plan of the banking entity must be 
limited to securities (in keeping with the liquidity management 
requirements proposed by the Federal banking agencies) and specifically 
contemplate and authorize the particular securities to be used for 
liquidity management purposes; describe the amount, types, and risks of 
securities that are consistent with the entity's liquidity management; 
and the liquidity circumstances in which the particular securities may 
or must be used.\240\ Second, any purchase or sale of securities 
contemplated and authorized by the plan must be principally for the 
purpose of managing the liquidity of the banking entity, and not for 
the purpose of short-term resale, benefitting from actual or expected 
short-term price movements, realizing short-term arbitrage profits, or 
hedging a position taken for such short-term purposes. Third, the plan 
must require that any securities purchased or sold for liquidity 
management purposes be highly liquid and limited to instruments the 
market, credit and other risks of which the banking entity does not 
reasonably expect to give rise to appreciable profits or losses as a 
result of short-term price movements.\241\ Fourth, the plan must limit 
any securities purchased or sold for liquidity management purposes to 
an amount that is consistent with the banking entity's near-term 
funding needs, including deviations from normal operations of the 
banking entity or any affiliate thereof, as estimated and documented 
pursuant to methods specified in the plan.\242\ Fifth, the banking 
entity must incorporate into its compliance program internal controls, 
analysis and independent testing designed to ensure that activities 
undertaken for liquidity management purposes are conducted in 
accordance with the requirements of the final rule and the entity's 
liquidity management plan. Finally, the plan must be consistent with 
the supervisory requirements, guidance and expectations regarding 
liquidity management of the Agency responsible for regulating the 
banking entity.
---------------------------------------------------------------------------

    \240\ To ensure sufficient flexibility to respond to liquidity 
needs arising from changing economic times, a banking entity should 
envision and address a range of liquidity circumstances in its 
liquidity management plan, and provide a mechanism for periodically 
reviewing and revising the liquidity management plan.
    \241\ The requirement to use highly liquid instruments is 
consistent with the focus of the clarifying exclusion on a banking 
entity's near-term liquidity needs. Thus, the final rules do not 
include commenters' suggested revisions to this requirement. See 
Clearing House Ass'n.; See also Occupy; Sens. Merkley & Levin (Feb. 
2012). The Agencies decline to identify particular types of 
securities that will be considered highly liquid for purposes of the 
exclusion, as requested by some commenters, in recognition that such 
a determination will depend on the facts and circumstances. See T. 
Rowe Price; State Street (Feb. 2012).
    \242\ The Agencies plan to construe ``near-term funding needs'' 
in a manner that is consistent with the laws, regulations, and 
issuances related to liquidity risk management. See, e.g., Liquidity 
Coverage Ratio: Liquidity Risk Measurement, Standards, and 
Monitoring, 78 FR 71,818 (Nov. 29, 2013); Basel Committee on Bank 
Supervision, Basel III: The Liquidity Coverage Ratio and Liquidity 
Risk Management Tools (January 2013) available at http://www.bis.org/publ/bcbs238.htm. The Agencies believe this should help 
address commenters' concerns about the proposed requirement. See, 
e.g., ABA (Keating); Allen & Overy (on behalf of Canadian Banks); 
CH/ABASA; BoA; JPMC.
---------------------------------------------------------------------------

    The final rule retains the provision that the financial instruments 
purchased and sold as part of a liquidity management plan be highly 
liquid and not reasonably expected to give rise to appreciable profits 
or losses as a result of short-term price movements. This requirement 
is consistent with the Agencies' expectation for liquidity management 
plans in the supervisory context. It is not intended to prevent firms 
from recognizing profits (or losses) on instruments purchased and sold 
for liquidity management purposes. Instead, this requirement is 
intended to underscore that the purpose of these transactions must be 
liquidity management. Thus, the timing of purchases and sales, the 
types and duration of positions taken and the incentives provided to 
managers of these purchases and sales must all indicate that managing 
liquidity, and not taking short-term profits (or limiting short-term 
losses), is the purpose of these activities.
    The exclusion as adopted does not apply to activities undertaken 
with the stated purpose or effect of hedging aggregate risks incurred 
by the banking entity or its affiliates related to asset-liability 
mismatches or other general market risks to which the entity or 
affiliates may be exposed. Further, the exclusion does not apply to any 
trading activities that expose banking entities to substantial risk 
from fluctuations in market values, unrelated to the management of 
near-term funding needs, regardless of the stated purpose of the 
activities.\243\
---------------------------------------------------------------------------

    \243\ See, e.g., Staff of S. Comm. on Homeland Sec. & 
Governmental Affairs Permanent Subcomm. on Investigations, 113th 
Cong., Report: JPMorgan Chase Whale Trades: A Case History of 
Derivatives Risks and Abuses (Apr. 11, 2013), available at http://www.hsgac.senate.gov/download/report-jpmorgan-chase-whale-trades-a-case-history-of-derivatives-risks-and-abuses-march-15-2013.
---------------------------------------------------------------------------

    Overall, the Agencies do not believe that the final rule will stand 
as an obstacle to or otherwise impair the ability of banking entities 
to manage the risks of their businesses and operate in a safe and sound 
manner. Banking entities engaging in bona fide liquidity management 
activities generally do not purchase or sell financial instruments for 
the purpose of short-term resale or to benefit from actual or expected 
short-term price movements. The Agencies have determined, in contrast 
to certain commenters' requests, not to expand this liquidity 
management provision to broadly allow asset-liability management, 
earnings management, or scenario hedging.\244\ To the extent these 
activities are for the purpose of profiting from short-term price 
movements or to hedge risks not related to short-term funding needs, 
they represent proprietary trading subject to section 13 of the BHC Act 
and the final rule; the activity would then be permissible only if it 
meets all of the requirements for an exemption, such as the risk-
mitigating hedging exemption, the exemption for trading in U.S. 
government securities, or another exemption.
---------------------------------------------------------------------------

    \244\ See, e.g., ABA (Keating); BoA; CH/ABASA; JPMC.
---------------------------------------------------------------------------

3. Transactions of Derivatives Clearing Organizations and Clearing 
Agencies
    A banking entity that is a central counterparty for clearing and 
settlement activities engages in the purchase and sale of financial 
instruments as an integral part of clearing and settling those 
instruments. The proposed definition of trading account excluded an 
account used to acquire or take one or more covered financial positions 
by

[[Page 5556]]

a derivatives clearing organization registered under the Commodity 
Exchange Act or a clearing agency registered under the Securities 
Exchange Act of 1934 in connection with clearing derivatives or 
securities transactions.\245\ The preamble to the proposed rule noted 
that the purpose of these transactions is to provide a clearing service 
to third parties, not to profit from short-term resale or short-term 
price movements.\246\
---------------------------------------------------------------------------

    \245\ See proposed rule Sec.  ----.3(b)(2)(iii)(D).
    \246\ See Joint Proposal, 76 FR 68,863.
---------------------------------------------------------------------------

    Several commenters supported the proposed exclusion for derivatives 
clearing organizations and urged the Agencies to expand the exclusion 
to cover a banking entity's clearing-related activities, such as 
clearing a trade for a customer, trading with a clearinghouse, or 
accepting positions of a defaulting member, on grounds that these 
activities are not proprietary trades and reduce systemic risk.\247\ 
One commenter recommended expanding the exclusion to non-U.S. central 
counterparties \248\ In contrast, one commenter argued that the 
exclusion for derivatives clearing organizations and clearing agencies 
had no statutory basis and should instead be a permitted activity under 
section 13(d)(1)(J).\249\
---------------------------------------------------------------------------

    \247\ See Allen & Overy (Clearing); Goldman (Prop. Trading); 
SIFMA et al. (Prop. Trading) (Feb. 2012); State Street (Feb. 2012).
    \248\ See IIB/EBF.
    \249\ See Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------

    After considering the comments received, the final rule retains the 
exclusion for purchases and sales of financial instruments by a banking 
entity that is a clearing agency or derivatives clearing organization 
in connection with its clearing activities.\250\ In response to 
comments,\251\ the Agencies have also incorporated two changes to the 
rule. First, the final rule applies the exclusion to the purchase and 
sale of financial instruments by a banking entity that is a clearing 
agency or derivatives clearing organization in connection with clearing 
financial instrument transactions. Second, in response to 
comments,\252\ the exclusion in the final rule is not limited to 
clearing agencies or derivatives clearing organizations that are 
subject to SEC or CFTC registration requirements and, instead, certain 
foreign clearing agencies and foreign derivatives clearing 
organizations will be permitted to rely on the exclusion if they are 
banking entities.
---------------------------------------------------------------------------

    \250\ ``Clearing agency'' is defined in the final rule with 
reference to the definition of this term in the Exchange Act. See 
final rule Sec.  ----.3(e)(2). ``Derivatives clearing organization'' 
is defined in the final rule as (i) a derivatives clearing 
organization registered under section 5b of the Commodity Exchange 
Act; (ii) a derivatives clearing organization that, pursuant to CFTC 
regulation, is exempt from the registration requirements under 
section 5b of the Commodity Exchange Act; or (iii) a foreign 
derivatives clearing organization that, pursuant to CFTC regulation, 
is permitted to clear for a foreign board of trade that is 
registered with the CFTC.
    \251\ See IIB/EBF; BNY Mellon et al.; SIFMA et al. 
(Prop.Trading) (Feb. 2012); Allen & Overy (Clearing); Goldman (Prop. 
Trading).
    \252\ See IIB/EBF; Allen & Overy (Clearing).
---------------------------------------------------------------------------

    The Agencies believe that clearing and settlement activity is not 
designed to create short-term trading profits. Moreover, excluding 
clearing and settlement activities prevents the final rule from 
inadvertently hindering the Dodd-Frank Act's goal of promoting central 
clearing of financial transactions. The Agencies have narrowly tailored 
this exclusion by allowing only central counterparties to use it and 
only with respect to their clearing and settlement activity.
4. Excluded Clearing-Related Activities of Clearinghouse Members
    In addition to the exclusion for trading activities of a 
derivatives clearing organization or clearing agency, some commenters 
requested an additional exclusion from the definition of ``trading 
account'' for clearing-related activities of members of these 
entities.\253\ These commenters noted that the proposed definition of 
``trading account'' provides an exclusion for positions taken by 
registered derivatives clearing organizations and registered clearing 
agencies \254\ and requested a corresponding exclusion for certain 
clearing-related activities of banking entities that are members of a 
clearing agency or members of a derivatives clearing organization 
(collectively, ``clearing members'').\255\
---------------------------------------------------------------------------

    \253\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Allen & 
Overy (Clearing); Goldman (Prop. Trading); State Street (Feb. 2012).
    \254\ See proposed rule Sec.  ----.3(b)(2)(iii)(D).
    \255\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Allen & 
Overy (Clearing); Goldman (Prop. Trading); State Street (Feb. 2012).
---------------------------------------------------------------------------

    Several commenters argued that certain aspects of the clearing 
process may require a clearing member to engage in principal 
transactions. For example, some commenters argued that a 
clearinghouse's default management process may require clearing members 
to take positions in financial instruments upon default of another 
clearing member.\256\ According to commenters, default management 
processes can involve: (i) Collection of initial and variation margin 
from customers under an ``agency model'' of clearing; (ii) porting, 
where a defaulting clearing member's customer positions and margin are 
transferred to another non-defaulting clearing member; \257\ (iii) 
hedging, where the clearing house looks to clearing members and third 
parties to enter into risk-reducing transactions and to flatten the 
market risk associated with the defaulting clearing member's house 
positions and non-ported customer positions; (iv) unwinding, where the 
defaulting member's open positions may be allocated to other clearing 
members, affiliates, or third parties pursuant to a mandatory auction 
process or forced allocation; \258\ and (v) imposing certain 
obligations on clearing members upon exhaustion of a guaranty 
fund.\259\
---------------------------------------------------------------------------

    \256\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Allen & 
Overy (Clearing); State Street (Feb. 2012). See also ISDA (Feb. 
2012).
    \257\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Allen & 
Overy (Clearing).
    \258\ See Allen & Overy (Clearing).
    \259\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------

    Commenters argued that, absent an exclusion from the definition of 
``trading account,'' some of these clearing-related activities could be 
considered prohibited proprietary trading under the proposal. Two 
commenters specifically contended that the dealer prong of the 
definition of ``trading account'' may cause certain of these activities 
to be considered proprietary trading.\260\ Some commenters suggested 
alternative avenues for permitting such clearing-related activity under 
the rules.\261\ Commenters argued that such clearing-related activities 
of banking entities should not be subject to the rule because they are 
risk-reducing, beneficial for the financial system, required by law 
under certain circumstances (e.g., central clearing requirements for 
swaps and security-based swaps under Title VII of the Dodd-Frank Act), 
and not used by banking entities to engage in proprietary trading.\262\
---------------------------------------------------------------------------

    \260\ See SIFMA et al. (Prop. Trading) (Feb. 2012) (arguing that 
the SEC has suggested that entities that collect margins from 
customers for cleared swaps may be required to be registered as 
broker-dealers); State Street (Feb. 2012).
    \261\ See Goldman (Prop. Trading); SIFMA et al. (Prop.Trading) 
(Feb. 2012); ISDA (Feb. 2012).
    \262\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman 
(Prop. Trading); State Street (Feb. 2012); Allen & Overy (Clearing).
---------------------------------------------------------------------------

    Commenters further argued that certain activities undertaken as 
part of a clearing house's daily risk management process may be 
impacted by the rule, including unwinding self-referencing transactions 
through a mandatory auction (e.g., where a firm acquired credit default 
swap (``CDS'') protection on itself as a result of a merger with 
another firm) \263\ and trade crossing, a mechanism employed by

[[Page 5557]]

certain clearing houses to ensure the accuracy of the price discovery 
process in the course of, among other things, calculating settlement 
prices and margin requirements.\264\
---------------------------------------------------------------------------

    \263\ See Allen & Overy (Clearing).
    \264\ See Allen & Overy (Clearing); SIFMA et al. (Prop.Trading) 
(Feb. 2012). These commenters stated that, in order to ensure that a 
clearing member is providing accurate end-of-day prices for its open 
positions, a clearing house may require the member to provide firm 
bids for such positions, which may be tested through a ``forced 
trade'' with another member. See id.; See also ISDA (Feb. 2012).
---------------------------------------------------------------------------

    The Agencies do not believe that certain core clearing-related 
activities conducted by a clearing member, often as required by 
regulation or the rules and procedures of a clearing agency, 
derivatives clearing organization, or designated financial market 
utility, represent proprietary trading as contemplated by the statute. 
For example, the clearing and settlement activities discussed above are 
not conducted for the purpose of profiting from short-term price 
movements. The Agencies believe that these clearing-related activities 
provide important benefits to the financial system.\265\ In particular, 
central clearing reduces counterparty credit risk,\266\ which can lead 
to a host of other benefits, including lower hedging costs, increased 
market participation, greater liquidity, more efficient risk sharing 
that promotes capital formation, and reduced operational risk.\267\
---------------------------------------------------------------------------

    \265\ For example, Title VII of the Dodd-Frank Act mandates the 
central clearing of swaps and security-based swaps, and requires 
that banking entities that are swap dealers, security-based swap 
dealers, major swap participants or major security-based swap 
participants collect variation margin from many counterparties on a 
daily basis for their swap or security-based swap activity. See 7 
U.S.C. 2(h); 15 U.S.C. 78c-3; 7 U.S.C. 6s(e); 15 U.S.C. 78o-10(e); 
Margin Requirements for Uncleared Swaps for Swap Dealers and Major 
Swap Participants, 76 FR 23,732 (Apr. 28, 2011). Additionally, the 
SEC's Rule 17Ad-22(d)(11) requires that each registered clearing 
agency establish, implement, maintain and enforce policies and 
procedures that set forth the clearing agency's default management 
procedures. See 17 CFR 240.17Ad-22(d)(11). See also Exchange Act 
Release No. 68,080 (Oct. 12, 2012), 77 FR 66,220, 66,283 (Nov. 2, 
2012).
    \266\ Centralized clearing affects counterparty risk in three 
basic ways. First, it redistributes counterparty risk among members 
through mutualization of losses, reducing the likelihood of 
sequential counterparty failure and contagion. Second, margin 
requirements and monitoring reduce moral hazard, reducing 
counterparty risk. Finally, clearing may reallocate counterparty 
risk outside of the clearing agency because netting may implicitly 
subordinate outside creditors' claims relative to other clearing 
member claims.
    \267\ See Proposed Rule, Cross-Border Security-Based Swap 
Activities, Exchange Act Release No. 69490 (May 1, 2013), 78 FR 
30,968, 31,162-31,163 (May 23, 2013).
---------------------------------------------------------------------------

    Accordingly, in response to comments, the final rule provides that 
proprietary trading does not include specified excluded clearing 
activities by a banking entity that is a member of a clearing agency, a 
member of a derivatives clearing organization, or a member of a 
designated financial market utility.\268\ ``Excluded clearing 
activities'' is defined in the rule to identify particular core 
clearing-related activities, many of which were raised by 
commenters.\269\ Specifically, the final rule will exclude the 
following activities by clearing members: (i) Any purchase or sale 
necessary to correct error trades made by or on behalf of customers 
with respect to customer transactions that are cleared, provided the 
purchase or sale is conducted in accordance with certain regulations, 
rules, or procedures; (ii) any purchase or sale related to the 
management of a default or threatened imminent default of a customer, 
subject to certain conditions, another clearing member, or the clearing 
agency, derivatives clearing organization, or designated financial 
market utility itself; \270\ and (iii) any purchase or sale required by 
the rules or procedures of a clearing agency, derivatives clearing 
organization, or designated financial market utility that mitigates 
risk to such agency, organization, or utility that would result from 
the clearing by a clearing member of security-based swaps that 
references the member or an affiliate of the member.\271\
---------------------------------------------------------------------------

    \268\ See final rule Sec.  ----.3(d)(5).
    \269\ See final rule Sec.  ----.3(e)(7).
    \270\ A number of commenters discussed the default management 
process and requested an exclusion for such activities. See SIFMA et 
al. (Prop. Trading) (Feb. 2012); Allen & Overy (Clearing); State 
Street (Feb. 2012). See also ISDA (Feb. 2012).
    \271\ See Allen & Overy (Clearing) (discussing rules that 
require unwinding self-referencing transactions through a mandatory 
auction (e.g., where a firm acquired CDS protection on itself as a 
result of a merger with another firm)).
---------------------------------------------------------------------------

    The Agencies are identifying specific activities in the rule to 
limit the potential for evasion that may arise from a more generalized 
approach. However, the relevant supervisory Agencies will be prepared 
to provide further guidance or relief, if appropriate, to ensure that 
the terms of the exclusion do not limit the ability of clearing 
agencies, derivatives clearing organizations, or designated financial 
market utilities to effectively manage their risks in accordance with 
their rules and procedures. In response to commenters requesting that 
the exclusion be available when a clearing member is required by rules 
of a clearing agency, derivatives clearing organization, or designated 
financial market utility to purchase or sell a financial instrument as 
part of establishing accurate prices to be used by the clearing agency, 
derivatives clearing organization, or designated financial market 
utility in its end of day settlement process,\272\ the Agencies note 
that whether this is an excluded clearing activity depends on the facts 
and circumstances. Similarly, the availability of other exemptions to 
the rule, such as the market-making exemption, depend on the facts and 
circumstances. This exclusion applies only to excluded clearing 
activities of clearing members. It does not permit a banking entity to 
engage in proprietary trading and claim protection for that activity 
because trades are cleared or settled through a central counterparty.
---------------------------------------------------------------------------

    \272\ See Allen & Overy (Clearing); SIFMA et al. (Prop. Trading) 
(Feb. 2012); See also ISDA (Feb. 2012).
---------------------------------------------------------------------------

5. Satisfying an Existing Delivery Obligation
    A few commenters requested additional or expanded exclusions from 
the definition of ``trading account'' for covering short sales or 
failures to deliver.\273\ These commenters alleged that a banking 
entity engages in this activity for purposes other than to benefit from 
short term price movements and that it is not proprietary trading as 
defined in the statute. In response to these comments, the final rule 
provides that a purchase or sale by a banking entity that satisfies an 
existing delivery obligation of the banking entity or its customers, 
including to prevent or close out a failure to deliver, in connection 
with delivery, clearing, or settlement activity is not proprietary 
trading.
---------------------------------------------------------------------------

    \273\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman 
(Prop. Trading).
---------------------------------------------------------------------------

    Among other things, this exclusion will allow a banking entity that 
is an SEC-registered broker-dealer to take action to address failures 
to deliver arising from its own trading activity or the trading 
activity of its customers.\274\ In certain circumstances, SEC-
registered broker-dealers are required to take such action under SEC 
rules.\275\ In addition, buy-in procedures of a clearing agency, 
securities exchange, or national securities association may require a

[[Page 5558]]

banking entity to deliver securities if a party with a fail to receive 
position takes certain action.\276\ When a banking entity purchases 
securities to meet an existing delivery obligation, it is engaging in 
activity that facilitates timely settlement of securities transactions 
and helps provide a purchaser of the securities with the benefits of 
ownership (e.g., voting and lending rights). In addition, a banking 
entity has limited discretion to determine when and how to take action 
to meet an existing delivery obligation.\277\ Providing a limited 
exclusion for this activity will avoid the potential for SEC-registered 
broker-dealers being subject to conflicting or inconsistent regulatory 
requirements with respect to activity required to meet the broker-
dealer's existing delivery obligations.
---------------------------------------------------------------------------

    \274\ In order to qualify for this exclusion, a banking entity's 
principal trading activity that results in its own failure to 
deliver must have been conducted in compliance with these rules.
    \275\ See, e.g., 17 CFR 242.204 (requiring, among other things, 
that a participant of a registered clearing agency or, upon 
reasonable allocation, a broker-dealer for which the participant 
clears trades or from which the participant receives trades for 
settlement, take action to close out a fail to deliver position in 
any equity security by borrowing or purchasing securities of like 
kind and quantity); 17 CFR 240.15c3-3(m) (providing that, if a 
broker-dealer executes a sell order of a customer and does not 
obtain possession of the securities from the customer within 10 
business days after settlement, the broker-dealer must immediately 
close the transaction with the customer by purchasing securities of 
like kind and quantity).
    \276\ See, e.g., NSCC Rule 11, NASDAQ Rule 11810, FINRA Rule 
11810.
    \277\ See, e.g., 17 CFR 242.204 (requiring action to close out a 
fail to deliver position in an equity security within certain 
specified timeframes); 17 CFR 240.15c3-3(m) (requiring a broker-
dealer to ``immediately'' close a transaction under certain 
circumstances).
---------------------------------------------------------------------------

6. Satisfying an Obligation in Connection With a Judicial, 
Administrative, Self-Regulatory Organization, or Arbitration Proceeding
    The Agencies recognize that, under certain circumstances, a banking 
entity may be required to purchase or sell a financial instrument at 
the direction of a judicial or regulatory body. For example, an 
administrative agency or self-regulatory organization (``SRO'') may 
require a banking entity to purchase or sell a financial instrument in 
the course of disciplinary proceedings against that banking 
entity.\278\ A banking entity may also be obligated to purchase or sell 
a financial instrument in connection with a judicial or arbitration 
proceeding.\279\ Such transactions do not represent trading for short-
term profit or gain and do not constitute proprietary trading under the 
statute.
---------------------------------------------------------------------------

    \278\ For example, an administrative agency or SRO may require a 
broker-dealer to offer to buy securities back from customers where 
the agency or SRO finds the broker-dealer fraudulently sold 
securities to those customers. See, e.g., In re Raymond James & 
Assocs., Exchange Act Release No. 64767, 101 S.E.C. Docket 1749 
(June 29, 2011); FINRA Dep't of Enforcement v. Pinnacle Partners 
Fin. Corp., Disciplinary Proceeding No. 2010021324501 (Apr. 25, 
2012); FINRA Dep't of Enforcement v. Fifth Third Sec., Inc., No. 
2005002244101 (Press Rel. Apr. 14, 2009).
    \279\ For instance, section 29 of the Exchange Act may require a 
broker-dealer to rescind a contract with a customer that was made in 
violation of the Exchange Act. Such rescission relief may involve 
the broker-dealer's repurchase of a financial instrument from a 
customer. See 15 U.S.C. 78cc; Reg'l Props., Inc. v. Fin. & Real 
Estate Consulting Co., 678 F.2d 552 (5th Cir. 1982); Freeman v. 
Marine Midland Bank N.Y., 419 F.Supp. 440 (E.D.N.Y. 1976).
---------------------------------------------------------------------------

    Accordingly, the Agencies have determined to adopt a provision 
clarifying that a purchase or sale of one or more financial instruments 
that satisfies an obligation of the banking entity in connection with a 
judicial, administrative, self-regulatory organization, or arbitration 
proceeding is not proprietary trading for purposes of these rules. This 
clarification will avoid the potential for conflicting or inconsistent 
legal requirements for banking entities.
7. Acting Solely as Agent, Broker, or Custodian
    The proposal clarified that proprietary trading did not include 
acting solely as agent, broker, or custodian for an unaffiliated third 
party.\280\ Commenters generally supported this aspect of the proposal. 
One commenter suggested that acting as agent, broker, or custodian for 
affiliates should be explicitly excluded from the definition of 
proprietary trading in the same manner as acting as agent, broker, or 
custodian for unaffiliated third parties.\281\
---------------------------------------------------------------------------

    \280\ See proposed rule Sec.  ----.3(b)(1).
    \281\ See Japanese Bankers Ass'n.
---------------------------------------------------------------------------

    Like the proposal, the final rule expressly provides that the 
purchase or sale of one or more financial instruments by a banking 
entity acting solely as agent, broker, or custodian is not proprietary 
trading because acting in these types of capacities does not involve 
trading as principal, which is one of the requisite aspects of the 
statutory definition of proprietary trading.\282\ The final rule has 
been modified to include acting solely as agent, broker, or custodian 
on behalf of an affiliate. However, the affiliate must comply with 
section 13 of the BHC Act and the final implementing rule; and may not 
itself engage in prohibited proprietary trading. To the extent a 
banking entity acts in both a principal and agency capacity for a 
purchase or sale, it may only use this exclusion for the portion of the 
purchase or sale for which it is acting as agent. The banking entity 
must use a separate exemption or exclusion, if applicable, to the 
extent it is acting in a principal capacity.
---------------------------------------------------------------------------

    \282\ See 12 U.S.C. 1851(h)(4). A common or collective 
investment fund that is an investment company under section 3(c)(3) 
or 3(c)(11) will not be deemed to be acting as principal within the 
meaning of Sec.  ----.3(a) because the fund is performing a 
traditional trust activity and purchases and sells financial 
instruments solely on behalf of customers as trustee or in a similar 
fiduciary capacity, as evidenced by its regulation under 12 CFR part 
9 (Fiduciary Activities of National Banks) or similar state laws.
---------------------------------------------------------------------------

8. Purchases or Sales Through a Deferred Compensation or Similar Plan
    While the proposed rule provided that the prohibition on covered 
fund activities and investments did not apply to certain instances 
where the banking entity acted through or on behalf of a pension or 
similar deferred compensation plan, no such similar treatment was given 
for proprietary trading. One commenter argued that the proposal 
restricted a banking entity's ability to engage in principal-based 
trading as an asset manager that serves the needs of the institutional 
investors, such as through ERISA pension and 401(k) plans.\283\
---------------------------------------------------------------------------

    \283\ See Ass'n. of Institutional Investors (Nov. 2012).
---------------------------------------------------------------------------

    To address these concerns, the final rule provides that proprietary 
trading does not include the purchase or sale of one or more financial 
instruments through a deferred compensation, stock-bonus, profit-
sharing, or pension plan of the banking entity that is established and 
administered in accordance with the laws of the United States or a 
foreign sovereign, if the purchase or sale is made directly or 
indirectly by the banking entity as trustee for the benefit of the 
employees of the banking entity or members of their immediate family. 
Banking entities often establish and act as trustee to pension or 
similar deferred compensation plans for their employees and, as part of 
managing these plans, may engage in trading activity. The Agencies 
believe that purchases or sales by a banking entity when acting through 
pension and similar deferred compensation plans generally occur on 
behalf of beneficiaries of the plan and consequently do not constitute 
the type of principal trading that is covered by the statute.
    The Agencies note that if a banking entity engages in trading 
activity for an unaffiliated pension or similar deferred compensation 
plan, the trading activity of the banking entity would not be 
proprietary trading under the final rule to the extent the banking 
entity was acting solely as agent, broker, or custodian.
9. Collecting a Debt Previously Contracted
    Several commenters argued that the final rule should exclude 
collecting and disposing of collateral in satisfaction of debts 
previously contracted from the definition of proprietary trading.\284\ 
Commenters argued that acquiring and

[[Page 5559]]

disposing of collateral in satisfaction of debt previously contracted 
does not involve trading with the intent of profiting from short-term 
price movements and, thus, should not be proprietary trading for 
purposes of this rule. Rather, this activity is a prudent and desirable 
part of lending and debt collection activities.
---------------------------------------------------------------------------

    \284\ See LSTA (Feb. 2012); JPMC; Goldman (Prop. Trading); SIFMA 
et al. (Prop.Trading) (Feb. 2012).
---------------------------------------------------------------------------

    The Agencies believe that the purchase and sale of a financial 
instrument in satisfaction of a debt previously contracted does not 
constitute proprietary trading. The Agencies believe an exclusion for 
purchases and sales in satisfaction of debts previously contracted is 
necessary for banking entities to continue to lend to customers, 
because it allows banking entities to continue lending activity with 
the knowledge that they will not be penalized for recouping losses 
should a customer default. Accordingly, the final rule provides that 
proprietary trading does not include the purchase or sale of one or 
more financial instruments in the ordinary course of collecting a debt 
previously contracted in good faith, provided that the banking entity 
divests the financial instrument as soon as practicable within the time 
period permitted or required by the appropriate financial supervisory 
agency.\285\
---------------------------------------------------------------------------

    \285\ See final rule Sec.  ----.3(d)(9).
---------------------------------------------------------------------------

    As a result of this exclusion, banking entities, including SEC-
registered broker-dealers, will be able to continue providing margin 
loans to their customers and may take possession of margined collateral 
following a customer's default or failure to meet a margin call under 
applicable regulatory requirements.\286\ Similarly, a banking entity 
that is a CFTC-registered swap dealer or SEC-registered security-based 
swap dealer may take, hold, and exchange any margin collateral as 
counterparty to a cleared or uncleared swap or security-based swap 
transaction, in accordance with the rules of the Agencies.\287\ This 
exclusion will allow banking entities to comply with existing 
regulatory requirements regarding the divestiture of collateral taken 
in satisfaction of a debt.
---------------------------------------------------------------------------

    \286\ For example, if any margin call is not met in full within 
the time required by Regulation T, then Regulation T requires a 
broker-dealer to liquidate securities sufficient to meet the margin 
call or to eliminate any margin deficiency existing on the day such 
liquidation is required, whichever is less. See 12 CFR 220.4(d).
    \287\ See SEC Proposed Rule, Capital, Margin, Segregation, 
Reporting and Recordkeeping Requirements for Security-Based Swap 
Dealers, Exchange Act Release No. 68071, 77 FR 70,214 (Nov. 23, 
2012); CFTC Proposed Rule, Margin Requirements for Uncleared Swaps 
for Swap Dealers and Major Swap Participants, 76 FR 23,732 (Apr. 28, 
2011); Banking Agencies' Proposed Rule, Margin and Capital 
Requirements for Covered Swap Entities, 76 FR 27,564 (May 11, 2011).
---------------------------------------------------------------------------

10. Other Requested Exclusions
    Commenters requested a number of additional exclusions from the 
trading account and, in turn, the prohibition on proprietary trading. 
In order to avoid potential evasion of the final rule, the Agencies 
decline to adopt any exclusions from the trading account other than the 
exclusions described above.\288\ The Agencies believe that various 
modifications to the final rule, including in particular to the 
exemption for market-making related activities, address many of 
commenters' concerns regarding unintended consequences of the 
prohibition on proprietary trading.
---------------------------------------------------------------------------

    \288\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012) 
(transactions that are not based on expected or anticipated 
movements in asset prices, such as fully collateralized swap 
transactions that serve funding purposes); Norinchukin and Wells 
Fargo (Prop. Trading) (derivatives that qualify for hedge 
accounting); GE (Feb. 2012) (transactions related to commercial 
contracts); Citigroup (Feb. 2012) (FX swaps and FX forwards); SIFMA 
et al. (Prop. Trading) (Feb. 2012) (interaffiliate transactions); T. 
Rowe Price (purchase and sale of shares in sponsored mutual funds); 
RMA (cash collateral pools); Alfred Brock (arbitrage trading); ICBA 
(securities traded pursuant to 12 U.S.C. 1831a(f)). The Agencies are 
concerned that these exclusions could be used to conduct 
impermissible proprietary trading, and the Agencies believe some of 
these exclusions are more appropriately addressed by other 
provisions of the rule. For example, derivatives qualifying for 
hedge accounting may be permitted under the hedging exemption.
---------------------------------------------------------------------------

2. Section ----.4(a): Underwriting Exemption
a. Introduction
    After carefully considering comments on the proposed underwriting 
exemption, the Agencies are adopting the proposed underwriting 
exemption substantially as proposed, but with certain refinements and 
clarifications to the proposed approach to better reflect the range of 
securities offerings that an underwriter may help facilitate on behalf 
of an issuer or selling security holder and the types of activities an 
underwriter may undertake in connection with a distribution of 
securities to facilitate the distribution process and provide important 
benefits to issuers, selling security holders, or purchasers in the 
distribution. The Agencies are adopting such an approach because the 
statute specifically permits banking entities to continue providing 
these beneficial services to clients, customers, and counterparties. At 
the same time, to reduce the potential for evasion of the general 
prohibition on proprietary trading, the Agencies are requiring, among 
other things, that the trading desk make reasonable efforts to sell or 
otherwise reduce its underwriting position (accounting for the 
liquidity, maturity, and depth of the market for the relevant type of 
security) and be subject to a robust risk limit structure that is 
designed to prevent a trading desk from having an underwriting position 
that exceeds the reasonably expected near term demands of clients, 
customers, or counterparties.
b. Overview
1. Proposed Underwriting Exemption
    Section 13(d)(1)(B) of the BHC Act provides an exemption from the 
prohibition on proprietary trading for the purchase, sale, acquisition, 
or disposition of securities and certain other instruments in 
connection with underwriting activities, to the extent that such 
activities are designed not to exceed the reasonably expected near term 
demands of clients, customers, or counterparties.\289\
---------------------------------------------------------------------------

    \289\ 12 U.S.C. 1851(d)(1)(B).
---------------------------------------------------------------------------

    Section ----.4(a) of the proposed rule would have implemented this 
exemption by requiring that a banking entity's underwriting activities 
comply with seven requirements. As discussed in more detail below, the 
proposed underwriting exemption required that: (i) A banking entity 
establish a compliance program under Sec.  ----.20; (ii) the covered 
financial position be a security; (iii) the purchase or sale be 
effected solely in connection with a distribution of securities for 
which the banking entity is acting as underwriter; (iv) the banking 
entity meet certain dealer registration requirements, where applicable; 
(v) the underwriting activities be designed not to exceed the 
reasonably expected near term demands of clients, customers, or 
counterparties; (vi) the underwriting activities be designed to 
generate revenues primarily from fees, commissions, underwriting 
spreads, or other income not attributable to appreciation in the value 
of covered financial positions or to hedging of covered financial 
positions; and (vii) the compensation arrangements of persons 
performing underwriting activities be designed not to reward 
proprietary risk-taking.\290\ The proposal explained that these seven 
criteria were proposed so that any banking entity relying on the 
underwriting exemption would be engaged in bona fide underwriting 
activities and would conduct those activities in a way that would not 
be susceptible to abuse through the taking of speculative, proprietary 
positions as

[[Page 5560]]

part of, or mischaracterized as, underwriting activity.\291\
---------------------------------------------------------------------------

    \290\ See proposed rule Sec.  ----.4(a).
    \291\ See Joint Proposal, 76 FR 68,866; CFTC Proposal, 77 FR 
8352.
---------------------------------------------------------------------------

2. Comments on Proposed Underwriting Exemption
    As a general matter, a few commenters expressed overall support for 
the proposed underwriting exemption.\292\ Some commenters indicated 
that the proposed exemption is too narrow and may negatively impact 
capital markets.\293\ As discussed in more detail below, many 
commenters expressed views on the effectiveness of specific 
requirements of the proposed exemption. Further, some commenters 
requested clarification or expansion of the proposed exemption for 
certain activities that may be conducted in the course of underwriting.
---------------------------------------------------------------------------

    \292\ See Barclays (stating that the proposed exemption 
generally effectuates the aims of the statute while largely avoiding 
undue interference, although the commenter also requested certain 
technical changes to the rule text); Alfred Brock.
    \293\ See, e.g., Lord Abbett; BoA; Fidelity; Chamber (Feb. 
2012).
---------------------------------------------------------------------------

    Several commenters suggested alternative approaches to implementing 
the statutory exemption for underwriting activities.\294\ More 
specifically, commenters recommended that the Agencies: (i) Provide a 
safe harbor for low risk, standard underwritings; \295\ (ii) better 
incorporate the statutory limitations on high-risk activity or 
conflicts of interest; \296\ (iii) prohibit banking entities from 
underwriting illiquid securities; \297\ (iv) prohibit banking entities 
from participating in private placements; \298\ (v) place greater 
emphasis on adequate internal compliance and risk management 
procedures; \299\ or (vi) make the exemption as broad as possible.\300\
---------------------------------------------------------------------------

    \294\ See Sens. Merkley & Levin (Feb. 2012); BoA; Fidelity; 
Occupy; AFR et al. (Feb. 2012).
    \295\ See Sens. Merkley & Levin (Feb. 2012) (suggesting a safe 
harbor for underwriting efforts that meet certain low-risk criteria, 
including that: The underwriting be in plain vanilla stock or bond 
offerings, including commercial paper, for established business and 
governments; and the distribution be completed within relevant time 
periods, as determined by asset classes, with relevant factors being 
the size of the issuer and the market served); Johnson & Prof. 
Stiglitz (expressing support for a narrow safe harbor for 
underwriting of basic stocks and bonds that raise capital for real 
economy firms).
    \296\ See Sens. Merkley & Levin (Feb. 2012) (suggesting that, 
for example, the exemption plainly prevent high-risk, conflict 
ridden underwritings of securitizations and structured products and 
cross-reference Section 621 of the Dodd-Frank Act, which prohibits 
certain material conflicts of interest in connection with asset-
backed securities).
    \297\ See AFR et al. (Feb. 2012) (recommending that the Agencies 
prohibit banking entities from acting as underwriter for assets 
classified as Level 3 under FAS 157, which would prohibit 
underwriting of illiquid and opaque securities without a genuine 
external market, and representing that such a restriction would be 
consistent with the statutory limitation on exposures to high-risk 
assets).
    \298\ See Occupy.
    \299\ See BoA (recommending that the Agencies establish a strong 
presumption that all of a banking entity's activities related to 
underwriting are permitted under the rules as long as the banking 
entity has adequate compliance and risk management procedures).
    \300\ See Fidelity (suggested that the rules be revised to 
``provide the broadest exemptions possible under the statute'' for 
underwriting and certain other permitted activities).
---------------------------------------------------------------------------

3. Final Underwriting Exemption
    After considering the comments received, the Agencies are adopting 
the underwriting exemption substantially as proposed, but with 
important modifications to clarify provisions or to address commenters' 
concerns. As discussed above, some commenters were generally supportive 
of the proposed approach to implementing the underwriting exemption, 
but noted certain areas of concern or uncertainty. The underwriting 
exemption the Agencies are adopting addresses these issues by further 
clarifying the scope of activities that qualify for the exemption. In 
particular, the Agencies are refining the proposed exemption to better 
capture the broad range of capital-raising activities facilitated by 
banking entities acting as underwriters on behalf of issuers and 
selling security holders.
    The final underwriting exemption includes the following components:
     A framework that recognizes the differences in 
underwriting activities across markets and asset classes by 
establishing criteria that will be applied flexibly based on the 
liquidity, maturity, and depth of the market for the particular type of 
security.
     A general focus on the ``underwriting position'' held by a 
banking entity or its affiliate, and managed by a particular trading 
desk, in connection with the distribution of securities for which such 
banking entity or affiliate is acting as an underwriter.\301\
---------------------------------------------------------------------------

    \301\ See infra Part IV.A.2.c.1.c.
---------------------------------------------------------------------------

     A definition of the term ``trading desk'' that focuses on 
the functionality of the desk rather than its legal status, and 
requirements that apply at the trading desk level of organization 
within a banking entity or across two or more affiliates.\302\
---------------------------------------------------------------------------

    \302\ See infra Part IV.A.2.c.1.c. The term ``trading desk'' is 
defined in final rule Sec.  ----.3(e)(13) as ``the smallest discrete 
unit of organization of a banking entity that purchases or sells 
financial instruments for the trading account of the banking entity 
or an affiliate thereof.''
---------------------------------------------------------------------------

     Five standards for determining whether a banking entity is 
engaged in permitted underwriting activities. Many of these criteria 
have similarities to those included in the proposed rule, but with 
important modifications in response to comments. These standards 
require that:
    [cir] The banking entity act as an ``underwriter'' for a 
``distribution'' of securities and the trading desk's underwriting 
position be related to such distribution. The final rule includes 
refined definitions of ``distribution'' and ``underwriter'' to better 
capture the broad scope of securities offerings used by issuers and 
selling security holders and the range of roles that a banking entity 
may play as intermediary in such offerings.\303\
---------------------------------------------------------------------------

    \303\ See final rule Sec. Sec.  ----.4(a)(2)(i), ----.4(a)(3), 
----.4(a)(4); See also infra Part IV.A.2.c.1.c.
---------------------------------------------------------------------------

    [cir] The amount and types of securities in the trading desk's 
underwriting position be designed not to exceed the reasonably expected 
near term demands of clients, customers, or counterparties, and 
reasonable efforts be 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.\304\
---------------------------------------------------------------------------

    \304\ See final rule Sec.  ----.4(a)(2)(ii); See also infra Part 
IV.A.2.c.2.c.
---------------------------------------------------------------------------

    [cir] The banking entity establish, implement, maintain, and 
enforce an internal compliance program that is reasonably designed to 
ensure the banking entity's compliance with the requirements of the 
underwriting exemption, including reasonably designed written policies 
and procedures, internal controls, analysis, and independent testing 
identifying and addressing:
    [ssquf] The products, instruments, or exposures each trading desk 
may purchase, sell, or manage as part of its underwriting activities;
    [ssquf] Limits for each trading desk, based on the nature and 
amount of the trading desk's underwriting activities, including the 
reasonably expected near term demands of clients, customers, or 
counterparties, on the amount, types, and risk of the trading desk's 
underwriting position, level of exposures to relevant risk factors 
arising from the trading desk's underwriting position, and period of 
time a security may be held;
    [ssquf] Internal controls and ongoing monitoring and analysis of 
each trading desk's compliance with its limits; and
    [ssquf] Authorization procedures, including escalation procedures 
that require review and approval of any trade that would exceed a 
trading desk's limit(s), demonstrable analysis of the basis for any 
temporary or permanent

[[Page 5561]]

increase to a trading desk's limit(s), and independent review of such 
demonstrable analysis and approval.\305\
---------------------------------------------------------------------------

    \305\ See final rule Sec.  ----.4(a)(2)(iii); See also infra 
Part IV.A.2.c.3.c.
---------------------------------------------------------------------------

    [cir] The compensation arrangements of persons performing the 
banking entity's underwriting activities are designed not to reward or 
incentivize prohibited proprietary trading.\306\
---------------------------------------------------------------------------

    \306\ See final rule Sec.  ----.4(a)(2)(iv); See also infra Part 
IV.A.2.c.4.c.
---------------------------------------------------------------------------

    [cir] The banking entity is licensed or registered to engage in the 
activity described in the underwriting exemption in accordance with 
applicable law.\307\
---------------------------------------------------------------------------

    \307\ See final rule Sec.  ----.4(a)(2)(v); See also infra Part 
IV.A.2.c.5.c.
---------------------------------------------------------------------------

    After considering commenters' suggested alternative approaches to 
implementing the statute's underwriting exemption, the Agencies have 
determined to retain the general structure of the proposed underwriting 
exemption. For instance, two commenters suggested providing a safe 
harbor for ``plain vanilla'' or ``basic'' underwritings of stocks and 
bonds.\308\ The Agencies do not believe that a safe harbor is necessary 
to provide certainty that a banking entity may act as an underwriter in 
these particular types of offerings. This is because ``plain vanilla'' 
or ``basic'' underwriting activity should be able to meet the 
requirements of the final rule. For example, the final definition of 
``distribution'' includes any offering of securities made pursuant to 
an effective registration statement under the Securities Act.\309\
---------------------------------------------------------------------------

    \308\ See Sens. Merkley & Levin (Feb. 2012); Johnson & Prof. 
Stiglitz. One of these commenters also suggested that the Agencies 
better incorporate the statutory limitations on material conflicts 
of interest and high-risk activities in the underwriting exemption 
by including additional provisions in the exemption to refer to 
these limitations. See Sens. Merkley & Levin (Feb. 2012). The 
Agencies note that these limitations are adopted in Sec.  ----.7 of 
the final rules, and this provision will apply to underwriting 
activities, as well as all other exempted activities.
    \309\ See final rule Sec.  ----.4(a)(3).
---------------------------------------------------------------------------

    Further, in response to one commenter's request that the final rule 
prohibit a banking entity from acting as an underwriter in illiquid 
assets that are determined to not have observable price inputs under 
accounting standards,\310\ the Agencies continue to believe that it 
would be inappropriate to incorporate accounting standards in the rule 
because accounting standards could change in the future without 
consideration of the potential impact on the final rule.\311\ Moreover, 
the Agencies do not believe it is necessary to differentiate between 
liquid and less liquid securities for purposes of determining whether a 
banking entity may underwrite a distribution of securities because, in 
either case, a banking entity must have a reasonable expectation of 
purchaser demand for the securities and must make reasonable efforts to 
sell or otherwise reduce its underwriting position within a reasonable 
period under the final rule.\312\
---------------------------------------------------------------------------

    \310\ See AFR et al. (Feb. 2012).
    \311\ See Joint Proposal, 76 FR 68,859 n.101 (explaining why the 
Agencies declined to incorporate certain accounting standards in the 
proposed rule); CFTC Proposal, 77 FR 8344 n.107.
    \312\ See infra Part IV.A.2.c.2.c.
---------------------------------------------------------------------------

    Another commenter suggested that the Agencies establish a strong 
presumption that all of a banking entity's activities related to 
underwriting are permitted under the rule as long as the banking entity 
has adequate compliance and risk management procedures.\313\ While 
strong compliance and risk management procedures are important for 
banking entities' permitted activities, the Agencies believe that an 
approach focused solely on the establishment of a compliance program 
would likely increase the potential for evasion of the general 
prohibition on proprietary trading. Similarly, the Agencies are not 
adopting an exemption that is unlimited, as requested by one commenter, 
because the Agencies believe controls are necessary to prevent 
potential evasion of the statute through, among other things, retaining 
an unsold allotment when there is sufficient customer interest for the 
securities and to limit the risks associated with these 
activities.\314\
---------------------------------------------------------------------------

    \313\ See BoA.
    \314\ See Fidelity.
---------------------------------------------------------------------------

    Underwriters play an important role in facilitating issuers' access 
to funding, and thus underwriters are important to the capital 
formation process and economic growth.\315\ Obtaining new financing can 
be expensive for an issuer because of the natural information advantage 
that less well-known issuers have over investors about the quality of 
their future investment opportunities. An underwriter can help reduce 
these costs by mitigating the information asymmetry between an issuer 
and its potential investors. The underwriter does this based in part on 
its familiarity with the issuer and other similar issuers as well as by 
collecting information about the issuer. This allows investors to look 
to the reputation and experience of the underwriter as well as its 
ability to provide information about the issuer and the underwriting. 
For these and other reasons, most U.S. issuers rely on the services of 
an underwriter when raising funds through public offerings. As 
recognized in the statute, the exemption is intended to permit banking 
entities to continue to perform the underwriting function, which 
contributes to capital formation and its positive economic effects.
---------------------------------------------------------------------------

    \315\ See, e.g., BoA (``The underwriting activities of U.S. 
banking entities are essential to capital formation and, therefore, 
economic growth and job creation.''); Goldman (Prop. Trading); Sens. 
Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------

c. Detailed Explanation of the Underwriting Exemption
1. Acting as an Underwriter for a Distribution of Securities
a. Proposed Requirements That the Purchase or Sale be Effected Solely 
in Connection With a Distribution of Securities for Which the Banking 
Entity Acts as an Underwriter and That the Covered Financial Position 
be a Security
    Section ----.4(a)(2)(iii) of the proposed rule required that the 
purchase or sale be effected solely in connection with a distribution 
of securities for which a banking entity is acting as underwriter.\316\ 
As discussed below, the Agencies proposed to define the terms 
``distribution'' and ``underwriter'' in the proposed rule. The proposed 
rule also required that the covered financial position being purchased 
or sold by the banking entity be a security.\317\
---------------------------------------------------------------------------

    \316\ See proposed rule Sec.  ----.4(a)(2)(iii).
    \317\ See proposed rule Sec.  ----.4(a)(2)(ii).
---------------------------------------------------------------------------

i. Proposed Definition of ``Distribution''
    The proposed definition of ``distribution'' mirrored the definition 
of this term used in the SEC's Regulation M under the Exchange 
Act.\318\ More specifically, the proposed rule defined ``distribution'' 
as ``an offering of securities, whether or not subject to registration 
under the Securities Act, that is distinguished from ordinary trading 
transactions by the magnitude of the offering and the presence of 
special selling efforts and selling methods.''\319\ The Agencies did 
not propose to define the terms ``magnitude'' and ``special selling 
efforts and selling methods,'' but stated that the Agencies would 
expect to rely on the same factors considered in Regulation M for 
assessing these elements.\320\ The Agencies noted that

[[Page 5562]]

``magnitude'' does not imply that a distribution must be large and, 
therefore, this factor would not preclude small offerings or private 
placements from qualifying for the proposed underwriting 
exemption.\321\
---------------------------------------------------------------------------

    \318\ See Joint Proposal, 76 FR 68,866-68,867; CFTC Proposal, 77 
FR 8352; 17 CFR 242.101; proposed rule Sec.  ----.4(a)(3).
    \319\ See proposed rule Sec.  ----.4(a)(3).
    \320\ See Joint Proposal, 76 FR 68,867 (``For example, the 
number of shares to be sold, the percentage of the outstanding 
shares, public float, and trading volume that those shares represent 
are all relevant to an assessment of magnitude. In addition, 
delivering a sales document, such as a prospectus, and conducting 
road shows are generally indicative of special selling efforts and 
selling methods. Another indicator of special selling efforts and 
selling methods is compensation that is greater than that for 
secondary trades but consistent with underwriting compensation for 
an offering.''); CFTC Proposal, 77 FR 8352; Review of 
Antimanipulation Regulation of Securities Offering, Exchange Act 
Release No. 33924 (Apr. 19, 1994), 59 FR 21,681, 21,684-21,685 (Apr. 
26, 1994).
    \321\ See Joint Proposal, 76 FR 68,867; CFTC Proposal, 77 FR 
8352.*COM057**COM057*
---------------------------------------------------------------------------

ii. Proposed Definition of ``Underwriter''
    Like the proposed definition of ``distribution,'' the Agencies 
proposed to define ``underwriter'' in a manner similar to the 
definition of this term in the SEC's Regulation M.\322\ The definition 
of ``underwriter'' in the proposed rule was: (i) Any person who has 
agreed with an issuer or selling security holder to: (a) Purchase 
securities for distribution; (b) engage in a distribution of securities 
for or on behalf of such issuer or selling security holder; or (c) 
manage a distribution of securities for or on behalf of such issuer or 
selling security holder; and (ii) a person who has an agreement with 
another person described in the preceding provisions to engage in a 
distribution of such securities for or on behalf of the issuer or 
selling security holder.\323\

    \322\ See Joint Proposal, 76 FR 68,866-68,867; CFTC Proposal, 77 
FR 8352; 17 CFR 242.101; proposed rule Sec.  ----.4(a)(4).
    \323\ See proposed rule Sec.  ----.4(a)(4). As noted in the 
proposal, the proposed rule's definition differed from the 
definition in Regulation M because the proposed rule's definition 
would also include a person who has an agreement with another 
underwriter to engage in a distribution of securities for or on 
behalf of an issuer or selling security holder. See Joint Proposal, 
76 FR 68,867; CFTC Proposal, 77 FR 8352.
---------------------------------------------------------------------------

    In connection with this proposed requirement, the Agencies noted 
that the precise activities performed by an underwriter may vary 
depending on the liquidity of the securities being underwritten and the 
type of distribution being conducted. To determine whether a banking 
entity is acting as an underwriter as part of a distribution of 
securities, the Agencies proposed to take into consideration the extent 
to which a banking entity is engaged in the following activities:
     Assisting an issuer in capital-raising;
     Performing due diligence;
     Advising the issuer on market conditions and assisting in 
the preparation of a registration statement or other offering document;
     Purchasing securities from an issuer, a selling security 
holder, or an underwriter for resale to the public;
     Participating in or organizing a syndicate of investment 
banks;
     Marketing securities; and
     Transacting to provide a post-issuance secondary market 
and to facilitate price discovery.\324\
---------------------------------------------------------------------------

    \324\ See Joint Proposal, 76 FR 68,867; CFTC Proposal, 77 FR 
8352.
---------------------------------------------------------------------------

The proposal recognized that there may be circumstances in which an 
underwriter would hold securities that it could not sell in the 
distribution for investment purposes. The Agencies stated that if the 
unsold securities were acquired in connection with underwriting under 
the proposed exemption, then the underwriter would be able to dispose 
of such securities at a later time.\325\
---------------------------------------------------------------------------

    \325\ See id.
---------------------------------------------------------------------------

iii. Proposed Requirement That the Covered Financial Position Be a 
Security
    Pursuant to Sec.  ----.4(a)(2)(ii) of the proposed exemption, a 
banking entity would be permitted to purchase or sell a covered 
financial position that is a security only in connection with its 
underwriting activities.\326\ The proposal stated that this requirement 
was meant to reflect the common usage and understanding of the term 
``underwriting.'' \327\ It was noted, however, that a derivative or 
commodity future transaction may be otherwise permitted under another 
exemption (e.g., the exemptions for market making-related or risk-
mitigating hedging activities).\328\
---------------------------------------------------------------------------

    \326\ See proposed rule Sec.  ----.4(a)(2)(ii).
    \327\ See Joint Proposal, 76 FR 68,866; CFTC Proposal, 77 FR 
8352.
    \328\ See Joint Proposal, 76 FR 68,866 n.132; CFTC Proposal, 77 
FR 8352 n.138.
---------------------------------------------------------------------------

b. Comments on the Proposed Requirements That the Trade Be Effected 
Solely in Connection With a Distribution for Which the Banking Entity 
Is Acting as an Underwriter and That the Covered Financial Position Be 
a Security
    In response to the proposed requirement that a purchase or sale be 
``effected solely in connection with a distribution of securities'' for 
which the ``banking entity is acting as underwriter,'' commenters 
generally focused on the proposed definitions of ``distribution'' and 
``underwriter'' and the types of activities that should be permitted 
under the ``in connection with'' standard. Commenters did not directly 
address the requirement in Sec.  ----.4(a)(2)(ii) of the proposed rule, 
which provided that the covered financial position purchased or sold 
under the exemption must be a security. A number of commenters 
expressed general concern that the proposed underwriting exemption's 
references to a ``purchase or sale of a covered financial position'' 
could be interpreted to require compliance with the proposed rule on a 
transaction-by-transaction basis. These commenters indicated that such 
an approach would be overly burdensome.\329\
---------------------------------------------------------------------------

    \329\ See, e.g., Goldman (Prop. Trading); SIFMA et al. (Prop. 
Trading) (Feb. 2012).
---------------------------------------------------------------------------

i. Definition of ``Distribution''
    Several commenters stated that the proposed definition of 
``distribution'' is too narrow,\330\ while one commenter stated that 
the proposed definition is too broad.\331\ Commenters who viewed the 
proposed definition as too narrow stated that it may exclude important 
capital-raising and financing transactions that do not appear to 
involve ``special selling efforts and selling methods'' or 
``magnitude.'' \332\ In particular, these commenters stated that the 
proposed definition of ``distribution'' may preclude a banking entity 
from participating in commercial paper issuances,\333\ bridge 
loans,\334\ ``at-the-market'' offerings or ``dribble out'' programs 
conducted off issuer shelf registrations,\335\ offerings in response to 
reverse inquiries,\336\ offerings through an automated execution 
system,\337\ small private offerings,\338\ or selling security holders' 
sales of securities of issuers with large market capitalizations that 
are executed as underwriting transactions in the normal course.\339\
---------------------------------------------------------------------------

    \330\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman 
(Prop. Trading); Wells Fargo (Prop. Trading); RBC.
    \331\ See Occupy.
    \332\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman 
(Prop. Trading); Wells Fargo (Prop. Trading); RBC.
    \333\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman 
(Prop. Trading); Wells Fargo (Prop. Trading). In addition, one 
commenter expressed general concern that the proposed rule would 
cause a reduction in underwriting services with respect to 
commercial paper, which would reduce liquidity in commercial paper 
markets and raise the costs of capital in already tight credit 
markets. See Chamber (Feb. 2012).
    \334\ See Goldman (Prop. Trading); Wells Fargo (Prop. Trading); 
RBC; LSTA (Feb. 2012).
    \335\ See Goldman (Prop. Trading).
    \336\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \337\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \338\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman 
(Prop. Trading); Wells Fargo (Prop. Trading).
    \339\ See RBC.
---------------------------------------------------------------------------

    Several commenters suggested that the proposed definition be 
modified to

[[Page 5563]]

include some or all of these types of offerings.\340\ For example, two 
commenters requested that the definition explicitly include all 
offerings of securities by an issuer.\341\ One of these commenters 
further requested a broader definition that would include any offering 
by a selling security holder that is registered under the Securities 
Act or that involves an offering document prepared by the issuer.\342\ 
Another commenter suggested that the rule explicitly authorize certain 
forms of offerings, such as offerings under Rule 144A, Regulation S, 
Rule 101(b)(10) of Regulation M, or the so-called ``section 4(1\1/2\)'' 
of the Securities Act, as well as transactions on behalf of selling 
security holders.\343\ Two commenters proposed approaches that would 
include the resale of notes or other debt securities received by a 
banking entity from a borrower to replace or refinance a bridge 
loan.\344\ One of these commenters stated that permitting a banking 
entity to receive and resell notes or other debt securities from a 
borrower to replace or refinance a bridge loan would preserve the 
ability of a banking entity to extend credit and offer customers a 
range of financing options. This commenter further represented that 
such an approach would be consistent with the exclusion of loans from 
the proposed definition of ``covered financial position'' and the 
commenter's recommended exclusion from the definition of ``trading 
account'' for collecting debts previously contracted.\345\
---------------------------------------------------------------------------

    \340\ See Goldman (Prop. Trading); SIFMA et al. (Prop. Trading) 
(Feb. 2012); RBC.
    \341\ See Goldman (Prop. Trading) (stating that this would 
capture, among other things, commercial paper issuances, issuer 
``dribble out'' programs, and small private offerings, which involve 
the purchase of securities directly from an issuer with a view 
toward resale, but may not always be clearly distinguished by 
``special selling efforts and selling methods'' or by 
``magnitude''); SIFMA et al. (Prop. Trading) (Feb. 2012).
    \342\ See SIFMA et al. (Prop. Trading) (Feb. 2012). This 
commenter indicated that expanding the definition of 
``distribution'' to include both offerings of securities by an 
issuer and offerings by a selling security holder that are 
registered under the Securities Act or that involve an offering 
document prepared by the issuer would ``include, for example, an 
offering of securities by an issuer or a selling security holder 
where securities are sold through an automated order execution 
system, offerings in response to reverse inquiries and commercial 
paper issuances.'' Id.
    \343\ See RBC.
    \344\ See Goldman (Prop. Trading); RBC. In addition, one 
commenter requested the Agencies clarify that permitted underwriting 
activities include the acquisition and resale of securities issued 
in lieu of or to refinance bridge loan facilities, irrespective of 
whether such activities qualify as ``distributions'' under the 
proposal. See LSTA (Feb. 2012).
    \345\ See Goldman (Prop. Trading).
---------------------------------------------------------------------------

    One commenter, however, stated that the proposed definition of 
``distribution'' is too broad. This commenter suggested that the 
underwriting exemption should only be available for registered 
offerings, and the rule should preclude a banking entity from 
participating in a private placement. According to the commenter, 
permitting a banking entity to participate in a private placement may 
facilitate evasion of the prohibition on proprietary trading.\346\
---------------------------------------------------------------------------

    \346\ See Occupy.
---------------------------------------------------------------------------

ii. Definition of ``Underwriter''
    Several commenters stated that the proposed definition of 
``underwriter'' is too narrow.\347\ Other commenters, however, stated 
that the proposed definition is too broad, particularly due to the 
proposed inclusion of selling group members.\348\
---------------------------------------------------------------------------

    \347\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman 
(Prop. Trading); Wells Fargo (Prop. Trading).
    \348\ See AFR et al. (Feb. 2012); Public Citizen; Occupy 
(suggesting that the Agencies exceeded their statutory authority by 
incorporating the Regulation M definition of ``underwriter,'' rather 
than the Securities Act definition of ``underwriter'').
---------------------------------------------------------------------------

    Commenters requesting a broader definition generally stated that 
the Agencies should instead use the Regulation M definition of 
``distribution participant'' or otherwise revise the definition of 
``underwriter'' to incorporate the concept of a ``distribution 
participant,'' as defined under Regulation M.\349\ According to these 
commenters, using the term ``distribution participant'' would better 
reflect current market practice and would include dealers that 
participate in an offering but that do not deal directly with the 
issuer or selling security holder and do not have a written agreement 
with the underwriter.\350\ One commenter further represented that the 
proposed provision for selling group members may be less inclusive than 
the Agencies intended because individual selling dealers or dealer 
groups may or may not have written agreements with an underwriter in 
privity of contract with the issuer.\351\ Another commenter requested 
that, if the ``distribution participant'' concept is not incorporated 
into the rule, the proposed definition of ``underwriter'' be modified 
to include a person who has an agreement with an affiliate of an issuer 
or selling security holder (e.g., an agreement with a parent company to 
distribute the issuer's securities).\352\
---------------------------------------------------------------------------

    \349\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman 
(Prop. Trading); Wells Fargo (Prop. Trading). The term 
``distribution participant'' is defined in Rule 100 of Regulation M 
as ``an underwriter, prospective underwriter, broker, dealer, or 
other person who has agreed to participate or is participating in a 
distribution.'' 17 CFR 242.100.
    \350\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman 
(Prop. Trading); Wells Fargo (Prop. Trading).
    \351\ See Goldman (Prop. Trading).
    \352\ See SIFMA et al. (Prop. Trading) (Feb. 2012). This 
commenter also requested a technical amendment to proposed rule 
Sec.  ----.4(a)(4)(ii) to clarify that the person is 
``participating'' in a distribution, not ``engaging'' in a 
distribution. See id.
---------------------------------------------------------------------------

    Other commenters opposed the inclusion of selling group members in 
the proposed definition of ``underwriter.'' These commenters stated 
that because selling group members do not provide a price guarantee to 
an issuer, they do not provide services to a customer and their 
activities should not qualify for the underwriting exemption.\353\
---------------------------------------------------------------------------

    \353\ See AFR et al. (Feb. 2012); Public Citizen.
---------------------------------------------------------------------------

    A number of commenters stated that it is unclear whether the 
proposed underwriting exemption would permit a banking entity to act as 
an authorized participant (``AP'') to an ETF issuer, particularly with 
respect to the creation and redemption of ETF shares or ``seeding'' an 
ETF for a short period of time when it is initially launched.\354\ For 
example, a few commenters noted that APs typically do not perform some 
or all of the activities that the Agencies proposed to consider to help 
determine whether a banking entity is acting as an underwriter in 
connection with a distribution of securities, including due diligence, 
advising an issuer on market conditions and assisting in preparation of 
a registration statement or offering documents, and participating in or 
organizing a syndicate of investment banks.\355\
---------------------------------------------------------------------------

    \354\ See BoA; ICI Global; Vanguard; ICI (Feb. 2012); SSgA (Feb. 
2012). As one commenter explained, an AP may ``seed'' an ETF for a 
short period of time at its inception by entering into several 
initial creation transactions with the ETF issuer and refraining 
from selling those shares to investors or redeeming them for a 
period of time to facilitate the ETF achieving its liquidity launch 
goals. See BoA.
    \355\ See ICI Global; ICI (Feb. 2012); Vanguard.
---------------------------------------------------------------------------

    However, one commenter appeared to oppose applying the underwriting 
exemption to certain AP activities. According to this commenter, APs 
are generally reluctant to concede that they are statutory underwriters 
because they do not perform all the activities associated with the 
underwriting of an operating company's securities. Further, this 
commenter expressed concern that, if an AP had to rely on the proposed 
underwriting exemption, the AP could be subject to heightened risk of 
incurring underwriting liability on the issuance of ETF shares traded 
by the AP. As a result of these considerations,

[[Page 5564]]

the commenter believed that a banking entity may be less willing to act 
as an AP for an ETF issuer if it were required to rely on the 
underwriting exemption.\356\
---------------------------------------------------------------------------

    \356\ See SSgA (Feb. 2012).
---------------------------------------------------------------------------

iii. ``Solely in Connection With'' Standard
    To qualify for the underwriting exemption, the proposed rule 
required a purchase or sale of a covered financial position to be 
effected ``solely in connection with'' a distribution of securities for 
which the banking entity is acting as underwriter. Several commenters 
expressed concern that the word ``solely'' in this provision may result 
in an overly narrow interpretation of permissible activities. In 
particular, these commenters indicated that the ``solely in connection 
with'' standard creates uncertainty about certain activities that are 
currently conducted in the course of an underwriting, such as customary 
underwriting syndicate activities.\357\ One commenter represented that 
such activities are traditionally undertaken to: Support the success of 
a distribution; mitigate risk to issuers, investors, and underwriters; 
and facilitate an orderly aftermarket.\358\ A few commenters further 
stated that requiring a trade to be ``solely'' in connection with a 
distribution by an underwriter would be inconsistent with the 
statute,\359\ may reduce future innovation in the capital-raising 
process,\360\ and could create market disruptions.\361\
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    \357\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman 
(Prop. Trading); BoA; Wells Fargo (Prop. Trading); Comm. on Capital 
Markets Regulation.
    \358\ See Goldman (Prop. Trading).
    \359\ See Goldman (Prop. Trading); Wells Fargo (Prop. Trading); 
SIFMA et al. (Prop. Trading) (Feb. 2012).
    \360\ See Goldman (Prop. Trading).
    \361\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------

    A number of commenters stated that it is unclear whether certain 
activities would qualify for the proposed underwriting exemption and 
requested that the Agencies adopt an exemption that is broad enough to 
permit such activities.\362\ Commenters stated that there are a number 
of activities that should be permitted under the underwriting 
exemption, including: (i) Creating a naked or covered syndicate short 
position in connection with an offering; \363\ (ii) creating a 
stabilizing bid; \364\ (iii) acquiring positions via overallotments 
\365\ or trading in the market to close out short positions in 
connection with an overallotment option or in connection with other 
stabilization activities; \366\ (iv) using call spread options in a 
convertible debt offering to mitigate dilution of existing 
shareholders; \367\ (v) repurchasing existing debt securities of an 
issuer in the course of underwriting a new series of debt securities in 
order to stimulate demand for the new issuance; \368\ (vi) purchasing 
debt securities of comparable issuers as a price discovery mechanism in 
connection with underwriting a new debt security; \369\ (vii) hedging 
the underwriter's exposure to a derivative strategy engaged in with an 
issuer; \370\ (viii) organizing and assembling a resecuritized product, 
including, for example, sourcing bond collateral over a period of time 
in anticipation of issuing new securities; \371\ and (ix) selling a 
security to an intermediate entity as part of the creation of certain 
structured products.\372\
---------------------------------------------------------------------------

    \362\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman 
(Prop. Trading); Wells Fargo (Prop. Trading); RBC.
    \363\ See SIFMA et al. (Prop. Trading) (Feb. 2012) (``The reason 
for creating the short positions (covered and naked) is to 
facilitate an orderly aftermarket and to reduce price volatility of 
newly offered securities. This provides significant value to issuers 
and selling security holders, as well as to investors, by giving the 
syndicate buying power that helps protect against immediate 
volatility in the aftermarket.''); RBC; Goldman (Prop. Trading).
    \364\ See SIFMA et al. (Prop. Trading) (Feb. 2012) 
(``Underwriters may also engage in stabilization activities under 
Regulation M by creating a stabilizing bid to prevent or slow a 
decline in the market price of a security. These activities should 
be encouraged rather than restricted by the Volcker Rule because 
they reduce price volatility and facilitate the orderly pricing and 
aftermarket trading of underwritten securities, thereby contributing 
to capital formation.'').
    \365\ See RBC.
    \366\ See Goldman (Prop. Trading).
    \367\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman 
(Prop. Trading) (stating that the call spread arrangement ``may make 
a wider range of financing options feasible for the issuer of the 
convertible debt'' and ``can help it to raise more capital at more 
attractive prices'').
    \368\ See Wells Fargo (Prop. Trading). The commenter further 
stated that the need to purchase the issuer's other debt securities 
from investors may arise if an investor has limited risk tolerance 
to the issuer's credit or has portfolio restrictions. According to 
the commenter, the underwriter would typically sell the debt 
securities it purchased from existing investors to new investors. 
See id.
    \369\ See Wells Fargo (Prop. Trading).
    \370\ See Goldman (Prop. Trading).
    \371\ See ASF (Feb. 2012) (stating that, for example, a banking 
entity may respond to customer or general market demand for highly-
rated mortgage paper by accumulating residential mortgage-backed 
securities over time and holding such securities in inventory until 
the transaction can be organized and assembled).
    \372\ See ICI (Feb. 2012) (stating that the sale of assets to an 
intermediate asset-backed commercial paper or tender option bond 
program should be permitted under the underwriting exemption if the 
sale is part of the creation of a structured security). See also AFR 
et al. (Feb. 2012) (stating that the treatment of a sale to an 
intermediate entity should depend on whether the banking entity or 
an external client is the driver of the demand and, if the banking 
entity is the driver of the demand, then the near term demand 
requirement should not be met). Two commenters stated that the 
underwriting exemption should not permit a banking entity to sell a 
security to an intermediate entity in the course of creating a 
structured product. See Occupy; Alfred Brock. These commenters were 
generally responding to a question on this issue in the proposal. 
See Joint Proposal, 76 FR 68,868-68,869 (question 78); CFTC 
Proposal, 77 FR 8354 (question 78).
---------------------------------------------------------------------------

c. Final Requirement That the Banking Entity Act as an Underwriter for 
a Distribution of Securities and the Trading Desk's Underwriting 
Position Be Related to Such Distribution
    The final rule requires that the banking entity act as an 
underwriter for a distribution of securities and the trading desk's 
underwriting position be related to such distribution.\373\ This 
requirement is substantially similar to the proposed rule,\374\ but 
with five key refinements. First, to address commenters' confusion 
about whether the underwriting exemption applies on a transaction-by-
transaction basis, the phrase ``purchase or sale'' has been modified to 
instead refer to the trading desk's ``underwriting position.'' Second, 
to balance this more aggregated position-based approach, the final rule 
specifies that the trading desk is the organizational level of a 
banking entity (or across one or more affiliated banking entities) at 
which the requirements of the underwriting exemption will be assessed. 
Third, the Agencies have made important modifications to the definition 
of ``distribution'' to better capture the various types of private and 
registered offerings a banking entity may be asked to underwrite by an 
issuer or selling security holder. Fourth, the definition of 
``underwriter'' has been refined to clarify that both members of the 
underwriting syndicate and selling group members may qualify as 
underwriters for purposes of this exemption. Finally, the word 
``solely'' has been removed to clarify that a broader scope of 
activities conducted in connection with underwriting (e.g., 
stabilization activities) are permitted under this exemption. These 
issues are discussed in turn below.
---------------------------------------------------------------------------

    \373\ Final rule Sec.  ----.4(a)(2)(i). The terms 
``distribution'' and ``underwriter'' are defined in final rule Sec.  
----.4(a)(3) and Sec.  ----.4(a)(4), respectively.
    \374\ Proposed rule Sec.  ----.4(a)(2)(iii) required that 
``[t]he purchase or sale is effected solely in connection with a 
distribution of securities for which the covered banking entity is 
acting as underwriter.''
---------------------------------------------------------------------------

i. Definition of ``Underwriting Position''
    In response to commenters' concerns about transaction-by-
transaction analyses,\375\ the Agencies are modifying

[[Page 5565]]

the exemption to clarify the level at which compliance with certain 
provisions will be assessed. The proposal was not intended to impose a 
transaction-by-transaction approach, and the final rule's requirements 
generally focus on the long or short positions in one or more 
securities held by a banking entity or its affiliate, and managed by a 
particular trading desk, in connection with a particular distribution 
of securities for which such banking entity or its affiliate is acting 
as an underwriter. Like Sec.  ----.4(a)(2)(ii) of the proposed rule, 
the definition of ``underwriting position'' is limited to positions in 
securities because the common usage and understanding of the term 
``underwriting'' is limited to activities in securities.
---------------------------------------------------------------------------

    \375\ See, e.g., Goldman (Prop. Trading); SIFMA et al. (Prop. 
Trading) (Feb. 2012).
---------------------------------------------------------------------------

    A trading desk's underwriting position constitutes the securities 
positions that are acquired in connection with a single distribution 
for which the relevant banking entity is acting as an underwriter. A 
trading desk may not aggregate securities positions acquired in 
connection with two or more distributions to determine its 
``underwriting position.'' A trading desk may, however, have more than 
one ``underwriting position'' at a particular point in time if the 
banking entity is acting as an underwriter for more than one 
distribution. As a result, the underwriting exemption's requirements 
pertaining to a trading desk's underwriting position will apply on a 
distribution-by-distribution basis.
    A trading desk's underwriting position can include positions in 
securities held at different affiliated legal entities, provided the 
banking entity is able to provide supervisors or examiners of any 
Agency that has regulatory authority over the banking entity pursuant 
to section 13(b)(2)(B) of the BHC Act with records, promptly upon 
request, that identify any related positions held at an affiliated 
entity that are being included in the trading desk's underwriting 
position for purposes of the underwriting exemption. Banking entities 
should be prepared to provide all records that identify all of the 
positions included in a trading desk's underwriting position and where 
such positions are held.
    The Agencies believe that a distribution-by-distribution approach 
is appropriate due to the relatively distinct nature of underwriting 
activities for a single distribution on behalf of an issuer or selling 
security holder. The Agencies do not believe that a narrower 
transaction-by-transaction analysis is necessary to determine whether a 
banking entity is engaged in permitted underwriting activities. The 
Agencies also decline to take a broader approach, which would allow a 
banking entity to aggregate positions from multiple distributions for 
which it is acting as an underwriter, because it would be more 
difficult for the banking entity's internal compliance personnel and 
Agency supervisors and examiners to review the trading desk's positions 
to assess the desk's compliance with the underwriting exemption. A more 
aggregated approach would increase the number of positions in different 
types of securities that could be included in the underwriting 
position, which would make it more difficult to determine that an 
individual position is related to a particular distribution of 
securities for which the banking entity is acting as an underwriter 
and, in turn, increase the potential for evasion of the general 
prohibition on proprietary trading.
ii. Definition of ``Trading Desk''
    The proposed underwriting exemption would have applied certain 
requirements across an entire banking entity. To promote consistency 
with the market-making exemption and address potential evasion 
concerns, the final rule applies the requirements of the underwriting 
exemption at the trading desk level of organization.\376\ This approach 
will result in the requirements of the underwriting exemption applying 
to the aggregate trading activities of a relatively limited group of 
employees on a single desk. Applying requirements at the trading desk 
level should facilitate banking entity and Agency monitoring and review 
of compliance with the exemption by limiting the location where 
underwriting activity may occur and allowing better identification of 
the aggregate trading volume that must be reviewed to determine whether 
the desk's activities are being conducted in a manner that is 
consistent with the underwriting exemption, while also allowing 
adequate consideration of the particular facts and circumstances of the 
desk's trading activities.
---------------------------------------------------------------------------

    \376\ See infra Part IV.A.3.c. (discussing the final market-
making exemption).
---------------------------------------------------------------------------

    The trading desk should be managed and operated as an individual 
unit and should reflect the level at which the profit and loss of 
employees engaged in underwriting activities is attributed. The term 
``trading desk'' in the underwriting context is intended to encompass 
what is commonly thought of as an underwriting desk. A trading desk 
engaged in underwriting activities would not necessarily be an active 
market participant that engages in frequent trading activities.
    A trading desk may manage an underwriting position that includes 
positions held by different affiliated legal entities.\377\ Similarly, 
a trading desk may include employees working on behalf of multiple 
affiliated legal entities or booking trades in multiple affiliated 
entities. The geographic location of individual traders is not 
dispositive for purposes of determining whether the employees are 
engaged in activities for a single trading desk.
---------------------------------------------------------------------------

    \377\ See supra note 302 and accompanying text.
---------------------------------------------------------------------------

iii. Definition of ``Distribution''
    The term ``distribution'' is defined in the final rule as: (i) An 
offering of securities, whether or not subject to registration under 
the Securities Act, that is distinguished from ordinary trading 
transactions by the presence of special selling efforts and selling 
methods; or (ii) an offering of securities made pursuant to an 
effective registration statement under the Securities Act.\378\ In 
response to comments, the proposed definition has been revised to 
eliminate the need to consider the ``magnitude'' of an offering and 
instead supplements the definition with an alternative prong for 
registered offerings under the Securities Act.\379\
---------------------------------------------------------------------------

    \378\ Final rule Sec.  ----.4(a)(3).
    \379\ Proposed rule Sec.  ----.4(a)(3) defined ``distribution'' 
as ``an offering of securities, whether or not subject to 
registration under the Securities Act, that is distinguished from 
ordinary trading transactions by the magnitude of the offering and 
the presence of special selling efforts and selling methods.''
---------------------------------------------------------------------------

    The proposed definition's reference to magnitude caused some 
commenter concern with respect to whether it could be interpreted to 
preclude a banking entity from intermediating a small private 
placement. After considering comments, the Agencies have determined 
that the requirement to have special selling efforts and selling 
methods is sufficient to distinguish between permissible securities 
offerings and prohibited proprietary trading, and the additional 
magnitude factor is not needed to further this objective.\380\ As 
proposed, the Agencies will rely on the same factors considered under 
Regulation M to analyze the presence of special selling efforts and 
selling

[[Page 5566]]

methods.\381\ Indicators of special selling efforts and selling methods 
include delivering a sales document (e.g., a prospectus), conducting 
road shows, and receiving compensation that is greater than that for 
secondary trades but consistent with underwriting compensation.\382\ 
For purposes of the final rule, each of these factors need not be 
present under all circumstances. Offerings that qualify as 
distributions under this prong of the definition include, among others, 
private placements in which resales may be made in reliance on the 
SEC's Rule 144A or other available exemptions \383\ and, to the extent 
the commercial paper being offered is a security, commercial paper 
offerings that involve the underwriter receiving special 
compensation.\384\
---------------------------------------------------------------------------

    \380\ The policy goals of this rule differ from those of the 
SEC's Regulation M, which is an anti-manipulation rule. The focus on 
magnitude is appropriate for that regulation because it helps 
identify offerings that can give rise to an incentive to condition 
the market for the offered security. To the contrary, this rule is 
intended to allow banking entities to continue to provide client-
oriented financial services, including underwriting services. The 
SEC emphasizes that this rule does not have any impact on Regulation 
M.
    \381\ See Joint Proposal, 76 FR 68,867; CFTC Proposal, 77 FR 
8352.
    \382\ See Joint Proposal, 76 FR 68,867; CFTC Proposal, 77 FR 
8352; Review of Antimanipulation Regulation of Securities Offering, 
Exchange Act Release No. 33924 (Apr. 19, 1994), 59 FR 21,681, 
21,684-21,685 (Apr. 26, 1994).
    \383\ The final rule does not provide safe harbors for 
particular distribution techniques. A safe harbor-based approach 
would provide certainty for specific types of offerings, but may not 
account for evolving market practices and distribution techniques 
that could technically satisfy a safe harbor but that might 
implicate the concerns that led Congress to enact section 13 of the 
BHC Act. See RBC.
    \384\ This clarification is intended to address commenters' 
concern regarding potential limitations on banking entities' ability 
to facilitate commercial paper offerings under the proposed 
underwriting exemption. See supra Part IV.A.2.c.1.b.i.
---------------------------------------------------------------------------

    The Agencies are also adopting a second prong to this definition, 
which will independently capture all offerings of securities that are 
made pursuant to an effective registration statement under the 
Securities Act.\385\ The registration prong of the definition is 
intended to provide another avenue by which an offering of securities 
may be conducted under the exemption, absent other special selling 
efforts and selling methods or a determination of whether such efforts 
and methods are being conducted. The Agencies believe this prong 
reduces potential administrative burdens by providing a bright-line 
test for what constitutes a distribution for purposes of the final 
rule. In addition, this prong is consistent with the purpose and goals 
of the statute because it reflects a common type of securities offering 
and does not raise evasion concerns as it is unlikely that an entity 
would go through the registration process solely to facilitate or 
engage in speculative proprietary trading.\386\ This prong would 
include, among other things, the following types of registered 
securities offerings: Offerings made pursuant to a shelf registration 
statement (whether on a continuous or delayed basis),\387\ bought 
deals,\388\ at the market offerings,\389\ debt offerings, asset-backed 
security offerings, initial public offerings, and other registered 
offerings. An offering can be a distribution for purposes of either 
Sec.  ----.4(a)(3)(i) or Sec.  ----.4(a)(3)(ii) of the final rule 
regardless of whether the offering is issuer driven, selling security 
holder driven, or arises as a result of a reverse inquiry.\390\ 
Provided the definition of distribution is met, an offering can be a 
distribution for purposes of this rule regardless of how it is 
conducted, whether by direct communication, exchange transactions, or 
automated execution system.\391\
---------------------------------------------------------------------------

    \385\ See, e.g., Form S-1 (17 CFR 239.11); Form S-3 (17 CFR 
239.13); Form S-8 (17 CFR 239.16b); Form F-1 (17 CFR 239.31); Form 
F-3 (17 CFR 239.33).
    \386\ Although the Agencies are providing an additional prong to 
the definition of ``distribution'' for registered offerings, the 
final rule does not limit the availability of the underwriting 
exemption to registered offerings, as suggested by one commenter. 
The statute does not include such an express limitation, and the 
Agencies decline to construe the statute to require such an 
approach. In response to the commenter stating that permitting a 
banking entity to participate in a private placement may facilitate 
evasion of the prohibition on proprietary trading, the Agencies 
believe this concern is addressed by the provision in the final rule 
requiring that a trading desk have a reasonable expectation of 
demand from other market participants for the amount and type of 
securities to be acquired from an issuer or selling security holder 
for distribution and make reasonable efforts to sell its 
underwriting position within a reasonable period. As discussed 
below, the Agencies believe this requirement in the final rule 
appropriately addresses evasion concerns that a banking entity may 
retain an unsold allotment for purely speculative purposes. Further, 
the Agencies believe that preventing a banking entity from 
facilitating a private offering could unnecessarily hinder capital-
raising without providing commensurate benefits because issuers use 
private offerings to raise capital in a variety of situations and 
the underwriting exemption's requirements limit the potential for 
evasion for both registered and private offerings, as noted above.
    \387\ See Securities Offering Reform, Securities Act Release No. 
8591 (July 19, 2005), 70 FR 44,722 (Aug. 3, 2005); 17 CFR 230.405 
(defining ``automatic shelf registration statement'' as a 
registration statement filed on Form S-3 (17 CFR 239.13) or Form F-3 
(17 CFR 239.33) by a well-known seasoned issuer pursuant to General 
Instruction I.D. or I.C. of such forms, respectively); 17 CFR 
230.415.
    \388\ A bought deal is a distribution technique whereby an 
underwriter makes a bid for securities without engaging in a 
preselling effort, such as book building or distribution of a 
preliminary prospectus. See, e.g., Delayed or Continuous Offering 
and Sale of Securities, Securities Act Release No. 6470 (June 9, 
1983), n.5.
    \389\ See, e.g., 17 CFR 230.415(a)(4) (defining ``at the market 
offering'' as ``an offering of equity securities into an existing 
trading market for outstanding shares of the same class at other 
than a fixed price''). At the market offerings may also be referred 
to as ``dribble out'' programs.
    \390\ Under the ``reverse inquiry'' process, an investor may be 
allowed to purchase securities from the issuer through an 
underwriter that is not designated in the prospectus as the issuer's 
agent by having such underwriter approach the issuer with an 
interest from the investor. See Joseph McLaughlin and Charles J. 
Johnson, Jr., ``Corporate Finance and the Securities Laws'' (4th ed. 
2006, supplemented 2012).
    \391\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------

    As discussed above, some commenters expressed concern that the 
proposed definition of ``distribution'' would prevent a banking entity 
from acquiring and reselling securities issued in lieu of or to 
refinance bridge loan facilities in reliance on the underwriting 
exemption. Bridge financing arrangements can be structured in many 
different ways, depending on the context and the specific objectives of 
the parties involved. As a result, the treatment of securities acquired 
in lieu of or to refinance a bridge loan and the subsequent sale of 
such securities under the final rule depends on the facts and 
circumstances. A banking entity may meet the terms of the underwriting 
exemption for its bridge loan activity, or it may be able to rely on 
the market-making exemption. If the banking entity's bridge loan 
activity does not qualify for an exemption under the rule, then it 
would not be permitted to engage in such activity.
iv. Definition of ``Underwriter''
    In response to comments, the Agencies are adopting certain 
modifications to the proposed definition of ``underwriter'' to better 
capture selling group members and to more closely resemble the 
definition of ``distribution participant'' in Regulation M. In 
particular, the Agencies are defining ``underwriter'' as: (i) A person 
who has agreed with an issuer or selling security holder to: (A) 
Purchase securities from the issuer or selling security holder for 
distribution; (B) engage in a distribution of securities for or on 
behalf of the issuer or selling security holder; or (C) manage a 
distribution of securities for or on behalf of the issuer or selling 
security holder; or (ii) a person who has agreed to participate or is 
participating in a distribution of such securities for or on behalf of 
the issuer or selling security holder.\392\
---------------------------------------------------------------------------

    \392\ See final rule Sec.  ----.4(a)(4).
---------------------------------------------------------------------------

    A number of commenters requested that the Agencies broaden the 
underwriting exemption to permit activities in connection with a 
distribution of securities by any distribution participant. A few of 
these commenters interpreted the proposed definition of ``underwriter'' 
as requiring a selling group member to have a written agreement with 
the underwriter

[[Page 5567]]

to participate in the distribution.\393\ These commenters noted that 
such a written agreement may not exist under all circumstances. The 
Agencies did not intend to require that members of the underwriting 
syndicate or the lead underwriter have a written agreement with all 
selling group members for each offering or that they be in privity of 
contract with the issuer or selling security holder. To provide clarity 
on this issue, the Agencies have modified the language of subparagraph 
(ii) of the definition to include firms that, while not members of the 
underwriting syndicate, have agreed to participate or are participating 
in a distribution of securities for or on behalf of the issuer or 
selling security holder.
---------------------------------------------------------------------------

    \393\ The basic documents in firm commitment underwritten 
securities offerings generally are: (i) The agreement among 
underwriters, which establishes the relationship among the managing 
underwriter, any co-managers, and the other members of the 
underwriting syndicate; (ii) the underwriting (or ``purchase'') 
agreement, in which the underwriters commit to purchase the 
securities from the issuer or selling security holder; and (iii) the 
selected dealers agreement, in which selling group members agree to 
certain provisions relating to the distribution. See Joseph 
McLaughlin and Charles J. Johnson, Jr., ``Corporate Finance and the 
Securities Laws'' (4th ed. 2006, supplemented 2012), Ch. 2. The 
Agencies understand that two firms may enter into a master agreement 
that governs all offerings in which both firms participate as 
members of the underwriting syndicate or as a member of the 
syndicate and a selling group member. See, e.g., SIFMA Master 
Selected Dealers Agreement (June 10, 2011), available at 
www.sifma.org.
---------------------------------------------------------------------------

    The final rule does not adopt a narrower definition of 
``underwriter,'' as suggested by two commenters.\394\ Although selling 
group members do not have a direct relationship with the issuer or 
selling security holder, they do help facilitate the successful 
distribution of securities to a wider variety of purchasers, such as 
regional or retail purchasers that members of the underwriting 
syndicate may not be able to access as easily. Thus, the Agencies 
believe it is consistent with the purpose of the statutory underwriting 
exemption and beneficial to recognize and allow the current market 
practice of an underwriting syndicate and selling group members 
collectively facilitating a distribution of securities. The Agencies 
note that because banking entities that are selling group members will 
be underwriters under the final rule, they will be subject to all the 
requirements of the underwriting exemption.
---------------------------------------------------------------------------

    \394\ See AFR et al. (Feb. 2012); Public Citizen.
---------------------------------------------------------------------------

    As provided in the preamble to the proposed rule, engaging in the 
following activities may indicate that a banking entity is acting as an 
underwriter under Sec.  ----.4(a)(4) as part of a distribution of 
securities:
     Assisting an issuer in capital-raising;
     Performing due diligence;
     Advising the issuer on market conditions and assisting in 
the preparation of a registration statement or other offering document;
     Purchasing securities from an issuer, a selling security 
holder, or an underwriter for resale to the public;
     Participating in or organizing a syndicate of investment 
banks;
     Marketing securities; and
     Transacting to provide a post-issuance secondary market 
and to facilitate price discovery.\395\
---------------------------------------------------------------------------

    \395\ See Joint Proposal, 76 FR 68,867; CFTC Proposal, 77 FR 
8352. Post-issuance secondary market activity is expected to be 
conducted in accordance with the market-making exemption.

The Agencies continue to take the view that the precise activities 
performed by an underwriter will vary depending on the liquidity of the 
securities being underwritten and the type of distribution being 
conducted. A banking entity is not required to engage in each of the 
above-noted activities to be considered an underwriter for purposes of 
this rule. In addition, the Agencies note that, to the extent a banking 
entity does not meet the definition of ``underwriter'' in the final 
rule, it may be able to rely on the market-making exemption in the 
final rule for its trading activity. In response to comments noting 
that APs for ETFs do not engage in certain of these activities and 
inquiring whether an AP would be able to qualify for the underwriting 
exemption for certain of its activities, the Agencies believe that many 
AP activities, such as conducting general creations and redemptions of 
ETF shares, are better suited for analysis under the market-making 
exemption because they are driven by the demands of other market 
participants rather than the issuer, the ETF.\396\ Whether an AP may 
rely on the underwriting exemption for its activities in an ETF will 
depend on the facts and circumstances, including, among other things, 
whether the AP meets the definition of ``underwriter'' and the offering 
of ETF shares qualifies as a ``distribution.''
---------------------------------------------------------------------------

    \396\ See infra Part IV.A.3.

    To provide further clarity about the scope of the definition of 
``underwriter,'' the Agencies are defining the terms ``selling security 
holder'' and ``issuer'' in the final rule. The Agencies are using the 
definition of ``issuer'' from the Securities Act because this 
definition is commonly used in the context of securities offerings and 
is well understood by market participants.\397\ A ``selling security 
holder'' is defined as ``any person, other than an issuer, on whose 
behalf a distribution is made.'' \398\ This definition is consistent 
with the definition of ``selling security holder'' found in the SEC's 
Regulation M.\399\
---------------------------------------------------------------------------

    \397\ See final rule Sec.  ----.3(e)(9) (defining the term 
``issuer'' for purposes of the proprietary trading provisions in 
subpart B of the final rule). Under section 2(a)(4) of the 
Securities Act, ``issuer'' is defined as ``every person who issues 
or proposes to issue any security; except that with respect to 
certificates of deposit, voting-trust certificates, or collateral-
trust certificates, or with respect to certificates of interest or 
shares in an unincorporated investment trust not having a board of 
directors (or persons performing similar functions) or of the fixed, 
restricted management, or unit type, the term `issuer' means the 
person or persons performing the acts and assuming the duties of 
depositor or manager pursuant to the provisions of the trust or 
other agreement or instrument under which such securities are 
issued; except that in the case of an unincorporated association 
which provides by its articles for limited liability of any or all 
of its members, or in the case of a trust, committee, or other legal 
entity, the trustees or members thereof shall not be individually 
liable as issuers of any security issued by the association, trust, 
committee, or other legal entity; except that with respect to 
equipment-trust certificates or like securities, the term `issuer' 
means the person by whom the equipment or property is or is to be 
used; and except that with respect to fractional undivided interests 
in oil, gas, or other mineral rights, the term `issuer' means the 
owner of any such right or of any interest in such right (whether 
whole or fractional) who creates fractional interests therein for 
the purpose of public offering.'' 15 U.S.C. 77b(a)(4).
    \398\ Final rule Sec.  ----.4(a)(5).
    \399\ See 17 CFR 242.100(b).
---------------------------------------------------------------------------

v. Activities Conducted ``in Connection With'' a Distribution
    As discussed above, several commenters expressed concern that the 
proposed underwriting exemption would not allow a banking entity to 
engage in certain auxiliary activities that may be conducted in 
connection with acting as an underwriter for a distribution of 
securities in the normal course. These commenters' concerns generally 
arose from the use of the word ``solely'' in Sec.  ----.4(a)(2)(iii) of 
the proposed rule, which commenters noted was not included in the 
statute's underwriting exemption.\400\ In addition, a number of 
commenters discussed particular activities they believed should be 
permitted under the underwriting exemption and indicated the term 
``solely'' created uncertainty about whether such activities would be 
permitted.\401\
---------------------------------------------------------------------------

    \400\ See supra Part IV.A.2.c.1.b.iii.
    \401\ See supra notes 357, 358, 363-372 and accompanying text.
---------------------------------------------------------------------------

    To reduce uncertainty in response to comments, the final rule 
requires a trading desk's underwriting position to be ``held . . . and 
managed . . . in connection with'' a single distribution

[[Page 5568]]

for which the relevant banking entity is acting as an underwriter, 
rather than requiring that a purchase or sale be ``effected solely in 
connection with'' such a distribution. Importantly, for purposes of 
establishing an underwriting position in reliance on the underwriting 
exemption, a trading desk may only engage in activities that are 
related to a particular distribution of securities for which the 
banking entity is acting as an underwriter. Activities that may be 
permitted under the underwriting exemption include stabilization 
activities,\402\ syndicate shorting and aftermarket short 
covering,\403\ holding an unsold allotment when market conditions may 
make it impracticable to sell the entire allotment at a reasonable 
price at the time of the distribution and selling such position when it 
is reasonable to do so,\404\ and helping the issuer mitigate its risk 
exposure arising from the distribution of its securities (e.g., 
entering into a call-spread option with an issuer as part of a 
convertible debt offering to mitigate dilution to existing 
shareholders).\405\ Such activities should be intended to effectuate 
the distribution process and provide benefits to issuers, selling 
security holders, or purchasers in the distribution. Existing laws, 
regulations, and self-regulatory organization rules limit or place 
certain requirements around many of these activities. For example, an 
underwriter's subsequent sale of an unsold allotment must comply with 
applicable provisions of the federal securities laws and the rules 
thereunder. Moreover, any position resulting from these activities must 
be included in the trading desk's underwriting position, which is 
subject to a number of restrictions in the final rule. Specifically, as 
discussed in more detail below, the trading desk must make reasonable 
efforts to sell or otherwise reduce its underwriting position within a 
reasonable period,\406\ and each trading desk must have robust limits 
on, among other things, the amount, types, and risks of its 
underwriting position and the period of time a security may be 
held.\407\ Thus, in general, the underwriting exemption would not 
permit a trading desk, for example, to acquire a position as part of 
its stabilization activities and hold that position for an extended 
period.
---------------------------------------------------------------------------

    \402\ See SIFMA et al. (Prop. Trading) (Feb. 2012). See Anti-
Manipulation Rules Concerning Securities Offerings, Exchange Act 
Release No. 38067 (Dec. 20, 1996), 62 FR 520, 535 (Jan. 3, 1997) 
(``Although stabilization is price-influencing activity intended to 
induce others to purchase the offered security, when appropriately 
regulated it is an effective mechanism for fostering an orderly 
distribution of securities and promotes the interests of 
shareholders, underwriters, and issuers.'').
    \403\ See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; Goldman 
(Prop. Trading). See Proposed Amendments to Regulation M: Anti-
Manipulation Rules Concerning Securities Offerings, Exchange Act 
Release No. 50831 (Dec. 9, 2004), 69 FR 75,774, 75,780 (Dec. 17, 
2004) (``In the typical offering, the syndicate agreement allows the 
managing underwriter to `oversell' the offering, i.e., establish a 
short position beyond the number of shares to which the underwriting 
commitment relates. The underwriting agreement with the issuer often 
provides for an `overallotment option' whereby the syndicate can 
purchase additional shares from the issuer or selling shareholders 
in order to cover its short position. To the extent that the 
syndicate short position is in excess of the overallotment option, 
the syndicate is said to have taken an `uncovered' short position. 
The syndicate short position, up to the amount of the overallotment 
option, may be covered by exercising the option or by purchasing 
shares in the market once secondary trading begins.'').
    \404\ See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; BoA; 
BDA (Feb. 2012).
    \405\ See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; Goldman 
(Prop. Trading).
    \406\ See final rule Sec.  ----.4(a)(2)(ii); infra Part 
IV.A.2.c.2.c. (discussing the requirement to make reasonable efforts 
to sell or otherwise reduce the underwriting position).
    \407\ See final rule Sec.  ----.4(a)(2)(iii)(B); infra Part 
IV.A.2.c.3.c. (discussing the required limits for trading desks 
engaged in underwriting activity).
---------------------------------------------------------------------------

    This approach does not mean that any activity that is arguably 
connected to a distribution of securities is permitted under the 
underwriting exemption. Certain activities noted by commenters are not 
core to the underwriting function and, thus, are not permitted under 
the final underwriting exemption. However, a banking entity may be able 
to rely on another exemption for such activities (e.g., the market-
making or hedging exemptions), if applicable. For example, a trading 
desk would not be able to use the underwriting exemption to purchase a 
financial instrument from a customer to facilitate the customer's 
ability to buy securities in the distribution.\408\ Further, purchasing 
another financial instrument to help determine how to price the 
securities that are subject to a distribution would not be permitted 
under the underwriting exemption.\409\ These two activities may be 
permitted under the market-making exemption, depending on the facts and 
circumstances. In response to one commenter's suggestion that hedging 
the underwriter's risk exposure be permissible under this exemption, 
the Agencies emphasize that hedging the underwriter's risk exposure is 
not permitted under the underwriting exemption.\410\ A banking entity 
must comply with the hedging exemption for such activity.
---------------------------------------------------------------------------

    \408\ See Wells Fargo (Prop. Trading). The Agencies do not 
believe this activity is consistent with underwriting activity 
because it could result in an underwriting desk holding a variety of 
positions over time that are not directly related to a distribution 
of securities the desk is conducting on behalf of an issuer or 
selling security holder. Further, the Agencies believe this activity 
may be more appropriately analyzed under the market-making exemption 
because market makers generally purchase or sell a financial 
instrument at the request of customers and otherwise routinely stand 
ready to purchase and sell a variety of related financial 
instruments.
    \409\ See id. The Agencies view this activity as inconsistent 
with underwriting because underwriters typically engage in other 
activities, such as book-building and other marketing efforts, to 
determine the appropriate price for a security and these activities 
do not involve taking positions that are unrelated to the securities 
subject to distribution. See infra IV.A.2.c.2.
    \410\ Although one commenter suggested that an underwriter's 
hedging activity be permitted under the underwriting exemption, we 
do not believe the requirements in the proposed hedging exemption 
would be unworkable or overly burdensome in the context of an 
underwriter's hedging activity. See Goldman (Prop. Trading). As 
noted above, underwriting activity is of a relatively distinct 
nature, which is substantially different from market-making 
activity, which is more dynamic and involves more frequent trading 
activity giving rise to a variety of positions that may naturally 
hedge the risks of certain other positions. The Agencies believe it 
is appropriate to require that a trading desk comply with the 
requirements of the hedging exemption when it is hedging the risks 
of its underwriting position, while allowing a trading desk's market 
making-related hedging under the market-making exemption.
---------------------------------------------------------------------------

    In response to comments about the sale of a security to an 
intermediate entity in connection with a structured finance 
product,\411\ the Agencies have not modified the underwriting 
exemption. Underwriting is distinct from product development. Thus, 
parties must adjust activities associated with developing structured 
finance products or meet the terms of other available exemptions. 
Similarly, the accumulation of securities or other assets in 
anticipation of a securitization or resecuritization is not an activity 
conducted ``in connection with'' underwriting for purposes of the 
exemption.\412\ This activity is typically engaged in by an issuer or 
sponsor of a securitized product in that capacity, rather than in the 
capacity of an underwriter. The underwriting exemption only permits a 
banking entity's activities when it is acting as an underwriter.
---------------------------------------------------------------------------

    \411\ See ICI (Feb. 2012); AFR et al. (Feb. 2012); Occupy; 
Alfred Brock.
    \412\ A banking entity may accumulate loans in anticipation of 
securitization because loans are not financial instruments under the 
final rule. See supra Part IV.A.1.c.
---------------------------------------------------------------------------

2. Near Term Customer Demand Requirement
a. Proposed Near Term Customer Demand Requirement
    Like the statute, Sec.  ----.4(a)(2)(v) of the proposed rule 
required that the underwriting activities of the banking entity with 
respect to the covered

[[Page 5569]]

financial position be designed not to exceed the reasonably expected 
near term demands of clients, customers, or counterparties.\413\
---------------------------------------------------------------------------

    \413\ See proposed rule Sec.  ----.4(a)(2)(v); Joint Proposal, 
76 FR 68,867; CFTC Proposal, 77 FR 8353.
---------------------------------------------------------------------------

b. Comments Regarding the Proposed Near Term Customer Demand 
Requirement
    Both the statute and the proposed rule require a banking entity's 
underwriting activity to be ``designed not to exceed the reasonably 
expected near term demands of clients, customers, or counterparties.'' 
\414\ Several commenters requested that this standard be interpreted in 
a flexible manner to allow a banking entity to participate in an 
offering that may require it to retain an unsold allotment for a period 
of time.\415\ In addition, one commenter stated that the final rule 
should provide flexibility in this standard by recognizing that the 
concept of ``near term'' differs between asset classes and depends on 
the liquidity of the market.\416\ Two commenters expressed views on how 
the near term customer demand requirement should work in the context of 
a securitization or creating what the commenters characterized as 
``structured products'' or ``structured instruments.'' \417\
---------------------------------------------------------------------------

    \414\ See supra Part IV.A.2.c.2.a.
    \415\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; BDA 
(Feb. 2012); RBC. Another commenter requested that this requirement 
be eliminated or changed to ``underwriting activities of the banking 
entity with respect to the covered financial position must be 
designed to meet the near-term demands of clients, customers, or 
counterparties.'' See Japanese Bankers Ass'n.
    \416\ See RBC (stating that the Board has found acceptable the 
retention of assets acquired in connection with underwriting 
activities for a period of 90 to 180 days and has further permitted 
holding periods of up to a year in certain circumstances, such as 
for less liquid securities).
    \417\ See AFR et al. (Feb. 2012); Sens. Merkley & Levin (Feb. 
2012).
---------------------------------------------------------------------------

    Many commenters expressed concern that the proposed requirement, if 
narrowly interpreted, could prevent an underwriter from holding a 
residual position for which there is no immediate demand from clients, 
customers, or counterparties.\418\ Commenters noted that there are a 
variety of offerings that present some risk of an underwriter having to 
hold a residual position that cannot be sold in the initial 
distribution, including ``bought deals,'' \419\ rights offerings,\420\ 
and fixed-income offerings.\421\ A few commenters noted that similar 
scenarios can arise in the case of an AP creating more shares of an ETF 
than it can sell \422\ and bridge loans.\423\ Two commenters indicated 
that if the rule does not provide greater clarity and flexibility with 
respect to the near term customer demand requirement, a banking entity 
may be less inclined to participate in a distribution where there is 
the potential risk of an unsold allotment, may price such risk into the 
fees charged to underwriting clients, or may be forced into a ``fire 
sale'' of the unsold allotment.\424\
---------------------------------------------------------------------------

    \418\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; BDA 
(Feb. 2012); RBC.
    \419\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; RBC. 
These commenters generally stated that an underwriter for a ``bought 
deal'' may end up with an unsold allotment because, pursuant to this 
type of offering, an underwriter makes a commitment to purchase 
securities from an issuer or selling security holder, without pre-
commitment marketing to gauge customer interest, in order to provide 
greater speed and certainty of execution. See SIFMA et al. (Prop. 
Trading) (Feb. 2012); RBC.
    \420\ See SIFMA et al. (Prop. Trading) (Feb. 2012) (representing 
that because an underwriter generally backstops a rights offering by 
committing to exercise any rights not exercised by shareholders, the 
underwriter may end up holding a residual portion of the offering if 
investors do not exercise all of the rights).
    \421\ See BDA (Feb. 2012). This commenter stated that 
underwriters frequently underwrite bonds in the fixed-income market 
knowing that they may need to retain unsold allotments in their 
inventory. The commenter indicated that this scenario arises because 
the fixed-income market is not as deep as other markets, so 
underwriters frequently cannot sell bonds when they go to market; 
instead, the underwriters will retain the bonds until a sufficient 
amount of liquidity is available in the market. See id.
    \422\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA.
    \423\ See BoA; RBC; LSTA (Feb. 2012). One of these commenters 
stated that, in the case of securities issued in lieu of or to 
refinance bridge loan facilities, market conditions or investor 
demand may change during the period of time between extension of the 
bridge commitment and when the bridge loan is required to be funded 
or such securities are required to be issued. As a result, this 
commenter requested that the near term demands of clients, 
customers, or counterparties be measured at the time of the initial 
extension of the bridge commitment. See LSTA (Feb. 2012).
    \424\ See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC.
---------------------------------------------------------------------------

    Several other commenters provided views on whether a banking entity 
should be able to hold a residual position from an offering pursuant to 
the underwriting exemption, although they did not generally link their 
comments to the proposed near term demand requirement.\425\ Many of 
these commenters expressed concern about permitting a banking entity to 
retain a portion of an underwriting and noted potential risks that may 
arise from such activity.\426\ For example, some of these commenters 
stated that retention or warehousing of underwritten securities can be 
an indication of impermissible proprietary trading intent (particularly 
if systematic), or may otherwise result in high-risk exposures or 
conflicts of interests.\427\ One of these commenters recommended the 
Agencies use a metric to monitor the size of residual positions 
retained by an underwriter,\428\ while another commenter suggested 
adding a requirement to the proposed exemption to provide that a 
``substantial'' unsold or retained allotment would be an indication of 
prohibited proprietary trading.\429\ Similarly, one commenter 
recommended that the Agencies consider whether there are sufficient 
provisions in the proposed rule to reduce the risks posed by banking 
entities retaining or warehousing underwritten instruments, such as 
subprime mortgages, collateralized debt obligation tranches, and high 
yield debt of leveraged buyout issuers, which poses heightened 
financial risk at the top of economic cycles.\430\
---------------------------------------------------------------------------

    \425\ See AFR et al. (Feb. 2012); CalPERS; Occupy; Public 
Citizen; Goldman (Prop. Trading); Fidelity; Japanese Bankers Ass'n.; 
Sens. Merkley & Levin (Feb. 2012); Alfred Brock.
    \426\ See AFR et al. (Feb. 2012); CalPERS; Occupy; Public 
Citizen; Alfred Brock.
    \427\ See AFR et al. (Feb. 2012) (recognizing, however, that a 
small portion of an underwriting may occasionally be ``hung''); 
CalPERS; Occupy (stating that a banking entity's retention of unsold 
allotments may result in potential conflicts of interest).
    \428\ See AFR et al. (Feb. 2012).
    \429\ See Occupy (stating that the meaning of the term 
``substantial'' would depend on the circumstances of the particular 
offering).
    \430\ See CalPERS.
---------------------------------------------------------------------------

    Other commenters indicated that undue restrictions on an 
underwriter's ability to retain a portion of an offering may result in 
certain harms to the capital-raising process. These commenters 
represented that unclear or negative treatment of residual positions 
will make banking entities averse to the risk of an unsold allotment, 
which may result in banking entities underwriting smaller offerings, 
less capital generation for issuers, or higher underwriting discounts, 
which would increase the cost of raising capital for businesses.\431\ 
One of these commenters suggested that a banking entity be permitted to 
hold a residual position under the underwriting exemption as long as it 
continues to take reasonable steps to attempt to dispose of the 
residual position in light of existing market conditions.\432\
---------------------------------------------------------------------------

    \431\ See Goldman (Prop. Trading); Fidelity (expressing concern 
that this may result in a more concentrated supply of securities 
and, thus, decrease the opportunity for diversification in the 
portfolios of shareholders' funds).
    \432\ See Goldman (Prop. Trading).
---------------------------------------------------------------------------

    In addition, in response to a question in the proposal, one 
commenter

[[Page 5570]]

expressed the view that the rule should not require documentation with 
respect to residual positions held by an underwriter.\433\ In the case 
of securitizations, one commenter stated that if the underwriter wishes 
to retain some of the securities or bonds in its longer-term investment 
book, such decisions should be made by a separate officer, subject to 
different standards and compensation.\434\
---------------------------------------------------------------------------

    \433\ See Japanese Bankers Ass'n.
    \434\ See Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------

    Two commenters discussed how the near term customer demand 
requirement should apply in the context of a banking entity acting as 
an underwriter for a securitization or structured product.\435\ One of 
these commenters indicated that the near term demand requirement should 
be interpreted to require that a distribution of securities facilitate 
pre-existing client demand. This commenter stated that a banking entity 
should not be considered to meet the terms of the proposed requirement 
if, on the firm's own initiative, it designs and structures a complex, 
novel instrument and then seeks customers for the instrument, while 
retaining part of the issuance on its own book. The commenter further 
emphasized that underwriting should involve two-way demand--clients who 
want assistance in marketing their securities and customers who may 
wish to purchase the securities--with the banking entity serving as an 
intermediary.\436\ Another commenter indicated that an underwriting 
should likely be seen as a distribution of all, or nearly all, of the 
securities related to a securitization (excluding any amount required 
for credit risk retention purposes) along a time line designed not to 
exceed reasonably expected near term demands of clients, customers, or 
counterparties. According to the commenter, this approach would serve 
to minimize the arbitrage and risk concentration possibilities that can 
arise through the securitization and sale of some tranches and the 
retention of other tranches.\437\
---------------------------------------------------------------------------

    \435\ See AFR et al. (Feb. 2012); Sens. Merkley & Levin (Feb. 
2012).
    \436\ See AFR et al. (Feb. 2012)
    \437\ See Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------

    One commenter expressed concern that the proposed near term 
customer demand requirement may impact a banking entity's ability to 
act as primary dealer because some primary dealers are obligated to bid 
on each issuance of a government's sovereign debt, without regard to 
expected customer demand.\438\ Two other commenters expressed general 
concern that the proposed underwriting exemption may be too narrow to 
permit banking entities that act as primary dealers in or for foreign 
jurisdictions to continue to meet the relevant jurisdiction's primary 
dealer requirements.\439\
---------------------------------------------------------------------------

    \438\ See Banco de M[eacute]xico.
    \439\ See SIFMA et al. (Prop. Trading) (Feb. 2012); IIB/EBF. One 
of these commenters represented that many banking entities serve as 
primary dealers in jurisdictions in which they operate, and primary 
dealers often: (i) Are subject to minimum purchase and other 
obligations in the jurisdiction's foreign sovereign debt; (ii) play 
important roles in underwriting and market making in State, 
provincial, and municipal debt issuances; and (iii) act as 
intermediaries through which a government's financial and monetary 
policies operate. This commenter stated that, due to these 
considerations, restrictions on the ability of banking entities to 
act as primary dealer are likely to harm the governments they serve. 
See IIB/EBF.
---------------------------------------------------------------------------

c. Final Near Term Customer Demand Requirement
    The final rule requires that the amount and types of the securities 
in the trading desk's underwriting position be designed not to exceed 
the reasonably expected near term demands of clients, customers, or 
counterparties, and reasonable efforts be 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.\440\ As noted above, the near term demand 
standard originates from section 13(d)(1)(B) of the BHC Act, and a 
similar requirement was included in the proposed rule.\441\ The 
Agencies are making certain modifications to the proposed approach in 
response to comments.
---------------------------------------------------------------------------

    \440\ Final rule Sec.  ----.4(a)(2)(ii).
    \441\ The proposed rule required the underwriting activities of 
the banking entity with respect to the covered financial position to 
be designed not to exceed the reasonably expected near term demands 
of clients, customers, or counterparties. See proposed rule Sec.  --
--.4(a)(2)(v).
---------------------------------------------------------------------------

    In particular, the Agencies are clarifying the operation of this 
requirement, particularly with respect to unsold allotments.\442\ Under 
this requirement, a trading desk must have a reasonable expectation of 
demand from other market participants for the amount and type of 
securities to be acquired from an issuer or selling security holder for 
distribution.\443\ Such reasonable expectation may be based on factors 
such as current market conditions and prior experience with similar 
offerings of securities. A banking entity is not required to engage in 
book-building or similar marketing efforts to determine investor demand 
for the securities pursuant to this requirement, although such efforts 
may form the basis for the trading desk's reasonable expectation of 
demand. While an issuer or selling security holder can be considered to 
be a client, customer, or counterparty of a banking entity acting as an 
underwriter for its distribution of securities, this requirement cannot 
be met by accounting solely for the issuer's or selling security 
holder's desire to sell the securities.\444\ However, the expectation 
of demand does not require a belief that the securities will be placed 
immediately. The time it takes to carry out a distribution may differ 
based on the liquidity, maturity, and depth of the market for the type 
of security.\445\
---------------------------------------------------------------------------

    \442\ See supra Part IV.A.2.c.2.b. (discussing commenters' 
concerns that the proposed near term customer demand requirement may 
limit a banking entity's ability to retain an unsold allotment).
    \443\ A banking entity may not structure a complex instrument on 
its own initiative using the underwriting exemption. It may use the 
underwriting exemption only with respect to distributions of 
securities that comply with the final rule. The Agencies believe 
this requirement addresses one commenter's concern that a banking 
entity could rely on the underwriting exemption without regard to 
anticipated customer demand. See AFR et al. (Feb. 2012) In addition, 
a trading desk hedging the risks of an underwriting position in a 
complex, novel instrument must comply with the hedging exemption in 
the final rule.
    \444\ An issuer or selling security holder for purposes of this 
rule may include, among others, corporate issuers, sovereign issuers 
for which the banking entity acts as primary dealer (or functional 
equivalent), or any other person that is an issuer, as defined in 
final rule Sec.  ----.3(e)(9), or a selling security holder, as 
defined in final rule Sec.  ----.4(a)(5). The Agencies believe that 
the underwriting exemption in the final rule should generally allow 
a primary dealer (or functional equivalent) to act as an underwriter 
for a sovereign government's issuance of its debt because, similar 
to other underwriting activities, this involves a banking entity 
agreeing to distribute securities for an issuer (in this case, the 
foreign sovereign) and engaging in a distribution of such 
securities. See SIFMA et al. (Prop. Trading) (Feb. 2012); IIB/EBF; 
Banco de M[eacute]xico. A banking entity acting as primary dealer 
(or functional equivalent) may also be able to rely on the market-
making exemption or other exemptions for some of its activities. See 
infra Part IV.A.3.c.2.c. The final rule defines ``client, customer, 
or counterparty'' for purposes of the underwriting exemption as 
``market participants that may transact with the banking entity in 
connection with a particular distribution for which the banking 
entity is acting as underwriter.'' Final rule Sec.  ----.4(a)(7).
    \445\ One commenter stated that, in the case of a 
securitization, an underwriting should be seen as a distribution of 
all, or nearly all, of the securities related to a securitization 
(excluding the amount required for credit risk retention purposes) 
along a time line designed not to exceed the reasonably expected 
near term demands of clients, customers, or counterparties. See 
Sens. Merkley & Levin (Feb. 2012). The final rule's near term 
customer demand requirement considers the liquidity, maturity, and 
depth of the market for the type of security and recognizes that the 
amount of time a trading desk may need to hold an underwriting 
position may vary based on these factors. The final rule does not, 
however, adopt a standard that applies differently based solely on 
the particular type of security being distributed (e.g., an asset-
backed security versus an equity security) or that precludes certain 
types of securities from being distributed by a banking entity 
acting as an underwriter in accordance with the requirements of this 
exemption because the Agencies believe the statute is best read to 
permit a banking entity to engage in underwriting activity to 
facilitate distributions of securities by issuers and selling 
security holders, regardless of type, to provide client-oriented 
financial services. That reading is consistent with the statute's 
language and finds support in the legislative history. See 156 Cong. 
Rec. S5895-S5896 (daily ed. July 15, 2010) (statement of Sen. 
Merkley) (stating that the underwriting exemption permits 
``transactions that are technically trading for the account of the 
firm but, in fact, facilitate the provision of near-term client-
oriented financial services''). In addition, with respect to this 
commenter's statement regarding credit risk retention requirements, 
the Agencies note that compliance with the credit risk retention 
requirements of Section 15G of the Exchange Act would not impact the 
availability of the underwriting exemption in the final rule.

---------------------------------------------------------------------------

[[Page 5571]]

    This requirement is not intended to prevent a trading desk from 
distributing an offering over a reasonable time consistent with market 
conditions or from retaining an unsold allotment of the securities 
acquired from an issuer or selling security holder where holding such 
securities is necessary due to circumstances such as less-than-expected 
purchaser demand at a given price.\446\ An unsold allotment is, 
however, subject to the requirement to make reasonable efforts to sell 
or otherwise reduce the underwriting position.\447\ The definition of 
``underwriting position'' includes, among other things, any residual 
position from the distribution that is managed by the trading desk. The 
final rule includes the requirement to make reasonable efforts to sell 
or otherwise reduce the trading desk's underwriting position in order 
to respond to comments on the issue of when a banking entity may retain 
an unsold allotment when it is acting as an underwriter, as discussed 
in more detail below, and ensure that the exemption is available only 
for activities that involve underwriting activities, and not prohibited 
proprietary trading.\448\
---------------------------------------------------------------------------

    \446\ This approach should help address commenters' concerns 
that an inflexible interpretation of the near term demand 
requirement could result in fire sales, higher fees for underwriting 
services, or reluctance to act as an underwriter for certain types 
of distributions that present a greater risk of unsold allotments. 
See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC. Further, the 
Agencies believe this should reduce commenters' concerns that, to 
the extent a delayed distribution of securities, which are acquired 
as a result of an outstanding bridge loan, is able to qualify for 
the underwriting exemption, a stringent interpretation of the near 
term demand requirement could prevent a banking entity from 
retaining such securities if market conditions are suboptimal or 
marketing efforts are not entirely successful. See RBC; BoA; LSTA 
(Feb. 2012). In response to one commenter's request that the 
Agencies allow a banking entity to assess near term demand at the 
time of the initial extension of the bridge commitment, the Agencies 
believe it could be appropriate to determine whether the banking 
entity has a reasonable expectation of demand from other market 
participants for the amount and type of securities to be acquired at 
that time, but note that the trading desk would continue to be 
subject to the requirement to make reasonable efforts to sell the 
resulting underwriting position at the time of the initial 
distribution and for the remaining time the securities are in its 
inventory. See LSTA (Feb. 2012).
    \447\ The Agencies believe that requiring a trading desk to make 
reasonable efforts to sell or otherwise reduce its underwriting 
position addresses commenters' concerns about the risks associated 
with unsold allotments or the retention of underwritten instruments 
because this requirement is designed to prevent a trading desk from 
retaining an unsold allotment for speculative purposes when there is 
customer buying interest for the relevant security at commercially 
reasonable prices. Thus, the Agencies believe this obviates the need 
for certain additional requirements suggested by commenters. See, 
e.g., Occupy; AFR et al. (Feb. 2012); CalPERS. The final rule 
strikes an appropriate balance between the concerns raised by these 
commenters and those noted by other commenters regarding the 
potential market impacts of strict requirements against holding an 
unsold allotment, such as higher fees to underwriting clients, fire 
sales of unsold allotments, or general reluctance to participate in 
any distribution that presents a risk of an unsold allotment. The 
requirement to make reasonable efforts to sell or otherwise reduce 
the underwriting position should not cause the market impacts 
predicted by these commenters because it does not prevent an 
underwriter from retaining an unsold allotment for a reasonable 
period or impose strict holding period limits on unsold allotments. 
See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; Goldman (Prop. 
Trading); Fidelity.
    \448\ This approach is generally consistent with one commenter's 
suggested approach to addressing the issue of unsold allotments. 
See, e.g., Goldman (Prop. Trading) (suggesting that a banking entity 
be permitted to hold a residual position under the underwriting 
exemption as long as it continues to take reasonable steps to 
attempt to dispose of the residual position in light of existing 
market conditions). In addition, allowing an underwriter to retain 
an unsold allotment under certain circumstances is consistent with 
the proposal. See Joint Proposal, 76 FR 68,867 (``There may be 
circumstances in which an underwriter would hold securities that it 
could not sell in the distribution for investment purposes. If the 
acquisition of such unsold securities were in connection with the 
underwriting pursuant to the permitted underwriting activities 
exemption, the underwriter would also be able to dispose of such 
securities at a later time.''); CFTC Proposal, 77 FR 8352. A number 
of commenters raised questions about whether the rule would permit 
retaining an unsold allotment. See Goldman (Prop. Trading); 
Fidelity; SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; RBC; AFR et 
al. (Feb. 2012); CalPERS; Occupy; Public Citizen; Alfred Brock.
---------------------------------------------------------------------------

    As a general matter, commenters expressed differing views on 
whether an underwriter should be permitted to hold an unsold allotment 
for a certain period of time after the initial distribution. For 
example, a few commenters suggested that limitations on retaining an 
unsold allotment would increase the cost of raising capital \449\ or 
would negatively impact certain types of securities offerings (e.g., 
bought deals, rights offerings, and fixed-income offerings).\450\ Other 
commenters, however, expressed concern that the proposed exemption 
would allow a banking entity to retain a portion of a distribution for 
speculative purposes.\451\
---------------------------------------------------------------------------

    \449\ See Goldman (Prop. Trading); Fidelity.
    \450\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; RBC.
    \451\ See AFR et al. (Feb. 2012); CalPERS; Occupy; Public 
Citizen; Alfred Brock.
---------------------------------------------------------------------------

    The Agencies believe the requirement to make reasonable efforts to 
sell or otherwise reduce the underwriting position appropriately 
addresses both sets of comments. More specifically, this standard 
clarifies that an underwriter generally may retain an unsold allotment 
that it was unable to sell to purchasers as part of the initial 
distribution of securities, provided it had a reasonable expectation of 
buying interest and engaged in reasonable selling efforts.\452\ This 
should reduce the potential for the negative impacts of a more 
stringent approach predicted by commenters, such as increased fees for 
underwriting, greater costs to businesses for raising capital, and 
potential fire sales of unsold allotments.\453\ However, to address 
concerns that a banking entity may retain an unsold allotment for 
purely speculative purposes, the Agencies are requiring that reasonable 
efforts be made to sell or otherwise reduce the underwriting position, 
which includes any unsold allotment, within a reasonable period. The 
Agencies agree with these commenters that systematic retention of an 
underwriting position, without engaging in efforts to sell the position 
and without regard to whether the trading desk is able to sell the 
securities at a commercially reasonable price, would be indicative of 
impermissible proprietary trading intent.\454\ The Agencies recognize 
that the meaning of ``reasonable period'' may differ based on the 
liquidity, maturity, and depth of the market for the relevant type of 
securities. For example, an underwriter may be more likely to retain an 
unsold allotment in a bond offering because liquidity in the fixed-
income market is generally not as deep as that in the equity market. If 
a trading desk retains an underwriting position for a period of time 
after the distribution, the trading desk must manage the risk of its 
underwriting position in accordance with its inventory and risk limits 
and authorization procedures. As discussed above, hedging transactions 
undertaken in connection with such risk management activities must be 
conducted in compliance with the

[[Page 5572]]

hedging exemption in Sec.  ----.5 of the final rule.
---------------------------------------------------------------------------

    \452\ To the extent that an AP for an ETF is able to meet the 
terms of the underwriting exemption for its activity, it may be able 
to retain ETF shares that it created if it had a reasonable 
expectation of buying interest in the ETF shares and engages in 
reasonable efforts to sell the ETF shares. See SIFMA et al. (Prop. 
Trading) (Feb. 2012); BoA.
    \453\ See Goldman (Prop. Trading); Fidelity; SIFMA et al. (Prop. 
Trading) (Feb. 2012); RBC.
    \454\ See AFR et al. (Feb. 2012); CalPERS; Occupy.
---------------------------------------------------------------------------

    The Agencies emphasize that the requirement to make reasonable 
efforts to sell or otherwise reduce the underwriting position applies 
to the entirety of the trading desk's underwriting position. As a 
result, this requirement applies to a number of different scenarios in 
which an underwriter may hold a long or short position in the 
securities that are the subject of a distribution for a period of time. 
For example, if an underwriter is facilitating a distribution of 
securities for which there is sufficient investor demand to purchase 
the securities at the offering price, this requirement would prevent 
the underwriter from retaining a portion of the allotment for its own 
account instead of selling the securities to interested investors. If 
instead there was insufficient investor demand at the time of the 
initial offering, this requirement would recognize that it may be 
appropriate for the underwriter to hold an unsold allotment for a 
reasonable period of time. Under these circumstances, the underwriter 
would need to make reasonable efforts to sell the unsold allotment when 
there is sufficient market demand for the securities.\455\ This 
requirement would also apply in situations where the underwriters sell 
securities in excess of the number of securities to which the 
underwriting commitment relates, resulting in a syndicate short 
position in the same class of securities that were the subject of the 
distribution.\456\ This provision of the final exemption would require 
reasonable efforts to reduce any portion of the syndicate short 
position attributable to the banking entity that is acting as an 
underwriter. Such reduction could be accomplished if, for example, the 
managing underwriter exercises an overallotment option or shares are 
purchased in the secondary market to cover the short position.
---------------------------------------------------------------------------

    \455\ The trading desk's retention and sale of the unsold 
allotment must comply with the federal securities laws and 
regulations, but is otherwise permitted under the underwriting 
exemption.
    \456\ See supra note 403.
---------------------------------------------------------------------------

    The near term demand requirement, including the requirement to make 
reasonable efforts to reduce the underwriting position, represents a 
new regulatory requirement for banking entities engaged in 
underwriting. At the margins, this requirement could alter the 
participation decision for some banking entities with respect to 
certain types of distributions, such as distributions that are more 
likely to result in the banking entity retaining an underwriting 
position for a period of time.\457\ However, the Agencies recognize 
that liquidity, maturity, and depth of the market vary across types of 
securities, and the Agencies expect that the express recognition of 
these differences in the rule should help mitigate any incentive to 
exit the underwriting business for certain types of securities or types 
of distributions.
---------------------------------------------------------------------------

    \457\ For example, some commenters suggested that the proposed 
underwriting exemption could have a chilling effect on banking 
entities' willingness to engage in underwriting activities. See, 
e.g., Lord Abbett; Fidelity. Further, some commenters expressed 
concern that the proposed near term customer demand requirement 
might negatively impact certain forms of capital-raising if the 
requirement is interpreted narrowly or inflexibly. See SIFMA et al. 
(Prop. Trading) (Feb. 2012); BoA; BDA (Feb. 2012); RBC.
---------------------------------------------------------------------------

3. Compliance Program Requirement
a. Proposed Compliance Program Requirement
    Section ----.4(a)(2)(i) of the proposed exemption required a 
banking entity to establish an internal compliance program, as required 
by Sec.  ----.20 of the proposed rule, that is designed to ensure the 
banking entity's compliance with the requirements of the underwriting 
exemption, including reasonably designed written policies and 
procedures, internal controls, and independent testing.\458\ This 
requirement was proposed so that any banking entity relying on the 
underwriting exemption would have reasonably designed written policies 
and procedures, internal controls, and independent testing in place to 
support its compliance with the terms of the exemption.\459\
---------------------------------------------------------------------------

    \458\ See proposed rule Sec.  ----.4(a)(2)(i).
    \459\ See Joint Proposal, 76 FR 68,866; CFTC Proposal, 77 FR 
8352.
---------------------------------------------------------------------------

b. Comments on the Proposed Compliance Program Requirement
    Commenters did not directly address the proposed compliance program 
requirement in the underwriting exemption. Comments on the proposed 
compliance program requirement of Sec.  ----.20 of the proposed rule 
are discussed in Part IV.C., below.
c. Final Compliance Program Requirement
    The final rule includes a compliance program requirement that is 
similar to the proposed requirement, but the Agencies are making 
certain enhancements to emphasize the importance of a strong internal 
compliance program. More specifically, the final rule requires that a 
banking entity's compliance program specifically include reasonably 
designed written policies and procedures, internal controls, analysis 
and independent testing \460\ identifying and addressing: (i) The 
products, instruments or exposures each trading desk may purchase, 
sell, or manage as part of its underwriting activities; \461\ (ii) 
limits for each trading desk, based on the nature and amount of the 
trading desk's underwriting activities, including the reasonably 
expected near term demands of clients, customers, or counterparties; 
\462\ (iii) internal controls and ongoing monitoring and analysis of 
each trading desk's compliance with its limits; \463\ and (iv) 
authorization procedures, including escalation procedures that require 
review and approval of any trade that would exceed one or more of a 
trading desk's limits, demonstrable analysis of the basis for any 
temporary or permanent increase to one or more of a trading desk's 
limits, and independent review (i.e., by risk managers and compliance 
officers at the appropriate level independent of the trading desk) of 
such demonstrable analysis and approval.\464\
---------------------------------------------------------------------------

    \460\ The independent testing standard is discussed in more 
detail in Part IV.C., which discusses the compliance program 
requirement in Sec.  ----.20 of the final rule.
    \461\ See final rule Sec.  ----.4(a)(2)(iii)(A).
    \462\ See final rule Sec.  ----.4(a)(2)(iii)(B). A trading desk 
must have limits on the amount, types, and risk of the securities in 
its underwriting position, level of exposures to relevant risk 
factors arising from its underwriting position, and period of time a 
security may be held. See id.
    \463\ See final rule Sec.  ----.4(a)(2)(iii)(C).
    \464\ See final rule Sec.  ----.4(a)(2)(iii)(D).
---------------------------------------------------------------------------

    As noted above, the proposed compliance program requirement did not 
include the four specific elements listed above in the proposed 
underwriting exemption, although each of these provisions was included 
in some form in the detailed compliance program requirement under 
Appendix C of the proposed rule.\465\ The Agencies are moving these 
particular requirements, with certain enhancements, into the 
underwriting exemption because the Agencies believe these are core 
elements of a program to ensure compliance with the underwriting 
exemption. These compliance procedures must be established, 
implemented, maintained, and enforced for each trading desk engaged in 
underwriting activity under Sec.  ----.4(a) of the final rule. Each of 
the

[[Page 5573]]

requirements in paragraphs (a)(2)(iii)(A) through (D) must be 
appropriately tailored to the individual trading activities and 
strategies of each trading desk.
---------------------------------------------------------------------------

    \465\ See Joint Proposal, 76 FR 68,963-68,967 (requiring certain 
banking entities to establish, maintain, and enforce compliance 
programs with, among other things: (i) Written policies and 
procedures that describe a trading unit's authorized instruments and 
products; (ii) internal controls for each trading unit, including 
risk limits for each trading unit and surveillance procedures; and 
(iii) a management framework, including management procedures for 
overseeing compliance with the proposed rule).
---------------------------------------------------------------------------

    The compliance program requirement in the underwriting exemption is 
substantially similar to the compliance program requirement in the 
market-making exemption, except that the Agencies are requiring more 
detailed risk management procedures in the market-making exemption due 
to the nature of that activity.\466\ The Agencies believe including 
similar compliance program requirements in the underwriting and market-
making exemptions may reduce burdens associated with building and 
maintaining compliance programs for each trading desk.
---------------------------------------------------------------------------

    \466\ See final rule Sec. Sec.  ----.4(a)(2)(iii), --
--.4(b)(2)(iii).
---------------------------------------------------------------------------

    Identifying in the compliance program the relevant products, 
instruments, and exposures in which a trading desk is permitted to 
trade will facilitate monitoring and oversight of compliance with the 
underwriting exemption. For example, this requirement should prevent an 
individual trader on an underwriting desk from establishing positions 
in instruments that are unrelated to the desk's underwriting function. 
Further, the identification of permissible products, instruments, and 
exposures will help form the basis for the specific types of position 
and risk limits that the banking entity must establish and is relevant 
to considerations throughout the exemption regarding the liquidity, 
maturity, and depth of the market for the relevant type of security.
    A trading desk must have limits on the amount, types, and risk of 
the securities in its underwriting position, level of exposures to 
relevant risk factors arising from its underwriting position, and 
period of time a security may be held. Limits established under this 
provision, and any modifications to these limits made through the 
required escalation procedures, must account for the nature and amount 
of the trading desk's underwriting activities, including the reasonably 
expected near term demands of clients, customers, or counterparties. 
Among other things, these limits should be designed to prevent a 
trading desk from systematically retaining unsold allotments even when 
there is customer demand for the positions that remain in the trading 
desk's inventory. The Agencies recognize that trading desks' limits may 
differ across types of securities and acknowledge that trading desks 
engaged in underwriting activities in less liquid securities, such as 
corporate bonds, may require different inventory, risk exposure, and 
holding period limits than trading desks engaged in underwriting 
activities in more liquid securities, such as certain equity 
securities. A trading desk hedging the risks of an underwriting 
position must comply with the hedging exemption, which provides for 
compliance procedures regarding risk management.\467\
---------------------------------------------------------------------------

    \467\ See final rule Sec.  ----.5.
---------------------------------------------------------------------------

    Furthermore, a banking entity must establish internal controls and 
ongoing monitoring and analysis of each trading desk's compliance with 
its limits, including the frequency, nature, and extent of a trading 
desk exceeding its limits.\468\ This may include the use of management 
and exception reports. Moreover, the compliance program must set forth 
a process for determining the circumstances under which a trading 
desk's limits may be modified on a temporary or permanent basis (e.g., 
due to market changes).
---------------------------------------------------------------------------

    \468\ See final rule Sec.  ----.4(a)(2)(iii)(C).
---------------------------------------------------------------------------

    As noted above, a banking entity's compliance program for trading 
desks engaged in underwriting activity must also include escalation 
procedures that require review and approval of any trade that would 
exceed one or more of a trading desk's limits, demonstrable analysis 
that the basis for any temporary or permanent increase to one or more 
of a trading desk's limits is consistent with the near term customer 
demand requirement, and independent review of such demonstrable 
analysis and approval.\469\ Thus, to increase a limit of a trading 
desk, there must be an analysis of why such increase would be 
appropriate based on the reasonably expected near term demands of 
clients, customers, or counterparties, which must be independently 
reviewed. A banking entity also must maintain documentation and records 
with respect to these elements, consistent with the requirement of 
Sec.  ----.20(b)(6).
---------------------------------------------------------------------------

    \469\ See final rule Sec.  ----.4(a)(2)(iii)(D).
---------------------------------------------------------------------------

    As discussed in more detail in Part IV.C., the Agencies recognize 
that the compliance program requirements in the final rule will impose 
certain costs on banking entities but, on balance, the Agencies believe 
such requirements are necessary to facilitate compliance with the 
statute and the final rule and to reduce the risk of evasion.\470\
---------------------------------------------------------------------------

    \470\ See Part IV.C. (discussing the compliance program 
requirement in Sec.  ----.20 of the final rule).
---------------------------------------------------------------------------

4. Compensation Requirement
a. Proposed Compensation Requirement
    Another provision of the proposed underwriting exemption required 
that the compensation arrangements of persons performing underwriting 
activities at the banking entity must be designed not to encourage 
proprietary risk-taking.\471\ In connection with this requirement, the 
proposal clarified that although a banking entity relying on the 
underwriting exemption may appropriately take into account revenues 
resulting from movements in the price of securities that the banking 
entity underwrites to the extent that such revenues reflect the 
effectiveness with which personnel have managed underwriting risk, the 
banking entity should provide compensation incentives that primarily 
reward client revenues and effective client service, not proprietary 
risk-taking.\472\
---------------------------------------------------------------------------

    \471\ See proposed rule Sec.  ----.4(a)(2)(vii); Joint Proposal, 
76 FR 68,868; CFTC Proposal, 77 FR 8353.
    \472\ See id.
---------------------------------------------------------------------------

b. Comments on the Proposed Compensation Requirement
    A few commenters expressed general support for the proposed 
requirement, but suggested certain modifications that they believed 
would enhance the requirement and make it more effective.\473\ 
Specifically, one commenter suggested tailoring the requirement to 
underwriting activity by, for example, ensuring that personnel involved 
in underwriting are given compensation incentives for the successful 
distribution of securities off the firm's balance sheet and are not 
rewarded for profits associated with securities that are not 
successfully distributed (although losses from such positions should be 
taken into consideration in determining the employee's compensation). 
This commenter further recommended that bonus compensation for a deal 
be withheld until all or a high percentage of the relevant securities 
are distributed.\474\ Finally, one commenter suggested that the term 
``designed'' should be removed from this provision.\475\
---------------------------------------------------------------------------

    \473\ See Occupy; AFR et al. (Feb. 2012); Better Markets (Feb. 
2012).
    \474\ See AFR et al. (Feb. 2012).
    \475\ See Occupy.
---------------------------------------------------------------------------

c. Final Compensation Requirement
    Similar to the proposed rule, the underwriting exemption in the 
final rule requires that the compensation arrangements of persons 
performing the banking entity's underwriting activities, as described 
in the exemption, be

[[Page 5574]]

designed not to reward or incentivize prohibited proprietary 
trading.\476\ The Agencies do not intend to preclude an employee of an 
underwriting desk from being compensated for successful underwriting, 
which involves some risk-taking.
---------------------------------------------------------------------------

    \476\ See final rule Sec.  ----.4(a)(2)(iv); proposed rule Sec.  
----.4(a)(2)(vii). This is consistent with the final compensation 
requirements in the market-making and hedging exemptions. See final 
rule Sec.  ----.4(b)(2)(v); final rule Sec.  ----.5(b)(3).
---------------------------------------------------------------------------

    Consistent with the proposal, activities for which a banking entity 
has established a compensation incentive structure that rewards 
speculation in, and appreciation of, the market value of securities 
underwritten by the banking entity are inconsistent with the 
underwriting exemption. A banking entity may, however, take into 
account revenues resulting from movements in the price of securities 
that the banking entity underwrites to the extent that such revenues 
reflect the effectiveness with which personnel have managed 
underwriting risk. The banking entity should provide compensation 
incentives that primarily reward client revenues and effective client 
services, not prohibited proprietary trading. For example, a 
compensation plan based purely on net profit and loss with no 
consideration for inventory control or risk undertaken to achieve those 
profits would not be consistent with the underwriting exemption.
    The Agencies are not adopting an approach that prevents an employee 
from receiving any compensation related to profits arising from an 
unsold allotment, as suggested by one commenter, because the Agencies 
believe the final rule already includes sufficient controls to prevent 
a trading desk from intentionally retaining an unsold allotment to make 
a speculative profit when such allotment could be sold to 
customers.\477\ The Agencies also are not requiring compensation to be 
vested for a period of time, as recommended by one commenter to reduce 
traders' incentives for undue risk-taking. The Agencies believe the 
final rule includes sufficient controls around risk-taking activity 
without a compensation vesting requirement because a banking entity 
must establish limits for a trading desk's underwriting position and 
the trading desk must make reasonable efforts to sell or otherwise 
reduce the underwriting position within a reasonable period.\478\ The 
Agencies continue to believe it is appropriate to focus on the design 
of a banking entity's compensation structure, so the Agencies are not 
removing the term ``designed'' from this provision.\479\ This retains 
an objective focus on actions that the banking entity can control--the 
design of its incentive compensation program--and avoids a subjective 
focus on whether an employee feels incentivized by compensation, which 
may be more difficult to assess. In addition, the framework of the 
final compensation requirement will allow banking entities to better 
plan and control the design of their compensation arrangements, which 
should reduce costs and uncertainty and enhance monitoring, than an 
approach focused solely on individual outcomes.
---------------------------------------------------------------------------

    \477\ See AFR et al. (Feb. 2012); supra Part IV.A.2.c.2.c. 
(discussing the requirement to make reasonable efforts to sell or 
otherwise reduce the underwriting position).
    \478\ See AFR et al. (Feb. 2012).
    \479\ See Occupy.
---------------------------------------------------------------------------

5. Registration Requirement
a. Proposed Registration Requirement
    Section ----.4(a)(2)(iv) of the proposed rule would have required 
that a banking entity have the appropriate dealer registration or be 
exempt from registration or excluded from regulation as a dealer to the 
extent that, in order to underwrite the security at issue, a person 
must generally be a registered securities dealer, municipal securities 
dealer, or government securities dealer.\480\ Further, if the banking 
entity was engaged in the business of a dealer outside the United 
States in a manner for which no U.S. registration is required, the 
proposed rule would have required the banking entity to be subject to 
substantive regulation of its dealing business in the jurisdiction in 
which the business is located.
---------------------------------------------------------------------------

    \480\ See proposed rule Sec.  ----.4(a)(2)(iv); Joint Proposal, 
76 FR 68,867; CFTC Proposal, 77 FR 8353. The proposal clarified 
that, in the case of a financial institution that is a government 
securities dealer, such institution must have filed notice of that 
status as required by section 15C(a)(1)(B) of the Exchange Act. See 
Joint Proposal, 76 FR 68,867; CFTC Proposal, 77 FR 8353.
---------------------------------------------------------------------------

b. Comments on Proposed Registration Requirement
    Commenters generally did not address the proposed dealer 
requirement in the underwriting exemption. However, as discussed below 
in Part IV.A.3.c.2.b., a number of commenters addressed a similar 
requirement in the proposed market-making exemption.
c. Final Registration Requirement
    The requirement in Sec.  ----.4(a)(2)(vi) of the underwriting 
exemption, which provides that the banking entity must be licensed or 
registered to engage in underwriting activity in accordance with 
applicable law, is substantively similar to the proposed dealer 
registration requirement in Sec.  ----.4(a)(2)(iv) of the proposed 
rule. The primary difference between the proposed requirement and the 
final requirement is that the Agencies have simplified the language of 
the rule. The Agencies have also made conforming changes to the 
corresponding requirement in the market-making exemption to promote 
consistency across the exemptions, where appropriate.\481\
---------------------------------------------------------------------------

    \481\ See Part IV.A.3.c.6. (discussing the registration 
requirement in the market-making exemption).
---------------------------------------------------------------------------

    As was proposed, this provision will require a U.S. banking entity 
to be an SEC-registered dealer in order to rely on the underwriting 
exemption in connection with a distribution of securities--other than 
exempted securities, security-based swaps, commercial paper, bankers 
acceptances or commercial bills--unless the banking entity is exempt 
from registration or excluded from regulation as a dealer.\482\ To the 
extent that a banking entity relies on the underwriting exemption in 
connection with a distribution of municipal securities or government 
securities, rather than the exemption in Sec.  ----.6(a) of the final 
rule, this provision may require the banking entity to be registered or 
licensed as a municipal securities dealer or government securities 
dealer, if required by applicable law. However, this provision does not 
require a banking entity to register in order to qualify for the 
underwriting exemption if the banking entity is not otherwise required 
to register by applicable law.
---------------------------------------------------------------------------

    \482\ For example, if a banking entity is a bank engaged in 
underwriting asset-backed securities for which it would be required 
to register as a securities dealer but for the exclusion contained 
in section 3(a)(5)(C)(iii) of the Exchange Act, the final rule would 
not require the banking entity to be a registered securities dealer 
to underwrite the asset-backed securities. See 15 U.S.C. 
78c(a)(5)(C)(iii).
---------------------------------------------------------------------------

    The Agencies have determined that, for purposes of the underwriting 
exemption, rather than require a banking entity engaged in the business 
of a securities dealer outside the United States to be subject to 
substantive regulation of its dealing business in the jurisdiction in 
which the business is located, a banking entity's dealing activity 
outside the U.S. should only be subject to licensing or registration 
provisions if required under applicable foreign law (provided no U.S. 
registration or licensing requirements apply to the banking entity's 
activities). In response to comments, the final rule recognizes that 
certain foreign jurisdictions may not provide for substantive 
regulation of dealing

[[Page 5575]]

businesses.\483\ The Agencies do not believe it is necessary to 
preclude banking entities from engaging in underwriting activities in 
such foreign jurisdictions to achieve the goals of section 13 of the 
BHC Act because these banking entities would continue to be subject to 
the other requirements of the underwriting exemption.
---------------------------------------------------------------------------

    \483\ See infra Part IV.A.3.c.6.c. (discussing comments on this 
issue with respect to the proposed dealer registration requirement 
in the market-making exemption).
---------------------------------------------------------------------------

6. Source of Revenue Requirement
a. Proposed Source of Revenue Requirement
    Under Sec.  ----.4(a)(2)(vi) of the proposed rule, the underwriting 
activities of a banking entity would have been required to be designed 
to generate revenues primarily from fees, commissions, underwriting 
spreads, or other income not attributable to appreciation in the value 
of covered financial positions or hedging of covered financial 
positions.\484\ The proposal clarified that underwriting spreads would 
include any ``gross spread'' (i.e., the difference between the price an 
underwriter sells securities to the public and the price it purchases 
them from the issuer) designed to compensate the underwriter for its 
services.\485\ This requirement provided that activities conducted in 
reliance on the underwriting exemption should demonstrate patterns of 
revenue generation and profitability consistent with, and related to, 
the services an underwriter provides to its customers in bringing 
securities to market, rather than changes in the market value of the 
underwritten securities.\486\
---------------------------------------------------------------------------

    \484\ See proposed rule Sec.  ----.4(a)(2)(vi); Joint Proposal, 
76 FR 68,867-68,868; CFTC Proposal, 77 FR 8353.
    \485\ See Joint Proposal, 76 FR 68,867-68,868 n.142; CFTC 
Proposal, 77 FR 8353 n.148.
    \486\ See Joint Proposal, 76 FR 68,867-68,868; CFTC Proposal, 77 
FR 8353.
---------------------------------------------------------------------------

b. Comments on the Proposed Source of Revenue Requirement
    A few commenters requested certain modifications to the proposed 
source of revenue requirement. These commenters' suggested revisions 
were generally intended either to refine the standard to better account 
for certain activities or to make it more stringent.\487\ Three 
commenters expressed concern that the proposed source of revenue 
requirement would negatively impact a banking entity's ability to act 
as a primary dealer or in a similar capacity.\488\
---------------------------------------------------------------------------

    \487\ See Goldman (Prop. Trading); Occupy; Sens. Merkley & Levin 
(Feb. 2012).
    \488\ See Banco de M[eacute]xico (stating that primary dealers 
need to profit from resulting proprietary positions in foreign 
sovereign debt, including by holding significant positions in 
anticipation of future price movements, in order to make the primary 
dealer business financially attractive); IIB/EBF (noting that 
primary dealers may actively seek to profit from price and interest 
rate movements of their holdings, which the relevant sovereign 
entity supports because such activity provides much-needed liquidity 
for securities that are otherwise largely purchased pursuant to buy-
and-hold strategies by institutional investors and other entities 
seeking safe returns and liquidity buffers); Japanese Bankers Ass'n.
---------------------------------------------------------------------------

    With respect to suggested modifications, one commenter recommended 
that ``customer revenue'' include revenues attributable to syndicate 
activities, hedging activities, and profits and losses from sales of 
residual positions, as long as the underwriter makes a reasonable 
effort to dispose of any residual position in light of existing market 
conditions.\489\ Another commenter indicated that the rule would better 
address securitization if it required compensation to be linked in part 
to risk minimization for the securitizer and in part to serving 
customers. This commenter suggested that such a framework would be 
preferable because, in the context of securitizations, fee-based 
compensation structures did not previously prevent banking entities 
from accumulating large and risky positions with significant market 
exposure.\490\
---------------------------------------------------------------------------

    \489\ See Goldman (Prop. Trading).
    \490\ See Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------

    To strengthen the proposed requirement, one commenter requested 
that the terms ``designed'' and ``primarily'' be removed and replaced 
by the word ``solely.'' \491\ Two other commenters requested that this 
requirement be interpreted to prevent a banking entity from acting as 
an underwriter for a distribution of securities if such securities lack 
a discernible and sufficiently liquid pre-existing market and a 
foreseeable market price.\492\
---------------------------------------------------------------------------

    \491\ See Occupy (requesting that the rule require automatic 
disgorgement of any profits arising from appreciation in the value 
of positions in connection with underwriting activities).
    \492\ See AFR et al. (Feb. 2012); Public Citizen.
---------------------------------------------------------------------------

c. Final Rule's Approach To Assessing Source of Revenue

    The Agencies believe the final rule includes sufficient controls 
around an underwriter's source of revenue and have determined not to 
adopt the additional requirement included in proposed rule Sec.  --
--.4(a)(2)(vi). The Agencies believe that removing this requirement 
addresses commenters' concerns that the proposed requirement did not 
appropriately reflect certain revenue sources from underwriting 
activity \493\ or may impact primary dealer activities.\494\ At the 
same time, the final rule continues to include provisions that focus on 
whether an underwriter is generating underwriting-related revenue and 
that should limit an underwriter's ability to generate revenues purely 
from price appreciation. In particular, the requirement to make 
reasonable efforts to sell or otherwise reduce the underwriting 
position within a reasonable period, which was not included in the 
proposed rule, should limit an underwriter's ability to gain revenues 
purely from price appreciation related to its underwriter position. 
Similarly, the determination of whether an underwriter receives special 
compensation for purposes of the definition of ``distribution'' takes 
into account whether a banking entity is generating underwriting-
related revenue.
---------------------------------------------------------------------------

    \493\ See Goldman (Prop. Trading).
    \494\ See Banco de M[eacute]xico; IIB/EBF; Japanese Bankers 
Ass'n.
---------------------------------------------------------------------------

    The final rule does not adopt a requirement that prevents an 
underwriter from generating any revenue from price appreciation out of 
concern that such a requirement could prevent an underwriter from 
retaining an unsold allotment under any circumstances, which would be 
inconsistent with other provisions of the exemption.\495\ Similarly, 
the Agencies are not adopting a source of revenue requirement that 
would prevent a banking entity from acting as underwriter for a 
distribution of securities if such securities lack a discernible and 
sufficiently liquid pre-existing market and a foreseeable market price, 
as suggested by two commenters.\496\ The Agencies believe these 
commenters' concern is mitigated by the near term demand requirement, 
which requires a trading desk to have a reasonable expectation of 
demand from other market participants for the amount and type of 
securities to be acquired from an issuer or selling security holder for 
distribution.\497\ Further, one commenter recommended a revenue 
requirement directed at securitization activities to prevent banking 
entities from accumulating large and risky positions with significant 
market

[[Page 5576]]

exposure.\498\ The Agencies believe the requirement to make reasonable 
efforts to sell or otherwise reduce the underwriting position should 
achieve this stated goal and, thus, the Agencies do not believe an 
additional revenue requirement for securitization activity is 
needed.\499\
---------------------------------------------------------------------------

    \495\ See Occupy; supra Part IV.A.2.c.2. (discussing comments on 
unsold allotments and the requirement in the final rule to make 
reasonable efforts to sell or otherwise reduce the underwriting 
position).
    \496\ See AFR et al. (Feb. 2012); Public Citizen.
    \497\ See supra Part IV.A.2.c.2.
    \498\ See Sens. Merkley & Levin (Feb. 2012).
    \499\ See final rule Sec.  ----.4(a)(2)(ii). Further, as noted 
above, this exemption does not permit the accumulation of assets for 
securitization. See supra Part IV.A.2.c.1.c.v.
---------------------------------------------------------------------------

3. Section ----.4(b): Market-Making Exemption
a. Introduction
    In adopting the final rule, the Agencies are striving to balance 
two goals of section 13 of the BHC Act: To allow market making, which 
is important to well-functioning markets as well as to the economy, and 
simultaneously to prohibit proprietary trading, unrelated to market 
making or other permitted activities, that poses significant risks to 
banking entities and the financial system. In response to comments on 
the proposed market-making exemption, the Agencies are adopting certain 
modifications to the proposed exemption to better account for the 
varying characteristics of market making-related activities across 
markets and asset classes, while requiring that banking entities 
maintain a robust set of risk controls for their market making-related 
activities. A flexible approach to this exemption is appropriate 
because the activities a market maker undertakes to provide important 
intermediation and liquidity services will differ based on the 
liquidity, maturity, and depth of the market for a given type of 
financial instrument. The statute specifically permits banking entities 
to continue to provide these beneficial services to their clients, 
customers, and counterparties.\500\ Thus, the Agencies are adopting an 
approach that recognizes the full scope of market making-related 
activities banking entities currently undertake and requires that these 
activities be subject to clearly defined, verifiable, and monitored 
risk parameters.
---------------------------------------------------------------------------

    \500\ As discussed in Part IV.A.3.c.2.c.i., infra, the terms 
``client,'' ``customer,'' and ``counterparty'' are defined in the 
same manner in the final rule. Thus, the Agencies use these terms 
synonymously throughout this discussion and sometimes use the term 
``customer'' to refer to all entities that meet the definition of 
``client, customer, and counterparty'' in the final rule's market-
making exemption.
---------------------------------------------------------------------------

b. Overview
1. Proposed Market-Making Exemption
    Section 13(d)(1)(B) of the BHC Act provides an exemption from the 
prohibition on proprietary trading for the purchase, sale, acquisition, 
or disposition of securities, derivatives, contracts of sale of a 
commodity for future delivery, and options on any of the foregoing in 
connection with market making-related activities, to the extent that 
such activities are designed not to exceed the reasonably expected near 
term demands of clients, customers, or counterparties.\501\
---------------------------------------------------------------------------

    \501\ 12 U.S.C. 1851(d)(1)(B).
---------------------------------------------------------------------------

    Section ----.4(b) of the proposed rule would have implemented this 
statutory exemption by requiring that a banking entity's market making-
related activities comply with seven standards. As discussed in the 
proposal, these standards were designed to ensure that any banking 
entity relying on the exemption would be engaged in bona fide market 
making-related activities and, further, would conduct such activities 
in a way that was not susceptible to abuse through the taking of 
speculative, proprietary positions as a part of, or mischaracterized 
as, market making-related activities. The Agencies proposed to use 
additional regulatory and supervisory tools in conjunction with the 
proposed market-making exemption, including quantitative measurements 
for banking entities engaged in significant covered trading activity in 
proposed Appendix A, commentary on how the Agencies proposed to 
distinguish between permitted market making-related activity and 
prohibited proprietary trading in proposed Appendix B, and a compliance 
regime in proposed Sec.  ----.20 and, where applicable, Appendix C of 
the proposal. This multi-faceted approach was intended to address the 
complexities of differentiating permitted market making-related 
activities from prohibited proprietary trading.\502\
---------------------------------------------------------------------------

    \502\ See Joint Proposal, 76 FR 68,869; CFTC Proposal, 77 FR 
8354-8355.
---------------------------------------------------------------------------

2. Comments on the Proposed Market-Making Exemption
    The Agencies received significant comment regarding the proposed 
market-making exemption. In this Part, the Agencies highlight the main 
issues, concerns, and suggestions raised by commenters with respect to 
the proposed market-making exemption. As discussed in greater detail 
below, commenters' views on the effectiveness of the proposed exemption 
varied. Commenters discussed a broad range of topics related to the 
proposed market-making exemption including, among others: The overall 
scope of the proposed exemption and potential restrictions on market 
making in certain markets or asset classes; the potential market impact 
of the proposed market-making exemption; the appropriate level of 
analysis for compliance with the proposed exemption; the effectiveness 
of the individual requirements of the proposed exemption; and specific 
activities that should or should not be considered permitted market 
making-related activity under the rule.
a. Comments on the Overall Scope of the Proposed Exemption
    With respect to the general scope of the exemption, a number of 
commenters expressed concern that the proposed approach to implementing 
the market-making exemption is too narrow or restrictive, particularly 
with respect to less liquid markets. These commenters expressed concern 
that the proposed exemption would not be workable in many markets and 
asset classes and does not take into account how market-making services 
are provided in those markets and asset classes.\503\ Some commenters 
expressed particular concern that the proposed exemption may restrict 
or limit certain activities currently conducted by market makers (e.g., 
holding inventory or interdealer trading).\504\ Several commenters 
stated

[[Page 5577]]

that the proposed exemption would create too much uncertainty regarding 
compliance \505\ and, further, may have a chilling effect on banking 
entities' market making-related activities.\506\ Due to the perceived 
restrictions and burdens of the proposed exemption, many commenters 
indicated that the rule may change the way in which market-making 
services are provided.\507\ A number of commenters expressed the view 
that the proposed exemption is inconsistent with Congressional intent 
because it would restrict and reduce banking entities' current market 
making-related activities.\508\
---------------------------------------------------------------------------

    \503\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012) 
(stating that the proposed exemption ``seems to view market making 
based on a liquid, exchange-traded equity model in which market 
makers are simple intermediaries akin to agents'' and that ``[t]his 
view does not fit market making even in equity markets and widely 
misses the mark for the vast majority of markets and asset 
classes''); SIFMA (Asset Mgmt.) (Feb. 2012); Credit Suisse (Seidel); 
ICI (Feb. 2012); BoA; Columbia Mgmt.; Comm. on Capital Markets 
Regulation; Invesco; ASF (Feb. 2012) (``The seven criteria in the 
proposed rule, and the related criterion for identifying permitted 
hedging, are overly restrictive and will make it impractical for 
dealers to continue making markets in most securitized products.''); 
Chamber (Feb. 2012) (expressing particular concern about the 
commercial paper market).
    \504\ Several commenters stated that the proposed rule would 
limit a market maker's ability to maintain inventory. See, e.g., 
NASP; Oliver Wyman (Dec. 2011); Wellington; Prof. Duffie; Standish 
Mellon; MetLife; Lord Abbett; NYSE Euronext; CIEBA; British 
Columbia; SIFMA et al. (Prop. Trading) (Feb. 2012); Shadow Fin. 
Regulatory Comm.; Credit Suisse (Seidel); Morgan Stanley; Goldman 
(Prop. Trading); BoA; STANY; SIFMA (Asset Mgmt.) (Feb. 2012); 
Chamber (Feb. 2012); IRSG; Abbott Labs et al. (Feb. 14, 2012); 
Abbott Labs et al. (Feb. 21, 2012); Australian Bankers Ass'n. (Feb. 
2012); FEI; ASF (Feb. 2012); RBC; PUC Texas; Columbia Mgmt.; SSgA 
(Feb. 2012); PNC et al.; Fidelity; ICI (Feb. 2012); British Bankers' 
Ass'n.; Comm. on Capital Markets Regulation; IHS; Oliver Wyman (Feb. 
2012); Thakor Study (stating that by artificially constraining the 
security holdings that a banking entity can have in its inventory 
for market making or proprietary trading purposes, section 13 of the 
BHC Act will make bank risk management less efficient and may 
adversely impact the diversified financial services business model 
of banks). However, some commenters stated that market makers should 
seek to minimize their inventory or should not need large 
inventories. See, e.g., AFR et al. (Feb. 2012); Public Citizen; 
Johnson & Prof. Stiglitz. Other commenters expressed concern that 
the proposed rule could limit interdealer trading. See, e.g., Prof. 
Duffie; Credit Suisse (Seidel); JPMC; Morgan Stanley; Goldman (Prop. 
Trading); Chamber (Feb. 2012); Oliver Wyman (Dec. 2011).
    \505\ See, e.g., BlackRock; Putnam; Fixed Income Forum/Credit 
Roundtable; ACLI (Feb. 2012); MetLife; IAA; Wells Fargo (Prop. 
Trading); T. Rowe Price; Sen. Bennet; Sen. Corker; PUC Texas; 
Fidelity; ICI (Feb. 2012); Invesco.
    \506\ See, e.g., Wellington; Prof. Duffie; Standish Mellon; 
Commissioner Barnier; NYSE Euronext; BoA; Citigroup (Feb. 2012); 
STANY; ICE; Chamber (Feb. 2012); BDA (Feb. 2012); Putnam; FTN; Fixed 
Income Forum/Credit Roundtable; ACLI (Feb. 2012); IAA; CME Group; 
Capital Group; PUC Texas; Columbia Mgmt.; SSgA (Feb. 2012); Eaton 
Vance; ICI (Feb. 2012); Invesco; Comm. on Capital Markets 
Regulation; Oliver Wyman (Feb. 2012); SIFMA (Asset Mgmt.) (Feb. 
2012); Thakor Study.
    \507\ For example, some commenters stated that market makers may 
revert to an agency or ``special order'' model. See, e.g., Barclays; 
Goldman (Prop. Trading); ACLI (Feb. 2012); Vanguard; RBC. In 
addition, some commenters stated that new systems will be developed, 
such as alternative market matching networks, but these commenters 
disagreed about whether such changes would happen in the near term. 
See, e.g., CalPERS; BlackRock; Stuyvesant; Comm. on Capital Markets 
Regulation. Other commenters stated that it is unlikely that new 
systems will be developed. See, e.g., SIFMA et al. (Prop. Trading) 
(Feb. 2012); Oliver Wyman (Feb. 2012). One commenter stated that the 
proposed rule may cause a banking organization that engages in 
significant market-making activity to give up its banking charter or 
spin off its market-making operations to avoid compliance with the 
proposed exemption. See Prof. Duffie.
    \508\ See, e.g., NASP; Wellington; JPMC; Morgan Stanley; Credit 
Suisse (Seidel); BoA; Goldman (Prop. Trading); Citigroup (Feb. 
2012); STANY; SIFMA (Asset Mgmt.) (Feb. 2012); Chamber (Feb. 2012); 
Putnam; ICI (Feb. 2012); Wells Fargo (Prop. Trading); NYSE Euronext; 
Sen. Corker; Invesco.
---------------------------------------------------------------------------

    Other commenters, however, stated that the proposed exemption was 
too broad and recommended that the rule place greater restrictions on 
market making, particularly in illiquid, nontransparent markets.\509\ 
Many of these commenters suggested that the exemption should only be 
available for traditional market-making activity in relatively safe, 
``plain vanilla'' instruments.\510\ Two commenters represented that the 
proposed exemption would have little to no impact on banking entities' 
current market making-related services.\511\
---------------------------------------------------------------------------

    \509\ See, e.g., Better Markets (Feb. 2012); Sens. Merkley & 
Levin (Feb. 2012); Occupy; AFR et al. (Feb. 2012); Public Citizen; 
Johnson & Prof. Stiglitz.
    \510\ See, e.g., Johnson & Prof. Stiglitz; Sens. Merkley & Levin 
(Feb. 2012); Occupy; AFR et al. (Feb. 2012); Public Citizen.
    \511\ See Occupy (``[I]t is unclear that this rule, as written, 
will markedly alter the current customer-serving business. Indeed, 
this rule has gone to excessive lengths to protect the covered 
banking entities' ability to maintain responsible customer-facing 
business.''); Alfred Brock.
---------------------------------------------------------------------------

    Commenters expressed differing views regarding the ease or 
difficulty of distinguishing permitted market making-related activity 
from prohibited proprietary trading. A number of commenters represented 
that it is difficult or impossible to distinguish prohibited 
proprietary trading from permitted market making-related activity.\512\ 
With regard to this issue, several commenters recommended that the 
Agencies not try to remove all aspects of proprietary trading from 
market making-related activity because doing so would likely restrict 
certain legitimate market-making activity.\513\
---------------------------------------------------------------------------

    \512\ See, e.g., Rep. Bachus et al.; IIF; Morgan Stanley 
(stating that beyond walled-off proprietary trading, the line is 
hard to draw, particularly because both require principal risk-
taking and the features of market making vary across markets and 
asset classes and become more pronounced in times of market stress); 
CFA Inst. (representing that the distinction is particularly 
difficult in the fixed-income market); ICFR; Prof. Duffie; WR 
Hambrecht.
    \513\ See, e.g., Chamber (Feb. 2012) (citing an article by 
Stephen Breyer stating that society should not expend 
disproportionate resources trying to reduce or eliminate ``the last 
10 percent'' of the risks of a certain problem); JPMC; RBC; ICFR; 
Sen. Hagan. One of these commenters indicated that any concerns that 
banking entities would engage in speculative trading as a result of 
an expansive market-making exemption would be addressed by other 
reform initiatives (e.g., Basel III implementation will provide 
laddered disincentives to holding positions as principal as a result 
of capital and liquidity requirements). See RBC.
---------------------------------------------------------------------------

    Other commenters were of the view that it is possible to 
differentiate between prohibited proprietary trading and permitted 
market making-related activity.\514\ For example, one commenter stated 
that, while the analysis may involve subtle distinctions, the 
fundamental difference between a banking entity's market-making 
activities and proprietary trading activities is the emphasis in market 
making on seeking to meet customer needs on a consistent and reliable 
basis throughout a market cycle.\515\ According to another commenter, 
holding substantial securities in a trading book for an extended period 
of time assumes the character of a proprietary position and, while 
there may be occasions when a customer-oriented purchase and subsequent 
sale extend over days and cannot be more quickly executed or hedged, 
substantial holdings of this character should be relatively rare and 
limited to less liquid markets.\516\
---------------------------------------------------------------------------

    \514\ See Wellington; Paul Volcker; Better Markets (Feb. 2012); 
Occupy.
    \515\ See Wellington.
    \516\ See Paul Volcker.
---------------------------------------------------------------------------

    Several commenters expressed general concern that the proposed 
exemption may be applied on a transaction-by-transaction basis and 
explained the burdens that may result from such an approach.\517\ 
Commenters appeared to attribute these concerns to language in the 
proposed exemption referring to a ``purchase or sale of a [financial 
instrument]'' \518\ or to language in Appendix B indicating that the 
Agencies may assess certain factors and criteria at different levels, 
including a ``single significant transaction.'' \519\ With respect to 
the burdens of a transaction-by-transaction analysis, some commenters 
noted that banking entities can engage in a large volume of market-
making transactions daily, which would make it burdensome to apply the 
exemption to each trade.\520\ A few commenters indicated that, even if 
the Agencies did not intend to require transaction-by-transaction 
analysis, the proposed rule's language can be read to imply such a 
requirement. These commenters indicated that ambiguity on this issue 
could have a chilling effect on market making or could allow some 
examiners to rigidly apply the requirements of the exemption on a 
trade-by-trade basis.\521\ Other commenters indicated that it would be 
difficult to determine whether a particular trade was or was not a 
market-making trade without consideration of the relevant unit's 
overall activities.\522\ One commenter elaborated on this point by 
stating that

[[Page 5578]]

``an analysis that seeks to characterize specific transactions as 
either market making. . . or prohibited activity does not accord with 
the way in which modern trading units operate, which generally view 
individual positions as a bundle of characteristics that contribute to 
their complete portfolio.'' \523\ This commenter noted that a position 
entered into as part of market making-related activities may serve 
multiple functions at one time, such as responding to customer demand, 
hedging a risk, and building inventory. The commenter also expressed 
concern that individual transactions or positions may not be severable 
or separately identifiable as serving a market-making purpose.\524\ Two 
commenters suggested that the requirements in the market-making 
exemption be applied at the portfolio level rather than the trade 
level.\525\
---------------------------------------------------------------------------

    \517\ See Wellington; SIFMA et al. (Prop. Trading) (Feb. 2012); 
Barclays; Goldman (Prop. Trading); HSBC; Fixed Income Forum/Credit 
Roundtable; ACLI (Feb. 2012); PUC Texas; ERCOT; Invesco. See also 
IAA (stating that it is unclear whether the requirements must be 
applied on a transaction-by-transaction basis or if compliance with 
the requirements is based on overall activities). This issue is 
addressed in Part IV.A.3.c.1.c., infra.
    \518\ See, e.g., Barclays; SIFMA et al. (Prop. Trading) (Feb. 
2012). As explained above, the term ``covered financial position'' 
from the proposal has been replaced by the term ``financial 
instrument'' in the final rule. Because the types of instruments 
included in both definitions are identical, the term ``financial 
instrument'' is used throughout this Part.
    \519\ See, e.g., Goldman (Prop. Trading); Wellington.
    \520\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); 
Barclays (stating that ``hundreds or thousands of trades can occur 
in a single day in a single trading unit'').
    \521\ See, e.g., ICI (Feb. 2012); Barclays; Goldman (Prop. 
Trading).
    \522\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); 
Goldman (Prop. Trading).
    \523\ SIFMA et al. (Prop. Trading) (Feb. 2012).
    \524\ See id. (suggesting that the Agencies ``give full effect 
to the statutory intent to allow market making by viewing the 
permitted activity on a holistic basis'').
    \525\ See ACLI (Feb. 2012); Fixed Income Forum/Credit 
Roundtable.
---------------------------------------------------------------------------

    Moreover, commenters also set forth their views on the 
organizational level at which the requirements of the proposed market-
making exemption should apply.\526\ The proposed exemption generally 
applied requirements to a ``trading desk or other organizational unit'' 
of a banking entity. In response to this proposed approach, commenters 
stated that compliance should be assessed at each trading desk or 
aggregation unit \527\ or at each trading unit.\528\
---------------------------------------------------------------------------

    \526\ See Wellington; Morgan Stanley; SIFMA et al. (Prop. 
Trading) (Feb. 2012); ACLI (Feb. 2012); Fixed Income Forum/Credit 
Roundtable. The Agencies address this topic in Part IV.A.3.c.1.c., 
infra.
    \527\ See Wellington. This commenter did not provide greater 
specificity about how it would define ``trading desk'' or 
``aggregation unit.'' See id.
    \528\ See Morgan Stanley (stating that ``trading unit'' should 
be defined as ``each organizational unit that is used to structure 
and control the aggregate risk-taking activities and employees that 
are engaged in the coordinated implementation of a customer-facing 
revenue generation strategy and that participate in the execution of 
any covered trading activity''); SIFMA et al. (Prop. Trading) (Feb. 
2012). One of these commenters discussed its suggested definition of 
``trading unit'' in the context of the proposed requirement to 
record and report certain quantitative measurements, but it is 
unclear that the commenter was also suggesting that this definition 
be used for purposes of the market-making exemption. For example, 
this commenter expressed support for a multi-level approach to 
defining ``trading unit,'' and it is not clear how a definition that 
captures multiple organizational levels across a banking 
organization would work in the context of the market-making 
exemption. See SIFMA et al. (Prop. Trading) (Feb. 2012) (suggested 
that ``trading unit'' be defined ``at a level that presents its 
activities in the context of the whole'' and noting that the 
appropriate level may differ depending on the structure of the 
banking entity).
---------------------------------------------------------------------------

    Several commenters suggested alternative or additive means of 
implementing the statutory exemption for market making-related 
activity.\529\ Commenters' recommended approaches varied, but a number 
of commenters requested approaches involving one or more of the 
following elements: (i) Safe harbors,\530\ bright lines,\531\ or 
presumptions of compliance with the exemption based on the existence of 
certain factors (e.g., compliance program, metrics, general customer 
focus or orientation, providing liquidity, and/or exchange registration 
as a market maker); \532\ (ii) a focus on metrics or other objective 
factors; \533\ (iii) guidance on permitted market making-related 
activity, rather than rule requirements; \534\ (iv) risk management 
structures and/or risk limits; \535\ (v) adding a new customer-facing 
criterion or focusing on client-related activities; \536\ (vi) capital 
and liquidity requirements; \537\ (vii) development of individualized 
plans for each banking entity, in coordination with regulators; \538\ 
(viii) ring fencing affiliates engaged in market making-related 
activity; \539\ (ix) margin requirements; \540\ (x) a compensation-
focused approach; \541\ (xi) permitting all swap dealing activity; 
\542\ (xii) additional provisions regarding material conflicts of 
interest and high-risk assets and trading strategies; \543\ and/or 
(xiii) making the exemption as broad as possible under the 
statute.\544\
---------------------------------------------------------------------------

    \529\ See, e.g., Wellington; Japanese Bankers Ass'n.; Prof. 
Duffie; IR&M; G2 FinTech; MetLife; NYSE Euronext; Anthony Flynn and 
Koral Fusselman; IIF; CalPERS; SIFMA et al. (Prop. Trading) (Feb. 
2012); Sens. Merkley & Levin (Feb. 2012); Shadow Fin. Regulatory 
Comm.; John Reed; Prof. Richardson; Credit Suisse (Seidel); JPMC; 
Morgan Stanley; Barclays; Goldman (Prop. Trading); BoA; Citigroup 
(Feb. 2012); STANY; ICE; BlackRock; Johnson & Prof. Stiglitz; Fixed 
Income Forum/Credit Roundtable; ACLI (Feb. 2012); Wells Fargo (Prop. 
Trading); WR Hambrecht; Vanguard; Capital Group; PUC Texas; SSgA 
(Feb. 2012); PNC et al.; Fidelity; Occupy; AFR et al. (Feb. 2012); 
Invesco; ISDA (Feb. 2012); Stephen Roach; Oliver Wyman (Feb. 2012). 
The Agencies respond to these comments in Part IV.A.3.b.3., infra.
    \530\ See, e.g., Sens. Merkley & Levin (Feb. 2012); John Reed; 
Prof. Richardson; Johnson & Prof. Stiglitz; Capital Group; Invesco; 
BDA (Feb. 2012) (Oct. 2012) (suggesting a safe harbor for any 
trading desk that effects more than 50 percent of its transactions 
through sales representatives).
    \531\ See, e.g., Flynn & Fusselman; Prof. Colesanti et al.
    \532\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); IIF; 
NYSE Euronext; Credit Suisse (Seidel); JPMC; Barclays; BoA; Wells 
Fargo (Prop. Trading) (suggesting that the rule: (i) Provide a 
general grant of authority to engage in any transactions entered 
into as part of a banking entity's market-making business, where 
``market making'' is defined as ``the business of being willing to 
facilitate customer purchases and sales of [financial instruments] 
as an intermediary over time and in size, including by holding 
positions in inventory;'' and (ii) allow banking entities to monitor 
compliance with this exemption internally through their compliance 
and risk management infrastructure); PNC et al.; Oliver Wyman (Feb. 
2012).
    \533\ See, e.g., Goldman (Prop. Trading); Morgan Stanley; 
Barclays; Wellington; CalPERS; BlackRock; SSgA (Feb. 2012); Invesco.
    \534\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012) 
(suggesting that this guidance could be incorporated in banking 
entities' policies and procedures for purposes of complying with the 
rule, in addition to the establishment of risk limits, controls, and 
metrics); JPMC; BoA; PUC Texas; SSgA (Feb. 2012); PNC et al.; Wells 
Fargo (Prop. Trading).
    \535\ See, e.g., Japanese Bankers Ass'n.; Citigroup (Feb. 2012).
    \536\ See, e.g., Morgan Stanley; Stephen Roach.
    \537\ See, e.g., Prof. Duffie; CalPERS; STANY; ICE; Vanguard; 
Capital Group.
    \538\ See MetLife; Fixed Income Forum/Credit Roundtable; ACLI 
(Feb. 2012).
    \539\ See, e.g., Prof. Duffie; Shadow Fin. Regulatory Comm. See 
also Wedbush.
    \540\ See WR Hambrecht.
    \541\ See G2 FinTech.
    \542\ See ISDA (Feb. 2012); ISDA (Apr. 2012).
    \543\ See Sens. Merkley & Levin (Feb. 2012) (stating that the 
exemption should expressly mention the conflicts provision and 
provide examples to warn against particular conflicts, such as 
recommending clients buy poorly performing assets in order to remove 
them from the banking entity's book or attempting to move market 
prices in favor of trading positions a banking entity has built up 
in order to make a profit); Stephen Roach (suggesting that the 
exemption integrate the limitations on permitted activities).
    \544\ See Fidelity (stating that the exemption needs to be as 
broad as possible to account for customer-facing principal trades, 
block trades, and market making in OTC derivatives). See also STANY 
(stating that it is better to make the exemption too broad than too 
narrow).
---------------------------------------------------------------------------

b. Comments Regarding the Potential Market Impact of the Proposed 
Exemption
    As discussed above, several commenters stated that the proposed 
rule would impact a banking entity's ability to engage in market 
making-related activity. Many of these commenters represented that, as 
a result, the proposed exemption would likely result in reduced 
liquidity,\545\

[[Page 5579]]

wider bid-ask spreads,\546\ increased market volatility,\547\ reduced 
price discovery or price transparency,\548\ increased costs of raising 
capital or higher financing costs,\549\ greater costs for investors or 
consumers,\550\ and slower execution times.\551\ Some commenters 
expressed particular concern about potential impacts on institutional 
investors (e.g., mutual funds and pension funds) \552\ or on small or 
midsized companies.\553\ A number of commenters discussed the 
interrelationship between primary and secondary market activity and 
indicated that restrictions on market making would impact the 
underwriting process.\554\
---------------------------------------------------------------------------

    \545\ See, e.g., AllianceBernstein; Rep. Bachus et al. (Dec. 
2011); EMTA; NASP; Wellington; Japanese Bankers Ass'n.; Sen. Hagan; 
Prof. Duffie; Investure; Standish Mellon; IR&M; MetLife; Lord 
Abbett; Commissioner Barnier; Quebec; IIF; Sumitomo Trust; Liberty 
Global; NYSE Euronext; CIEBA; EFAMA; SIFMA et al. (Prop. Trading) 
(Feb. 2012); Credit Suisse (Seidel); JPMC; Morgan Stanley; Barclays; 
Goldman (Prop. Trading); BoA; Citigroup (Feb. 2012); STANY; ICE; 
BlackRock; SIFMA (Asset Mgmt.) (Feb. 2012); BDA (Feb. 2012); Putnam; 
Fixed Income Forum/Credit Roundtable; Western Asset Mgmt.; ACLI 
(Feb. 2012); IAA; CME Group; Wells Fargo (Prop. Trading); Abbott 
Labs et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 21, 2012); T. 
Rowe Price; Australian Bankers Ass'n. (Feb. 2012); FEI; AFMA; Sen. 
Carper et al.; PUC Texas; ERCOT; IHS; Columbia Mgmt.; SSgA (Feb. 
2012); PNC et al.; Eaton Vance; Fidelity; ICI (Feb. 2012); British 
Bankers' Ass'n.; Comm. on Capital Markets Regulation; Union Asset; 
Sen. Casey; Oliver Wyman (Dec. 2011); Oliver Wyman (Feb. 2012) 
(providing estimated impacts on asset valuation, borrowing costs, 
and transaction costs in the corporate bond market based on 
hypothetical liquidity reduction scenarios); Thakor Study. The 
Agencies respond to comments regarding the potential market impact 
of the rule in Part IV.A.3.b.3., infra.
    \546\ See, e.g., AllianceBernstein; Wellington; Investure; 
Standish Mellon; MetLife; Lord Abbett; Barclays; Goldman (Prop. 
Trading); Citigroup (Feb. 2012); BlackRock; Putnam; ACLI (Feb. 
2012); Abbott Labs et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 
21, 2012); T. Rowe Price; Sen. Carper et al.; IHS; Columbia Mgmt.; 
ICI (Feb. 2012) British Bankers' Ass'n.; Comm. on Capital Markets 
Regulation; Thakor Study (stating that section 13 of the BHC Act 
will likely result in higher bid-ask spreads by causing at least 
some retrenchment of banks from market making, resulting in fewer 
market makers and less competition).
    \547\ See, e.g., Wellington; Prof. Duffie; Standish Mellon; Lord 
Abbett; IIF; SIFMA et al. (Prop. Trading) (Feb. 2012); Barclays; 
Goldman (Prop. Trading); BDA (Feb. 2012); IHS; FTN; IAA; Wells Fargo 
(Prop. Trading); T. Rowe Price; Columbia Mgmt.; SSgA (Feb. 2012); 
Eaton Vance; British Bankers' Ass'n.; Comm. on Capital Markets 
Regulation.
    \548\ See, e.g., Prof. Duffie (arguing that, for example, 
``during the financial crisis of 2007-2009, the reduced market 
making capacity of major dealer banks caused by their insufficient 
capital levels resulted in dramatic downward distortions in 
corporate bond prices''); IIF; Barclays; IAA; Vanguard; Wellington; 
FTN.
    \549\ See, e.g., AllianceBernstein; Chamber (Dec. 2011); Members 
of Congress (Dec. 2011); Wellington; Sen. Hagan; Prof. Duffie; IR&M; 
MetLife; Lord Abbett; Liberty Global; NYSE Euronext; SIFMA et al. 
(Prop. Trading) (Feb. 2012); NCSHA; ASF (Feb. 2012) (stating that 
``[f]ailure to permit the activities necessary for banking entities 
to act in [a] market-making capacity [in asset-backed securities] 
would have a dramatic adverse effect on the ability of securitizers 
to access the asset-backed securities markets and thus to obtain the 
debt financing necessary to ensure a vibrant U.S. economy''); Credit 
Suisse (Seidel); JPMC; Morgan Stanley; Barclays; Goldman (Prop. 
Trading); BoA; Citigroup (Feb. 2012); STANY; BlackRock; Chamber 
(Feb. 2012); IHS; BDA (Feb. 2012); Fixed Income Forum/Credit 
Roundtable; ACLI (Feb. 2012); Wells Fargo (Prop. Trading); Abbott 
Labs et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 21, 2012); T. 
Rowe Price; FEI; AFMA; SSgA (Feb. 2012); PNC et al.; ICI (Feb. 
2012); British Bankers' Ass'n.; Oliver Wyman (Dec. 2011); Oliver 
Wyman (Feb. 2012); GE (Feb. 2012); Thakor Study (stating that when a 
firm's cost of capital goes up, it invests less--resulting in lower 
economic growth and lower employment--and citing supporting data 
indicating that a 1 percent increase in the cost of capital would 
lead to a $55 to $82.5 billion decline in aggregate annual capital 
spending by U.S. nonfarm firms and job losses between 550,000 and 
1.1 million per year in the nonfarm sector). One commenter further 
noted that a higher cost of capital can lead a firm to make riskier, 
short-term investments. See Thakor Study.
    \550\ See, e.g., Wellington; Standish Mellon; IR&M; MetLife; 
Lord Abbett; NYSE Euronext; CIEBA; Barclays; Goldman (Prop. 
Trading); BoA; Citigroup (Feb. 2012); STANY; ICE; BlackRock; Fixed 
Income Forum/Credit Roundtable; ACLI (Feb. 2012); IAA; Abbott Labs 
et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 21, 2012); T. Rowe 
Price; Vanguard; Australian Bankers Ass'n. (Feb. 2012); FEI; Sen. 
Carper et al.; Columbia Mgmt.; SSgA (Feb. 2012); ICI (Feb. 2012); 
Comm. on Capital Markets Regulation; TMA Hong Kong; Sen. Casey; IHS; 
Oliver Wyman (Dec. 2011); Oliver Wyman (Feb. 2012); Thakor Study.
    \551\ See, e.g., Barclays; FTN; Abbott Labs et al. (Feb. 14, 
2012); Abbott Labs et al. (Feb. 21, 2012).
    \552\ See, e.g., AllianceBernstein (stating that, to the extent 
the rule reduces liquidity provided by market makers, open end 
mutual funds that are largely driven by the need to respond to both 
redemptions and subscriptions will be immediately impacted in terms 
of higher trading costs); Wellington (indicating that periods of 
extreme market stress are likely to exacerbate costs and challenges, 
which could force investors such as mutual funds and pension funds 
to accept distressed prices to fund redemptions or pay current 
benefits); Lord Abbett (stating that certain factors, such as 
reduced bank capital to support market-making businesses and 
economic uncertainty, have already reduced liquidity and caused 
asset managers to have an increased preference for highly liquid 
credits and expressing concern that, if section 13 of the BHC Act 
further reduces liquidity, then: (i) Asset managers' increased 
preference for highly liquid credit could lead to unhealthy 
portfolio concentrations, and (ii) asset managers will maintain a 
larger cash cushion in portfolios that may be subject to redemption, 
which will likely result in investors getting poorer returns); 
EFAMA; BlackRock (stating that investment decisions are heavily 
dependent on a liquidity factor input, so as liquidity dissipates, 
investment strategies become more limited and returns to investors 
are diminished by wider spreads and higher transaction costs); CFA 
Inst. (noting that a mutual fund that tries to liquidate holdings to 
meet redemptions may have difficulty selling at acceptable prices, 
thus impairing the fund's NAV for both redeeming investors and for 
those that remain in the fund); Putnam; Fixed Income Forum/Credit 
Roundtable; ACLI; T. Rowe Price; Vanguard; IAA; FEI; Sen. Carper et 
al.; Columbia Mgmt.; ICI (Feb. 2012); Invesco; Union Asset; Standish 
Mellon; Morgan Stanley; SIFMA (Asset Mgmt.) (Feb. 2012).
    \553\ See, e.g., CIEBA (stating that for smaller issuers in 
particular, market makers need to have incentives to make markets, 
and the proposal removes important incentives); ACLI (indicating 
that lower liquidity will most likely result in higher costs for 
issuers of debt and, for lesser known or lower quality issuers, this 
cost may be significant and in some cases prohibitive because the 
cost will vary depending on the credit quality of the issuer, the 
amount of debt it has in the market, and the maturity of the 
security); PNC et al. (expressing concern that a regional bank's 
market-making activity for small and middle market customers is more 
likely to be inappropriately characterized as impermissible 
proprietary trading due to lower trading volume involving less 
liquid securities); Morgan Stanley; Chamber (Feb. 2012); Abbott Labs 
et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 21, 2012); FEI; ICI 
(Feb. 2012); TMA Hong Kong; Sen. Casey.
    \554\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; RBC; 
NYSE Euronext; Credit Suisse (Seidel).
---------------------------------------------------------------------------

    A few commenters expressed the view that reduced liquidity would 
not necessarily be a negative result.\555\ For example, two commenters 
noted that liquidity is vulnerable to liquidity spirals, in which a 
high level of market liquidity during one period feeds a sharp decline 
in liquidity during the next period by initially driving asset prices 
upward and supporting increased leverage. The commenters explained that 
liquidity spirals lead to ``fire sales'' by market speculators when 
events reveal that assets are overpriced and speculators must sell 
their assets to reduce their leverage.\556\ According to another 
commenter, banking entities' access to the safety net allows them to 
distort market prices and, arguably, produce excess liquidity. The 
commenter further represented that it would be preferable to allow the 
discipline of the market to choose the pricing of securities and the 
amount of liquidity.\557\ Some commenters cited an economic study 
indicating that the U.S. financial system has become less efficient in 
generating economic growth in recent years, despite increased trading 
volumes.\558\
---------------------------------------------------------------------------

    \555\ See, e.g., Paul Volcker; AFR et al. (Feb. 2012); Public 
Citizen; Prof. Richardson; Johnson & Prof. Stiglitz; Better Markets 
(Feb. 2012); Prof. Johnson.
    \556\ See AFR et al. (Feb. 2012); Public Citizen. See also Paul 
Volcker (stating that at some point, greater liquidity, or the 
perception of greater liquidity, may encourage more speculative 
trading).
    \557\ See Prof. Richardson.
    \558\ See, e.g., Johnson & Prof. Stiglitz (citing Thomas 
Phillippon, Has the U.S. Finance Industry Become Less Efficient?, 
NYU Working Paper, Nov. 2011); AFR et al. (Feb. 2012); Public 
Citizen; Better Markets (Feb. 2012); Prof. Johnson.
---------------------------------------------------------------------------

    Some commenters stated that it is unlikely the proposed rule would 
result in the negative market impacts identified above, such as reduced 
market liquidity.\559\ For example, a few commenters stated that other 
market participants, who are not subject to section 13 of the BHC Act, 
may enter the market or increase their trading activities to make up 
for any reduction in banking entities' market-making

[[Page 5580]]

activity or other trading activity.\560\ For instance, one of these 
commenters suggested that the revenue and profits from market making 
will be sufficient to attract capital and competition to that 
activity.\561\ In addition, one commenter expressed the view that 
prohibiting proprietary trading may support more liquid markets by 
ensuring that banking entities focus on providing liquidity as market 
makers, rather than taking liquidity from the market in the course of 
``trading to beat'' institutional buyers like pension funds, university 
endowments, and mutual funds.\562\ Another commenter stated that, while 
section 13 of the BHC Act may temporarily reduce trading volume and 
excessive liquidity at the peak of market bubbles, it should increase 
the long-run stability of the financial system and render genuine 
liquidity and credit availability more reliable over the long 
term.\563\
---------------------------------------------------------------------------

    \559\ See, e.g., Sens. Merkley & Levin (Feb. 2012) (stating that 
there is no convincing, independent evidence that the rule would 
increase trading costs or reduce liquidity, and the best evidence 
available suggests that the buy-side firms would greatly benefit 
from the competitive pressures that transparency can bring); Better 
Markets (Feb. 2012) (``Industry's claim that [section 13 of the BHC 
Act] will `reduce market liquidity, capital formation, and credit 
availability, and thereby hamper economic growth and job creation' 
disregard the fact that the financial crisis did more damage to 
those concerns than any rule or reform possibly could.''); Profs. 
Stout & Hastings; Prof. Johnson; Occupy; Public Citizen; Profs. 
Admati & Pfleiderer; Better Markets (June 2012); AFR et al. (Feb. 
2012). One commenter stated that the proposed rule would improve 
market liquidity, efficiency, and price transparency. See Alfred 
Brock.
    \560\ See, e.g., Sens. Merkley & Levin (Feb. 2012); Prof. 
Richardson; Better Markets (Feb. 2012); Profs. Stout & Hastings; 
Prof. Johnson; Occupy; Public Citizen; Profs. Admati & Pfleiderer; 
Better Markets (June 2012). Similarly, one commenter indicated that 
non-banking entity market participants could fill the current role 
of banking entities in the market if implementation of the rule is 
phased in. See ACLI (Feb. 2012).
    \561\ See Better Markets (Feb. 2012).
    \562\ See Prof. Johnson.
    \563\ See AFR et al. (Feb. 2012).
---------------------------------------------------------------------------

    Other commenters, however, indicated that it is uncertain or 
unlikely that non-banking entities will enter the market or increase 
their trading activities, particularly in the short term.\564\ For 
example, one commenter noted the investment that banking entities have 
made in infrastructure for trading and compliance would take smaller or 
new firms years and billions of dollars to replicate.\565\ Another 
commenter questioned whether other market participants, such as hedge 
funds, would be willing to dedicate capital to fully serving customer 
needs, which is required to provide ongoing liquidity.\566\ One 
commenter stated that even if non-banking entities move in to replace 
lost trading activity from banking entities, the value of the current 
interdealer network among market makers will be reduced due to the exit 
of banking entities.\567\ Several commenters expressed the view that 
migration of market making-related activities to firms outside the 
banking system would be inconsistent with Congressional intent and 
would have potentially adverse consequences for the safety and 
soundness of the U.S. financial system.\568\
---------------------------------------------------------------------------

    \564\ See, e.g., Wellington; Prof. Duffie; Investure; IIF; 
Liberty Global; SIFMA et al. (Prop. Trading) (Feb. 2012); Credit 
Suisse (Seidel); JPMC; Morgan Stanley; Barclays; BoA; STANY; SIFMA 
(Asset Mgmt.) (Feb. 2012); FTN; Western Asset Mgmt.; IAA; PUC Texas; 
ICI (Feb. 2012); IIB/EBF; Invesco. In addition, some commenters 
recognized that other market participants are likely to fill banking 
entities' roles in the long term, but not in the short term. See, 
e.g., ICFR; Comm. on Capital Markets Regulation; Oliver Wyman (Feb. 
2012).
    \565\ See Oliver Wyman (Feb. 2012) (``Major bank-affiliated 
market makers have large capital bases, balance sheets, technology 
platforms, global operations, relationships with clients, sales 
forces, risk infrastructure, and management processes that would 
take smaller or new dealers years and billions of dollars to 
replicate.'').
    \566\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \567\ See Thakor Study.
    \568\ See, e.g., Prof. Duffie; Oliver Wyman (Feb. 2012).
---------------------------------------------------------------------------

    Many commenters requested additional clarification on how the 
proposed market-making exemption would apply to certain asset classes 
and markets or to particular types of market making-related activities. 
In particular, commenters requested greater clarity regarding the 
permissibility of: (i) interdealer trading,\569\ including trading for 
price discovery purposes or to test market depth; \570\ (ii) inventory 
management; \571\ (iii) block positioning activity; \572\ (iv) acting 
as an authorized participant or market maker in ETFs; \573\ (v) 
arbitrage or other activities that promote price transparency and 
liquidity; \574\ (vi) primary dealer activity; \575\ (vii) market 
making in futures and options; \576\ (viii) market making in new or 
bespoke products or customized hedging contracts; \577\ and (ix) inter-
affiliate transactions.\578\ As discussed in more detail in Part 
IV.B.2.c., a number of commenters requested that the market-making 
exemption apply to the restrictions on acquiring or retaining an 
ownership interest in a covered fund.\579\ Some commenters stated that 
no other activities should be considered permitted market making-
related activity under the rule.\580\ In addition, a few commenters 
requested clarification that high-frequency trading would not qualify 
for the market-making exemption.\581\
---------------------------------------------------------------------------

    \569\ See, e.g., MetLife; SIFMA et al. (Prop. Trading) (Feb. 
2012); RBC; Credit Suisse (Seidel); JPMC; BoA; ACLI (Feb. 2012); AFR 
et al. (Feb. 2012); ISDA (Feb. 2012); Goldman (Prop. Trading); 
Oliver Wyman (Feb. 2012).
    \570\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Chamber 
(Feb. 2012); Goldman (Prop. Trading).
    \571\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); 
Credit Suisse (Seidel); Goldman (Prop. Trading); MFA; RBC.
    \572\ See infra Part IV.A.3.c.1.b.ii. (discussing commenters' 
requests for greater clarity regarding the permissibility of block 
positioning activity).
    \573\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); 
Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); BoA; ICI 
(Feb. 2012); ICI Global; Vanguard; SSgA (Feb. 2012).
    \574\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit 
Suisse (Seidel); JPMC; Goldman (Prop. Trading); FTN; RBC; ISDA (Feb. 
2012).
    \575\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; 
Goldman (Prop. Trading); Banco de M[eacute]xico; IIB/EBF.
    \576\ See CME Group (requesting clarification that the market-
making exemption permits a banking entity to engage in market making 
in exchange-traded futures and options because the dealer 
registration requirement in Sec.  ----.4(b)(2)(iv) of the proposed 
rule did not refer to such instruments and stating that lack of an 
explicit exemption would reduce market-making activities in these 
instruments, which would decrease liquidity). But See Johnson & 
Prof. Stiglitz (stating that the Agencies should pay special 
attention to options trading and other derivatives because they are 
highly volatile assets that are difficult if not impossible to 
effectively hedge, except through a completely matched position, and 
suggesting that options and similar derivatives may need to be 
required to be sold only as riskless principal under Sec.  --
--.6(b)(1)(ii) of the proposed rule or significantly limited through 
capital charges); Sens. Merkley & Levin (Feb. 2012) (stating that 
asset classes that are particularly hard to hedge, such as options, 
should be given special attention under the hedging exemption).
    \577\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); 
Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); SIFMA (Asset 
Mgmt.) (Feb. 2012). Other commenters, however, stated that banking 
entities should be limited in their ability to rely on the market-
making exemption to conduct transactions in bespoke or customized 
derivatives. See, e.g., AFR et al. (Feb. 2012); Public Citizen.
    \578\ See, e.g., Japanese Bankers Ass'n. (stating that 
transactions with affiliates and subsidiaries and related to hedging 
activities are a type of market making-related activity or risk-
mitigating hedging activity that should be exempted by the rule); 
SIFMA et al. (Prop. Trading) (Feb. 2012). According to one of these 
commenters, inter-affiliate transactions should be viewed as part of 
a coordinated activity for purposes of determining whether a banking 
entity qualifies for an exemption. This commenter stated that, for 
example, if a market maker shifts positions held in inventory to an 
affiliate that is better able to manage the risk of such positions, 
both the market maker and its affiliate would be engaged in 
permitted market making-related activity. This commenter further 
represented that fitting the inter-affiliate swap into the exemption 
may be difficult (e.g., one of the affiliates entering into the swap 
may not be holding itself out as a willing counterparty). See SIFMA 
et al. (Prop. Trading) (Feb. 2012).
    \579\ See, e.g., Cleary Gottlieb; JPMC; BoA; Credit Suisse 
(Williams).
    \580\ See, e.g., Occupy; Alfred Brock.
    \581\ See, e.g., Occupy; AFR et al. (Feb. 2012); Public Citizen; 
Johnson & Prof. Stiglitz; Sens. Merkley & Levin (Feb. 2012); John 
Reed.
---------------------------------------------------------------------------

3. Final Market-Making Exemption
    After carefully considering comment letters, the Agencies are 
adopting certain refinements to the proposed market-making exemption. 
The Agencies are adopting a market-making exemption that is consistent 
with the statutory exemption for this activity and designed to permit 
banking entities to continue providing intermediation and liquidity 
services. The Agencies note that, while all market-making activity 
should ultimately be related to the intermediation of trading, whether 
directly to individual customers through bilateral transactions or more 
broadly to

[[Page 5581]]

a given marketplace, certain characteristics of a market-making 
business may differ among markets and asset classes.\582\ The final 
rule is intended to account for these differences to allow banking 
entities to continue to engage in market making-related activities by 
providing customer intermediation and liquidity services across markets 
and asset classes, if such activities do not violate the statutory 
limitations on permitted activities (e.g., by involving or resulting in 
a material conflict of interest with a client, customer, or 
counterparty) and are conducted in conformance with the exemption.
---------------------------------------------------------------------------

    \582\ Consistent with the FSOC study and the proposal, the final 
rule recognizes that the precise nature of a market maker's 
activities often varies depending on the liquidity, trade size, 
market infrastructure, trading volumes and frequency, and geographic 
location of the market for any particular type of financial 
instrument. See Joint Proposal, 76 FR 68,870; CFTC Proposal, 77 FR 
8356; FSOC study (stating that ``characteristics of permitted 
activities in one market or asset class may not be the same in 
another market (e.g., permitted activities in a liquid equity 
securities market may vary significantly from an illiquid over-the-
counter derivatives market)'').
---------------------------------------------------------------------------

    At the same time, the final rule requires development and 
implementation of trading, risk and inventory limits, risk management 
strategies, analyses of how the specific market making-related 
activities are designed not to exceed the reasonably expected near term 
demands of customers, compensation standards, and monitoring and review 
requirements that are consistent with market-making activities.\583\ 
These requirements are designed to distinguish exempt market making-
related activities from impermissible proprietary trading. In addition, 
these requirements are designed to ensure that a banking entity is 
aware of, monitors, and limits the risks of its exempt activities 
consistent with the prudent conduct of market making-related 
activities.
---------------------------------------------------------------------------

    \583\ Certain of these requirements, like the requirements to 
have risk and inventory limits, risk management strategies, and 
monitoring and review requirements were included in the enhanced 
compliance program requirement in proposed Appendix C, but were not 
separately included in the proposed market-making exemption. Like 
the statute, the proposed rule would have required that market 
making-related activities be designed not to exceed the reasonably 
expected near term demand of clients, customers, or counterparties. 
The Agencies are adding an explicit requirement in the final rule 
that a trading desk conduct analyses of customer demand for purposes 
of complying with this statutory requirement.
---------------------------------------------------------------------------

    As described in detail below, the final market-making exemption 
consists of the following elements:
     A framework that recognizes the differences in market 
making-related activities across markets and asset classes by 
establishing criteria that can be applied based on the liquidity, 
maturity, and depth of the market for the particular type of financial 
instrument.
     A general focus on analyzing the overall ``financial 
exposure'' and ``market-maker inventory'' held by any given trading 
desk rather than a transaction-by-transaction analysis. The ``financial 
exposure'' reflects the aggregate risks of the financial instruments, 
and any associated loans, commodities, or foreign exchange or currency, 
held by a banking entity or its affiliate and managed by a particular 
trading desk as part of its market making-related activities. The 
``market-maker inventory'' means all of the positions, in the financial 
instruments for which the trading desk stands ready to make a market 
that are managed by the trading desk, including the trading desk's open 
positions or exposures arising from open transactions.\584\
---------------------------------------------------------------------------

    \584\ See infra Part IV.A.3.c.1.c.ii. See also final rule 
Sec. Sec.  ----.4(b)(4), (5).
---------------------------------------------------------------------------

     A definition of the term ``trading desk'' that focuses on 
the operational functionality of the desk rather than its legal status, 
and requirements that apply at the trading desk level of organization 
within a single banking entity or across two or more affiliates.\585\
---------------------------------------------------------------------------

    \585\ See infra Part IV.A.3.c.1.c.i. The term ``trading desk'' 
is defined as ``the smallest discrete unit of organization of a 
banking entity that buys or sells financial instruments for the 
trading account of the banking entity or an affiliate thereof.'' 
Final rule Sec.  ----.3(e)(13).
---------------------------------------------------------------------------

     Five requirements for determining whether a banking entity 
is engaged in permitted market making-related activities. Many of these 
criteria have similarities to the factors included in the proposed 
rule, but with important modifications in response to comments. These 
standards require that:
    [cir] The trading desk that establishes and manages a financial 
exposure routinely stands ready to purchase and sell one or more types 
of financial instruments related to its financial exposure and is 
willing and available to quote, buy and sell, or otherwise enter into 
long and short positions in those types of financial instruments for 
its own account, in commercially reasonable amounts and throughout 
market cycles, on a basis appropriate for the liquidity, maturity, and 
depth of the market for the relevant types of financial instruments; 
\586\
---------------------------------------------------------------------------

    \586\ See final rule Sec.  ----.4(b)(2)(i); infra Part 
IV.A.3.c.1.c.iii.
---------------------------------------------------------------------------

    [cir] The amount, types, and risks of the financial instruments in 
the trading desk's market-maker inventory are designed not to exceed, 
on an ongoing basis, the reasonably expected near term demands of 
clients, customers, or counterparties, as required by the statute and 
based on certain factors and analysis; \587\
---------------------------------------------------------------------------

    \587\ See final rule Sec.  ----.4(b)(2)(ii); infra Part 
IV.A.3.c.2.c. In addition, the Agencies are adopting a definition of 
the terms ``client,'' ``customer,'' and ``counterparty'' in Sec.  --
--.4(b)(3) of the final rule.
---------------------------------------------------------------------------

    [cir] The banking entity has established and implements, maintains, 
and enforces an internal compliance program that is reasonably designed 
to ensure its compliance with the market-making exemption, including 
reasonably designed written policies and procedures, internal controls, 
analysis, and independent testing identifying and addressing:
    [ssquf] The financial instruments each trading desk stands ready to 
purchase and sell in accordance with Sec.  ----.4(b)(2)(i) of the final 
rule;
    [ssquf] The actions the trading desk will take to demonstrably 
reduce or otherwise significantly mitigate promptly the risks of its 
financial exposure consistent with its established limits; the 
products, instruments, and exposures each trading desk may use for risk 
management purposes; the techniques and strategies each trading desk 
may use to manage the risks of its market making-related activities and 
inventory; and the process, strategies, and personnel responsible for 
ensuring that the actions taken by the trading desk to mitigate these 
risks are and continue to be effective; \588\
---------------------------------------------------------------------------

    \588\ Routine market making-related risk management activity by 
a trading desk is permitted under the market-making exemption and, 
provided the standards of the exemption are met, is not required to 
separately meet the requirements of the hedging exemption. The 
circumstances under which risk management activity relating to the 
trading desk's financial exposure is permitted under the market-
making exemption or must separately comply with the hedging 
exemption are discussed in more detail in Parts IV.A.3.c.1.c.ii. and 
IV.A.3.c.4., infra.
---------------------------------------------------------------------------

    [ssquf] Limits for each trading desk, based on the nature and 
amount of the trading desk's market making-related activities, 
including factors used to determine the reasonably expected near term 
demands of clients, customers, or counterparties, on: the amount, 
types, and risks of its market-maker inventory; the amount, types, and 
risks of the products, instruments, and exposures the trading desk uses 
for risk management purposes; the level of exposures to relevant risk 
factors arising from its financial exposure; and the period of time a 
financial instrument may be held;
    [ssquf] Internal controls and ongoing monitoring and analysis of 
each trading desk's compliance with its limits; and
    [ssquf] Authorization procedures, including escalation procedures 
that

[[Page 5582]]

require review and approval of any trade that would exceed a trading 
desk's limit(s), demonstrable analysis that the basis for any temporary 
or permanent increase to a trading desk's limit(s) is consistent with 
the requirements of the market-making exemption, and independent review 
of such demonstrable analysis and approval; \589\
---------------------------------------------------------------------------

    \589\ See final rule Sec.  ----.4(b)(2)(iii); infra Part 
IV.A.3.c.3.
---------------------------------------------------------------------------

    [cir] To the extent that any limit identified above is exceeded, 
the trading desk takes action to bring the trading desk into compliance 
with the limits as promptly as possible after the limit is exceeded; 
\590\
---------------------------------------------------------------------------

    \590\ See final rule Sec.  ----.4(b)(2)(iv).
---------------------------------------------------------------------------

    [cir] The compensation arrangements of persons performing market 
making-related activities are designed not to reward or incentivize 
prohibited proprietary trading; \591\ and
---------------------------------------------------------------------------

    \591\ See final rule Sec.  ----.4(b)(2)(v); infra Part 
IV.A.3.c.5.
---------------------------------------------------------------------------

    [cir] The banking entity is licensed or registered to engage in 
market making-related activities in accordance with applicable 
law.\592\
---------------------------------------------------------------------------

    \592\ See final rule Sec.  ----.4(b)(2)(vi); infra Part 
IV.A.3.c.6. As discussed further below, this provision pertains to 
legal registration or licensing requirements that may apply to an 
entity engaged in market making-related activities, depending on the 
facts and circumstances. This provision would not require a banking 
entity to comply with registration requirements that are not 
required by law, such as discretionary registration with a national 
securities exchange as a market maker on that exchange.
---------------------------------------------------------------------------

     The use of quantitative measurements to highlight 
activities that warrant further review for compliance with the 
exemption.\593\ As discussed further in Part IV.C.3., the Agencies have 
reduced some of the compliance burdens by adopting a more tailored 
subset of metrics than was proposed to better focus on those metrics 
that the Agencies believe are most germane to the evaluation of the 
activities that firms conduct under the market-making exemption.
---------------------------------------------------------------------------

    \593\ See infra Part IV.C.3.
---------------------------------------------------------------------------

    In refining the proposed approach to implementing the statute's 
market-making exemption, the Agencies closely considered the various 
alternative approaches suggested by commenters.\594\ However, like the 
proposed approach, the final market-making exemption continues to 
adhere to the statutory mandate that provides for an exemption to the 
prohibition on proprietary trading for market making-related 
activities. Therefore, the final rule focuses on providing a framework 
for assessing whether trading activities are consistent with market 
making. The Agencies believe this approach is consistent with the 
statute \595\ and strikes an appropriate balance between commenters' 
desire for both clarity and flexibility. For example, while a bright-
line or safe harbor based approach would generally provide a high 
degree of certainty about whether an activity qualifies for the market-
making exemption, it would also provide less flexibility to recognize 
the differences in market-making activities across markets and asset 
classes.\596\ In addition, any bright-line approach would be more 
likely to be subject to gaming and avoidance as new products and types 
of trading activities are developed than other approaches to 
implementing the market-making exemption.\597\ Although a purely 
guidance-based approach would provide greater flexibility, it would 
also provide less clarity, which could make it difficult for trading 
personnel, internal compliance personnel, and Agency supervisors and 
examiners to determine whether an activity complies with the rule and 
would lead to an increased risk of evasion of the statutory 
requirements.\598\
---------------------------------------------------------------------------

    \594\ See supra Part IV.A.3.b.2.
    \595\ Certain approaches suggested by commenters, such as 
relying solely on capital requirements, requiring ring fencing, 
permitting all swap dealing activity, or focusing solely on how 
traders are compensated do not appear to be consistent with the 
statutory language because they do not appear to limit market 
making-related activity to that which is designed not to exceed the 
reasonably expected near term demands of clients, customers, or 
counterparties, as required by the statute. See Prof. Duffie; STANY; 
ICE; Shadow Fin. Regulatory Comm.; ISDA (Feb. 2012); ISDA (Apr. 
2012); G2 FinTech.
    \596\ While an approach establishing a number of safe harbors 
that are each tailored to a specific asset class would address the 
need to recognize differences across asset classes, such an approach 
may also increase the complexity of the final rule. Further, 
commenters did not provide sufficient information to determine the 
appropriate parameters of a safe harbor-based approach.
    \597\ As noted above, a number of commenters suggested the 
Agencies adopt a bright-line rule, provide a safe harbor for certain 
types of activities, or establish a presumption of compliance based 
on certain factors. See, e.g., Sens. Merkley & Levin (Feb. 2012); 
John Reed; Prof. Richardson; Johnson & Prof. Stiglitz; Capital 
Group; Invesco; BDA (Oct. 2012); Flynn & Fusselman; Prof. Colesanti 
et al.; SIFMA et al. (Prop. Trading) (Feb. 2012); IIF; NYSE 
Euronext; Credit Suisse (Seidel); JPMC; Barclays; BoA; Wells Fargo 
(Prop. Trading); PNC et al.; Oliver Wyman (Feb. 2012). Many of these 
commenters expressed general concern that the proposed market-making 
exemption may create uncertainty for individual traders engaged in 
market making-related activity and suggested that their proposed 
approach would alleviate such concern. The Agencies believe that the 
enhanced focus on risk and inventory limits for each trading desk 
(which must be tied to the near term customer demand requirement) 
and the clarification that the final market-making exemption does 
not require a trade-by-trade analysis should address concerns about 
individual traders having to assess whether they are complying with 
the market-making exemption on a trade-by-trade basis.
    \598\ Several commenters suggested a guidance-based approach, 
rather than requirements in the final rule. See, e.g., SIFMA et al. 
(Prop. Trading) (Feb. 2012) (suggesting that this guidance could 
then be incorporated in banking entities' policies and procedures 
for purposes of complying with the rule, in addition to the 
establishment of risk limits, controls, and metrics); JPMC; BoA; PUC 
Texas; SSgA (Feb. 2012); PNC et al.; Wells Fargo (Prop. Trading).
---------------------------------------------------------------------------

    Some commenters suggested an approach to implementing the market-
making exemption that would focus on metrics or other objective 
factors.\599\ As discussed below, a number of commenters expressed 
support for using the metrics as a tool to monitor trading activity and 
not to determine compliance with the rule.\600\ While the Agencies 
agree that quantitative measurements are useful for purposes of 
monitoring a trading desk's activities and are requiring certain 
banking entities to calculate, record, and report quantitative 
measurements to the Agencies in the final rule, the Agencies do not 
believe that quantitative measurements should be used as a dispositive 
tool for determining compliance with the market-making exemption.\601\
---------------------------------------------------------------------------

    \599\ See, e.g., Goldman (Prop. Trading); Morgan Stanley; 
Barclays; Wellington; CalPERS; BlackRock; SSgA (Feb. 2012); Invesco.
    \600\ See infra Part IV.C.3. (discussing the final rule's 
metrics requirement). See SIFMA et al. (Prop. Trading) (Feb. 2012); 
Wells Fargo (Prop. Trading); RBC; ICI (Feb. 2012); Occupy (stating 
that there are serious limits to the capabilities of the metrics and 
the potential for abuse and manipulation of the input data is 
significant); Alfred Brock.
    \601\ See infra Part IV.C.3. (discussing the final metrics 
requirement).
---------------------------------------------------------------------------

    In response to two commenters' request that the final rule focus on 
a banking entity's risk management structures or risk limits and not on 
attempting to define market-making activities,\602\ the Agencies do not 
believe that management of risk, on its own, is sufficient to 
differentiate permitted market making-related activities from 
impermissible proprietary trading. For example, the existence of a risk 
management framework or risk limits, while important, would not ensure 
that a trading desk is acting as a market maker by engaging in 
customer-facing activity and providing intermediation and liquidity 
services.\603\ The Agencies also decline to take an approach to 
implementing the market-making exemption that would require the 
development of individualized plans for each banking entity in 
coordination with the Agencies, as suggested by a few

[[Page 5583]]

commenters.\604\ The Agencies believe it is useful to establish a 
consistent framework that will apply to all banking entities to reduce 
the potential for unintended competitive impacts that could arise if 
each banking entity is subject to an individualized plan that is 
tailored to its specific organizational structure and trading 
activities and strategies.
---------------------------------------------------------------------------

    \602\ See, e.g., Japanese Bankers Ass'n.; Citigroup (Feb. 2012).
    \603\ However, as discussed below, the Agencies believe risk 
limits can be a useful tool when they must account for the nature 
and amount of a particular trading desk's market making-related 
activities, including the reasonably expected near term demands of 
clients, customers, or counterparties.
    \604\ See MetLife; Fixed Income Forum/Credit Roundtable; ACLI 
(Feb. 2012).
---------------------------------------------------------------------------

    Although the Agencies are not in the final rule modifying the basic 
structure of the proposed market-making exemption, certain general 
items suggested by commenters, such as enhanced compliance program 
elements and risk limits, have been incorporated in the final rule text 
for the market-making exemption, instead of a separate appendix.\605\ 
Moreover, as described below, the final market-making exemption 
includes specific substantive changes in response to a wide variety of 
commenter concerns.
---------------------------------------------------------------------------

    \605\ The Agencies are not, however, adding certain additional 
requirements suggested by commenters, such as a new customer-facing 
criterion, margin requirements, or additional provisions regarding 
material conflicts of interest or high-risk assets or trading 
strategies. See, e.g., Morgan Stanley; Stephen Roach; WR Hambrecht; 
Sens. Merkley & Levin (Feb. 2012). The Agencies believe that the 
final rule includes sufficient requirements to ensure that a trading 
desk relying on the market-making exemption is engaged in customer-
facing activity (for example, the final rule requires the trading 
desk to stand ready to buy and sell a type of financial instrument 
as market maker and that the trading desk's market-maker inventory 
is designed not to exceed the reasonably expected near term demands 
of clients, customers, or counterparties). The Agencies decline to 
include margin requirements in the final exemption because banking 
entities are currently subject to a number of different margin 
requirements, including those applicable to, among others: SEC-
registered broker-dealers; CFTC-registered swap dealers; SEC-
registered security-based swap dealers: And foreign dealer entities. 
Further, the Agencies are not providing new requirements regarding 
material conflicts of interest and high-risk assets and trading 
strategies in the market-making exemption because the Agencies 
believe these issues are adequately addressed in Sec.  ----.7 of the 
final rule. The limitations in Sec.  ----.7 will apply to market 
making-related activities and all other exempted activities.
---------------------------------------------------------------------------

    The Agencies understand that the economics of market making--and 
financial intermediation in general--require a market maker to be 
active in markets. In determining the appropriate scope of the market-
making exemption, the Agencies have been mindful of commenters' views 
on market making and liquidity. Several commenters stated that the 
proposed rule would impact a banking entity's ability to engage in 
market making-related activity, with corresponding reductions in market 
liquidity.\606\ However, commenters disagreed about whether reduced 
liquidity would be beneficial or detrimental to the market, or if any 
such reductions would even materialize.\607\ Many commenters stated 
that reduced liquidity could lead to other negative market impacts, 
such as wider spreads, higher transaction costs, greater market 
volatility, diminished price discovery, and increased cost of capital.
---------------------------------------------------------------------------

    \606\ See supra note 545 and accompanying text. The Agencies 
acknowledge that reduced liquidity can be costly. One commenter 
provided estimated impacts on asset valuation, borrowing costs, and 
transaction costs in the corporate bond market based on certain 
hypothetical scenarios of reduced market liquidity. This commenter 
noted that its hypothetical liquidity shifts of 5, 10, and 15 
percentile points were ``necessarily arbitrary'' but judged ``to be 
realistic potential outcomes of the proposed rule.'' Oliver Wyman 
(Feb. 2012). Because the Agencies have made significant 
modifications to the proposed rule in response to comments, the 
Agencies believe this commenter's concerns about the market impacts 
of the proposed rule have been substantially addressed.
    \607\ As noted above, a few commenters stated that reduced 
liquidity may provide certain benefits. See, e.g., Paul Volcker; AFR 
et al. (Feb. 2012); Public Citizen; Prof. Richardson; Johnson & 
Prof. Stiglitz; Better Markets (Feb. 2012); Prof. Johnson. However, 
a number of commenters stated that reduced liquidity would have 
negative market impacts. See supra note 545 and accompanying text.
---------------------------------------------------------------------------

    The Agencies understand that market makers play an important role 
in providing and maintaining liquidity throughout market cycles and 
that restricting market-making activity may result in reduced 
liquidity, with corresponding negative market impacts. For instance, 
absent a market maker who stands ready to buy and sell, investors may 
have to make large price concessions or otherwise expend resources 
searching for counterparties. By stepping in to intermediate trades and 
provide liquidity, market makers thus add value to the financial system 
by, for example, absorbing supply and demand imbalances. This often 
means taking on financial exposures, in a principal capacity, to 
satisfy reasonably expected near term customer demand, as well as to 
manage the risks associated with meeting such demand.
    The Agencies recognize that, as noted by commenters, liquidity can 
be associated with narrower spreads, lower transaction costs, reduced 
volatility, greater price discovery, and lower costs of capital.\608\ 
The Agencies agree with these commenters that liquidity provides 
important benefits to the financial system, as more liquid markets are 
characterized by competitive market makers, narrow bid-ask spreads, and 
frequent trading, and that a narrowly tailored market-making exemption 
could negatively impact the market by, as described above, forcing 
investors to make price concessions or unnecessarily expend resources 
searching for counterparties.\609\ For example, while bid-ask spreads 
compensate market makers for providing liquidity when asset values are 
uncertain, under competitive forces, dealers compete with respect to 
spreads, thus lowering their profit margins on a per trade basis and 
benefitting investors.\610\ Volatility is driven by both uncertainty 
about fundamental value and the liquidity needs of investors. When 
markets are illiquid, participants may have to make large price 
concessions to find a counterparty willing to trade, increasing the 
importance of the liquidity channel for addressing volatility. If 
liquidity-based volatility is not diversifiable, investors will require 
a risk premium for holding liquidity risk, increasing the cost of 
capital.\611\ Commenters additionally suggested that the effects of 
diminished liquidity could be concentrated in securities markets for 
small or midsize companies or for lesser-known issuers, where trading 
is already infrequent.\612\ Volume in these

[[Page 5584]]

markets can be low, increasing the inventory risk of market makers. The 
Agencies recognize that, if the final rule creates disincentives for 
banking entities to provide liquidity, these low volume markets may be 
impacted first.
---------------------------------------------------------------------------

    \608\ See supra Part IV.A.3.b.2.b.
    \609\ See supra Part IV.A.3.b.2.b. As discussed above, a few 
other commenters suggested that to the extent liquidity is 
vulnerable to destabilizing liquidity spirals, any reduced liquidity 
stemming from section 13 of the BHC Act and its implementing rules 
would not necessarily be a negative result. See AFR et al. (Feb. 
2012); Public Citizen. See also Paul Volcker. These commenters also 
suggested that the Agencies adopt stricter conditions in the market-
making exemption, as discussed throughout this Part IV.A.3. However, 
liquidity--essentially, the ease with which assets can be converted 
into cash--is not destabilizing in and of itself. Rather, liquidity 
spirals are a function of how firms are funded. During market 
downturns, when margin requirements tend to increase, firms that 
fund their operations with leverage face higher costs of providing 
liquidity; firms that run up against their maximum leverage ratios 
may be forced to retreat from market making, contributing to the 
liquidity spiral. Viewed in this light, it is institutional features 
of financial markets--in particular, leverage--rather than liquidity 
itself that contributes to liquidity spirals.
    \610\ Wider spreads can be costly for investors. For example, 
one commenter estimated that a 10 basis point increase in spreads in 
the corporate bond market would cost investors $29 billion per year. 
See Wellington. Wider spreads can also be particularly costly for 
open-end mutual funds, which must trade in and out of the fund's 
portfolio holdings on a daily basis in order to satisfy redemptions 
and subscriptions. See Wellington; AllianceBernstein.
    \611\ A higher cost of capital increases financing costs and 
translates into reduced capital investment. While one commenter 
estimated that a one percent increase in the cost of capital would 
lead to a $55 to $82.5 billion decline in capital investments by 
U.S. nonfarm firms, the Agencies cannot independently verify these 
potential costs. Further, this commenter did not indicate what 
aspect of the proposed rule could cause a one percent increase in 
the cost of capital. See Thakor Study. In any event, the Agencies 
have made significant changes to the proposed approach to 
implementing the market-making exemption that should help address 
this commenter's concern.
    \612\ See, e.g., CIEBA; ACLI; PNC et al.; Morgan Stanley; 
Chamber (Feb. 2012); Abbott Labs et al. (Feb. 14, 2012); FEI; ICI 
(Feb. 2012); TMA Hong Kong; Sen. Casey.
---------------------------------------------------------------------------

    As discussed above, the Agencies received several comments 
suggesting that the negative consequences associated with reduced 
liquidity would be unlikely to materialize under the proposed rule. For 
example, a few commenters stated that non-bank financial 
intermediaries, who are not subject to section 13 of the BHC Act, may 
increase their market-making activities in response to any reduction in 
market making by banking entities, a topic the Agencies discuss in more 
detail below.\613\ In addition, some commenters suggested that the 
restrictions on proprietary trading would support liquid markets by 
encouraging banking entities to focus on financial intermediation 
activities that supply liquidity, rather than proprietary trades that 
demand liquidity, such as speculative trades or trades that front-run 
institutional investors.\614\ The statute prohibits proprietary trading 
activity that is not exempted. As such, the termination of nonexempt 
proprietary trading activities of banking entities may lead to some 
general reductions in liquidity of certain asset classes. Although the 
Agencies cannot say with any certainty, there is good reason to believe 
that to a significant extent the liquidity reductions of this type may 
be temporary since the statute does not restrict proprietary trading 
activities of other market participants. Thus, over time, non-banking 
entities may provide much of the liquidity that is lost by restrictions 
on banking entities' trading activities. If so, eventually, the 
detrimental effects of increased trading costs, higher costs of 
capital, and greater market volatility should be mitigated.
---------------------------------------------------------------------------

    \613\ See, e.g., Sens. Merkley & Levin (Feb. 2012); Prof. 
Richardson; Better Markets (Feb. 2012); Profs. Stout & Hastings; 
Prof. Johnson; Occupy; Public Citizen; Profs. Admati & Pfleiderer; 
Better Markets (June 2012).
    \614\ See, e.g., Prof. Johnson.
---------------------------------------------------------------------------

    Based on the many detailed comments provided, the Agencies have 
made substantive refinements to the market-making exemption that the 
Agencies believe will reduce the likelihood that the rule, as 
implemented, will negatively impact the ability of banking entities to 
engage in the types of market making-related activities permitted under 
the statute and, therefore, will continue to promote the benefits to 
investors and other market participants described above, including 
greater market liquidity, narrower bid-ask spreads, reduced price 
concessions and price impact, lower volatility, and reduced 
counterparty search costs, thus reducing the cost of capital. For 
instance, the final market-making exemption does not require a trade-
by-trade analysis, which was a significant source of concern from 
commenters who represented, among other things, that a trade-by-trade 
analysis could have a chilling effect on individual traders' 
willingness to engage in market-making activities.\615\ Rather, the 
final rule has been crafted around the overall market making-related 
activities of individual trading desks, with various requirements that 
these activities be demonstrably related to satisfying reasonably 
expected near term customer demands and other market-making activities. 
The Agencies believe that applying certain requirements to the 
aggregate risk exposure of a trading desk, along with the requirement 
to establish risk and inventory limits to routinize a trading desk's 
compliance with the near term customer demand requirement, will reduce 
negative potential impacts on individual traders' decision-making 
process in the normal course of market making.\616\ In addition, in 
response to a large number of comments expressing concern that the 
proposed market-making exemption would restrict or prohibit market 
making-related activities in less liquid markets, the Agencies are 
clarifying that the application of certain requirements in the final 
rule, such as the frequency of required quoting and the near term 
demand requirement, will account for the liquidity, maturity, and depth 
of the market for a given type of financial instrument. Thus, banking 
entities will be able to continue to engage in market making-related 
activities across markets and asset classes.
---------------------------------------------------------------------------

    \615\ See supra note 517 (discussing commenters' concerns 
regarding a trade-by-trade analysis).
    \616\ For example, by clarifying that individual trades will not 
be viewed in isolation and requiring strong compliance procedures, 
this approach will generally allow an individual trader to operate 
within the compliance framework established for his or her trading 
desk without having to assess whether each individual transaction 
complies with all requirements of the market-making exemption.
---------------------------------------------------------------------------

    At the same time, the Agencies recognize that an overly broad 
market-making exemption may allow banking entities to mask speculative 
positions as liquidity provision or related hedges. The Agencies 
believe the requirements included in the final rule are necessary to 
prevent such evasion of the market-making exemption, ensure compliance 
with the statute, and facilitate internal banking entity and external 
Agency reviews of compliance with the final rule. Nevertheless, the 
Agencies acknowledge that these additional costs may have an impact on 
banking entities' willingness to engage in market making-related 
activities. Banking entities will incur certain compliance costs in 
connection with their market making-related activities under the final 
rule. For example, banking entities may not currently limit their 
trading desks' market-maker inventory to that which is designed not to 
exceed reasonably expected near term customer demand, as required by 
the statute.
    As discussed above, commenters presented diverging views on whether 
non-banking entities are likely to enter the market or increase their 
market-making activities if the final rule should cause banking 
entities to reduce their market-making activities.\617\ The Agencies 
note that prior to the Gramm-Leach-Bliley Act of 1999, market-making 
services were more commonly provided by non-bank-affiliated broker-
dealers than by banking entities. As discussed above, by intermediating 
and facilitating trading, market makers provide value to the markets 
and profit from providing liquidity. Should banking entities retreat 
from making markets, the profit opportunities available from providing 
liquidity will provide an incentive for non-bank-affiliated broker-
dealers to enter the market and intermediate trades. The Agencies are 
unable to assess the likely effect with any certainty, but the Agencies 
recognize that a market-making operation requires certain 
infrastructure and capital, which will impact the ability of non-
banking entities to enter the market-making business or to increase 
their presence. Therefore, should banking entities retreat from making 
markets, there could be a transition period with reduced liquidity as 
non-banking entities build up the needed infrastructure and obtain 
capital. However, because the Agencies have substantially modified this 
exemption in response to comments to ensure that

[[Page 5585]]

market making related to near-term customer demand is permitted as 
contemplated by the statute, the Agencies do not believe the final rule 
should significantly impact currently-available market-making 
services.\618\
---------------------------------------------------------------------------

    \617\ See supra notes 560 and 564 and accompanying text 
(discussing comments on the issue of whether non-banking entities 
are likely to enter the market or increase their trading activities 
in response to reduced trading activity by banking entities). For 
example, one commenter stated that broker-dealers that are not 
affiliated with a bank would have reduced access to lender-of-last 
resort liquidity from the central bank, which could limit their 
ability to make markets during times of market stress or when 
capital buffers are small. See Prof. Duffie. However, another 
commenter noted that the presence and evolution of market making 
after the enactment of the Glass-Steagall Act mutes this particular 
concern. See Prof. Richardson.
    \618\ Certain non-banking entities, such as some SEC-registered 
broker-dealers that are not banking entities subject to the final 
rule, currently engage in market-making activities and, thus, should 
have the needed infrastructure and may attract additional capital. 
If the final rule has a marginal impact on banking entities' 
willingness to engage in market making-related activities, these 
non-banking entities should be able to respond by increasing their 
market making-related activities. The Agencies recognize, however, 
that firms that do not have existing infrastructure or sufficient 
capital are unlikely to be able to act as market makers shortly 
after the final rule is implemented. Nevertheless, because some non-
bank-affiliated broker-dealers currently operate market-making 
desks, and because it was the dominant model prior to the Gramm-
Leach-Bliley Act, the Agencies believe that non-bank-affiliated 
financial intermediaries will be able to provide market-making 
services longer term.
---------------------------------------------------------------------------

c. Detailed Explanation of the Market-Making Exemption
1. Requirement To Routinely Stand Ready to Purchase and Sell
a. Proposed Requirement To Hold Self Out
    Section ----.4(b)(2)(ii) of the proposed rule would have required 
the trading desk or other organizational unit that conducts the 
purchase or sale in reliance on the market-making exemption to hold 
itself out as being willing to buy and sell, including through entering 
into long and short positions in, the financial instrument for its own 
account on a regular or continuous basis.\619\ The proposal stated that 
a banking entity could rely on the proposed exemption only for the type 
of financial instrument that the entity actually made a market in.\620\
---------------------------------------------------------------------------

    \619\ See proposed rule Sec.  ----.4(b)(2)(ii).
    \620\ See Joint Proposal, 76 FR 68,870 (``Notably, this 
criterion requires that a banking entity relying on the exemption 
with respect to a particular transaction must actually make a market 
in the [financial instrument] involved; simply because a banking 
entity makes a market in one type of [financial instrument] does not 
permit it to rely on the market-making exemption for another type of 
[financial instrument].''); CFTC Proposal, 77 FR 8355-8356.
---------------------------------------------------------------------------

    The proposal recognized that the precise nature of a market maker's 
activities often varies depending on the liquidity, trade size, market 
infrastructure, trading volumes and frequency, and geographic location 
of the market for any particular financial instrument.\621\ To account 
for these variations, the Agencies proposed indicia for assessing 
compliance with this requirement that differed between relatively 
liquid markets and less liquid markets. Further, the Agencies 
recognized that the proposed indicia could not be applied at all times 
and under all circumstances because some may be inapplicable to the 
specific asset class or market in which the market making-related 
activity is conducted.
---------------------------------------------------------------------------

    \621\ See Joint Proposal, 76 FR 68,870; CFTC Proposal, 77 FR 
8356.
---------------------------------------------------------------------------

    In particular, the proposal stated that a trading desk or other 
organizational unit's market making-related activities in relatively 
liquid markets, such as equity securities or other exchange-traded 
instruments, should generally include: (i) Making continuous, two-sided 
quotes and holding oneself out as willing to buy and sell on a 
continuous basis; (ii) a pattern of trading that includes both 
purchases and sales in roughly comparable amounts to provide liquidity; 
(iii) making continuous quotations that are at or near the market on 
both sides; and (iv) providing widely accessible and broadly 
disseminated quotes.\622\ With respect to market making in less liquid 
markets, the proposal noted that the appropriate indicia of market 
making-related activities will vary, but should generally include: (i) 
holding oneself out as willing and available to provide liquidity by 
providing quotes on a regular (but not necessarily continuous) basis; 
\623\ (ii) with respect to securities, regularly purchasing securities 
from, or selling securities to, clients, customers, or counterparties 
in the secondary market; and (iii) transaction volumes and risk 
proportionate to historical customer liquidity and investments 
needs.\624\
---------------------------------------------------------------------------

    \622\ See Joint Proposal, 76 FR 68,870-68,871; CFTC Proposal, 77 
FR 8356. These proposed factors are generally consistent with the 
indicia used by the SEC to assess whether a broker-dealer is engaged 
in bona fide market making for purposes of Regulation SHO under the 
Exchange Act. See Joint Proposal, 76 FR 68,871 n.148; CFTC Proposal, 
77 FR 8356 n.155.
    \623\ The Agencies noted that, with respect to this factor, the 
frequency of regular quotations will vary, as moderately illiquid 
markets may involve quotations on a daily or more frequent basis, 
while highly illiquid markets may trade only by appointment. See 
Joint Proposal, 76 FR 68,871 n.149; CFTC Proposal, 77 FR 8356 n.156.
    \624\ See Joint Proposal, 76 FR 68,871; CFTC Proposal, 77 FR 
8356.
---------------------------------------------------------------------------

    In discussing this proposed requirement, the Agencies stated that 
bona fide market making-related activity may include certain block 
positioning and anticipatory position-taking. More specifically, the 
proposal indicated that the bona fide market making-related activity 
described in Sec.  ----.4(b)(2)(ii) of the proposed rule would include: 
(i) block positioning if undertaken by a trading desk or other 
organizational unit of a banking entity for the purpose of 
intermediating customer trading; \625\ and (ii) taking positions in 
securities in anticipation of customer demand, so long as any 
anticipatory buying or selling activity is reasonable and related to 
clear, demonstrable trading interest of clients, customers, or 
counterparties.\626\
---------------------------------------------------------------------------

    \625\ In the preamble to the proposed rule, the Agencies stated 
that the SEC's definition of ``qualified block positioner'' may 
serve as guidance in determining whether a block positioner engaged 
in block positioning is engaged in bona fide market making for 
purposes of Sec.  ----.4(b)(2)(ii) of the proposed rule. See Joint 
Proposal, 76 FR 68,871 n.151; CFTC Proposal, 77 FR 8356 n.157.
    \626\ See Joint Proposal, 76 FR 68,871; CFTC Proposal, 77 FR 
8356-8357.
---------------------------------------------------------------------------

b. Comments on the Proposed Requirement To Hold Self Out
    Commenters raised many issues regarding Sec.  ----.4(b)(2)(ii) of 
the proposed exemption, which would require a trading desk or other 
organizational unit to hold itself out as willing to buy and sell the 
financial instrument for its own account on a regular or continuous 
basis. As discussed below, some commenters viewed the proposed 
requirement as too restrictive, while other commenters stated that the 
requirement was too permissive. Two commenters expressed support for 
the proposed requirement.\627\ A number of commenters provided views on 
statements in the proposal regarding indicia of bona fide market making 
in more and less liquid markets and the permissibility of block 
positioning and anticipatory position-taking.
---------------------------------------------------------------------------

    \627\ See Sens. Merkley & Levin (Feb. 2012); Alfred Brock.
---------------------------------------------------------------------------

    Several commenters represented that the proposed requirement was 
too restrictive.\628\ For example, a number of these commenters 
expressed concern that the proposed requirement may limit a banking 
entity's ability to act as a market maker under certain circumstances, 
including in less liquid markets, for instruments lacking a two-sided 
market, or in customer-driven, structured transactions.\629\ In 
addition, a few commenters expressed specific concern about how this 
requirement would impact more limited market-making activity conducted 
by banks.\630\
---------------------------------------------------------------------------

    \628\ See infra Part IV.A.3.c.1.c.iii. (addressing these 
concerns).
    \629\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); 
Morgan Stanley; Barclays; Goldman (Prop. Trading); ABA; Chamber 
(Feb. 2012); BDA (Feb. 2012); Fixed Income Forum/Credit Roundtable; 
ACLI (Feb. 2012); T. Rowe Price; PUC Texas; PNC; MetLife; RBC; IHS; 
SSgA (Feb. 2012).
    \630\ See, e.g., PNC (stating that the proposed rule needs to 
account for market making by regional banks on behalf of small and 
middle-market customers whose securities are less liquid); ABA 
(stating that the rule should continue to permit banks to provide 
limited liquidity by buying securities that they feel are suitable 
for their retail and institutional customer base by stating that a 
bank is ``holding itself out'' when it buys and sells securities 
that are suitable for its customers).

---------------------------------------------------------------------------

[[Page 5586]]

    Many commenters indicated that it was unclear whether this 
provision would require a trading desk or other organizational unit to 
regularly or continuously quote every financial instrument in which a 
market is made, but expressed concern that the proposed language could 
be interpreted in this manner.\631\ These commenters noted that there 
are thousands of individual instruments within a given asset class, 
such as corporate bonds, and that it would be burdensome for a market 
maker to provide quotes in such a large number of instruments on a 
regular or continuous basis.\632\ One of these commenters represented 
that, because customer demand may be infrequent in a particular 
instrument, requiring a banking entity to provide regular or continuous 
quotes in the instrument may not provide a benefit to its 
customers.\633\ A few commenters requested that the Agencies provide 
further guidance on this issue or modify the proposed standard to state 
that holding oneself out in a range of similar instruments will be 
considered to be within the scope of permitted market making-related 
activities.\634\
---------------------------------------------------------------------------

    \631\ This issue is further discussed in Part IV.A.3.c.1.c.iii., 
infra.
    \632\ See, e.g., Goldman (Prop. Trading) (stating that it would 
be burdensome for a U.S. credit market-making business to be 
required to produce and disseminate quotes for thousands of 
individual bond CUSIPs that trade infrequently and noting that a 
market maker in credit markets will typically disseminate indicative 
prices for the most liquid instruments but, for the thousands of 
other instruments that trade infrequently, the market maker will 
generally provide a price for a trade upon request from another 
market participant); Morgan Stanley; SIFMA et al. (Prop. Trading) 
(Feb. 2012); RBC. See also BDA (Feb. 2012); FTN (stating that in 
some markets, such as the markets for residential mortgage-backed 
securities and investment grade corporate debt, a market maker will 
hold itself out in a subset of instruments (e.g., particular issues 
in the investment grade corporate debt market with heavy trading 
volume or that are in the midst of particular credit developments), 
but will trade in other instruments within the group or sector upon 
inquiry from customers and other dealers); Oliver Wyman (Feb. 2012) 
(discussing data regarding the number of U.S. corporate bonds and 
frequency of trading in such bonds in 2009).
    \633\ See Goldman (Prop. Trading).
    \634\ See, e.g., RBC (recommending that the Agencies clarify 
that a trading desk is required to hold itself out as willing to buy 
and sell a particular type of ``product''); SIFMA et al. (Prop. 
Trading) (Feb. 2012) (suggesting that the Agencies use the term 
``instrument,'' rather than ``covered financial position,'' to 
provide greater clarity); CIEBA (supporting alternative criteria 
that would require a banking entity to hold itself out generally as 
a market maker for the relevant asset class, but not for every 
instrument it purchases and sells); Goldman (Prop. Trading). One of 
these commenters recommended that the Agencies recognize and permit 
the following kinds of activity in related financial instruments: 
(i) Options market makers should be deemed to be engaged in market 
making in all put and call series related to a particular underlying 
security and should be permitted to trade the underlying security 
regardless of whether such trade qualifies for the hedging 
exemption; (ii) convertible bond traders should be permitted to 
trade in the associated equity security; (iii) a market maker in one 
issuer's bonds should be considered a market maker in similar bonds 
of other issuers; and (iv) a market maker in standardized interest 
rate swaps should be considered to be engaged in market making-
related activity if it engages in a customized interest rate swap 
with a customer upon request. See RBC.
---------------------------------------------------------------------------

    To address concerns about the restrictiveness of this requirement, 
commenters suggested certain modifications. For example, some 
commenters suggested adding language to the requirement to account for 
market making in markets that do not typically involve regular or 
continuous, or two-sided, quoting.\635\ In addition, a few commenters 
requested that the requirement expressly include transactions in new 
instruments or transactions in instruments that occur infrequently to 
address situations where a banking entity may not have previously had 
the opportunity to hold itself out as willing to buy and sell the 
applicable instrument.\636\ Other commenters supported alternative 
criteria for assessing whether a banking entity is acting as a market 
maker, such as: (i) a willingness to respond to customer demand by 
providing prices upon request; \637\ (ii) being in the business of 
providing prices upon request for that financial instrument or other 
financial instruments in the same or similar asset class or product 
class; \638\ or (iii) a historical test of market-making activity, with 
compliance judged on the basis of actual trades.\639\ Finally, two 
commenters stated that this requirement should be moved to Appendix B 
of the rule,\640\ which, according to one of these commenters, would 
provide the Agencies greater flexibility to consider the facts and 
circumstances of a particular activity.\641\
---------------------------------------------------------------------------

    \635\ See, e.g., Morgan Stanley (suggesting that the Agencies 
add the phrase ``or, in markets where regular or continuous quotes 
are not typically provided, the trading unit stands ready to provide 
quotes upon request''); Barclays (suggesting addition of the phrase 
``to the extent that two-sided markets are typically made by market 
makers in a given product,'' as well as changing the reference to 
``purchase or sale'' to ``market making-related activity'' to avoid 
any inference of a trade-by-trade analysis). See also Fixed Income 
Forum/Credit Roundtable. To address concerns about the requirement's 
application to bespoke products, one commenter suggested that the 
rule clearly state that a banking entity fulfills this requirement 
if it markets structured transactions to its client base and stands 
ready to enter into such transactions with customers, even though 
transactions may occur on a relatively infrequent basis. See JPMC.
    \636\ See Wells Fargo (Prop. Trading); RBC (supporting this 
approach as an alternative to removing the requirement from the 
rule, but primarily supporting its removal). See also ISDA (Feb. 
2012) (stating that the analysis of compliance with the proposed 
requirement must carefully consider the degree of presence a market 
maker wishes to have in a given market, which may include being a 
leader in certain types of instruments, having a secondary presence 
in others, and potentially leaving or entering other submarkets).
    \637\ See SIFMA et al. (Prop. Trading) (Feb. 2012). This 
commenter also suggested that such test be assessed at the ``trading 
unit'' level. See id.
    \638\ See Goldman (Prop. Trading).
    \639\ See FTN.
    \640\ See Flynn & Fusselman; JPMorgan.
    \641\ See JPMC.
---------------------------------------------------------------------------

    Other commenters took the view that the proposed requirement was 
too permissive.\642\ For example, one commenter stated that the 
proposed standard provided too much room for interpretation and would 
be difficult to measure and monitor. This commenter expressed 
particular concern that a trading desk or other organizational unit 
could meet this requirement by regularly or continuously making wide, 
out of context quotes that do not present any real risk of execution 
and do not contribute to market liquidity.\643\ Some commenters 
suggested the Agencies place greater restrictions on a banking entity's 
ability to rely on the market-making exemption in certain illiquid 
markets, such as assets that cannot be reliably valued, products that 
do not have a genuine external market, or instruments for which a 
banking entity does not expect to have customers wishing to both buy 
and sell.\644\ In support of these requests, commenters stated that 
trading in illiquid products raises certain concerns under the rule, 
including: a lack of reliable data for purposes of using metrics to 
monitor a banking entity's market making-related activity (e.g., 
products whose valuations are determined by an internal model that can 
be manipulated, rather than an observable market price); \645\ relation 
to the last financial crisis; \646\ lack of important benefits to the 
real economy; \647\ similarity to prohibited proprietary trading; \648\ 
and inconsistency with the statute's requirements that market making-
related activity must be ``designed not to exceed the reasonably 
expected near

[[Page 5587]]

term demands of clients, customers, or counterparties'' and must not 
result in a material exposure to high-risk assets or high-risk trading 
strategies.\649\
---------------------------------------------------------------------------

    \642\ See, e.g., Occupy; AFR et al. (Feb. 2012); Public Citizen; 
Johnson & Prof. Stiglitz; John Reed. See infra note 746 and 
accompanying text (responding to these comments).
    \643\ See Occupy.
    \644\ See Occupy; AFR et al. (Feb. 2012); Public Citizen; 
Johnson & Prof. Stiglitz; Sens. Merkley & Levin (Feb. 2012); John 
Reed.
    \645\ See AFR et al. (Feb. 2012); Occupy.
    \646\ See Occupy.
    \647\ See John Reed.
    \648\ See Johnson & Prof. Stiglitz.
    \649\ See Sens. Merkley & Levin (Feb. 2012) (stating that a 
banking entity must have or reasonably expect at least two 
customers--one for each side of the trade--and must have a 
reasonable expectation of the second customer coming to take the 
position or risk off its books in the ``near term''); AFR et al. 
(Feb. 2012); Public Citizen.
---------------------------------------------------------------------------

    These commenters also requested that the proposed requirement be 
modified in certain ways. In particular, several commenters stated that 
the proposed exemption should only permit market making in assets that 
can be reliably valued through external market transactions.\650\ In 
order to implement such a limitation, three commenters suggested that 
the Agencies prohibit banking entities from market making in assets 
classified as Level 3 under FAS 157.\651\ One of these commenters 
explained that Level 3 assets are generally highly illiquid assets 
whose fair value cannot be determined using either market prices or 
models.\652\ In addition, a few commenters suggested that banking 
entities be subject to additional capital charges for market making in 
illiquid products.\653\ Another commenter stated that the Agencies 
should require all market making-related activity to be conducted on a 
multilateral organized electronic trading platform or exchange to make 
it possible to monitor and confirm certain trading data.\654\ Two 
commenters emphasized that their recommended restrictions on market 
making in illiquid markets should not prohibit banking entities from 
making markets in corporate bonds.\655\
---------------------------------------------------------------------------

    \650\ See AFR et al. (Feb. 2012) (stating that the rule should 
ban market making in illiquid and opaque securities with no genuine 
external market, but permit market making in somewhat illiquid 
securities, such as certain corporate bonds, as long as the 
securities can be reliably valued with reference to other extremely 
similar securities that are regularly traded in liquid markets and 
the financial outcome of the transaction is reasonably predictable); 
Johnson & Prof. Stiglitz (recommending that permitted market making 
be limited to assets that can be reliably valued in, at a minimum, a 
moderately liquid market evidenced by trading within a reasonable 
period, such as a week, through a real transaction and not simply 
with interdealer trades); Public Citizen (stating that market making 
should be limited to assets that can be reliably valued in a market 
where transactions take place on a weekly basis).
    \651\ See AFR et al. (Feb. 2012) (stating that such a limitation 
would be consistent with the proposed limitation on ``high-risk 
assets'' and the discussion of this limitation in proposed Appendix 
C); Public Citizen; Prof. Richardson.
    \652\ See Prof. Richardson.
    \653\ Two commenters recommended that banking entities be 
required to treat trading in assets that cannot be reliably valued 
and that trade only by appointment, such as bespoke derivatives and 
structured products, as providing an illiquid bespoke loan, which 
are subject to higher capital charges under the Federal banking 
agencies' capital rules. See Johnson & Prof. Stiglitz; John Reed. 
Another commenter suggested that, if not directly prohibited, 
trading in bespoke instruments that cannot be reliably valued should 
be assessed an appropriate capital charge. See Public Citizen.
    \654\ See Occupy. This commenter further suggested that the 
exemption exclude all activities that include: (i) Assets whose 
changes in value cannot be mitigated by effective hedges; (ii) new 
products with rapid growth, including those that do not have a 
market history; (iii) assets or strategies that include significant 
imbedded leverage; (iv) assets or strategies that have demonstrated 
significant historical volatility; (v) assets or strategies for 
which the application of capital and liquidity standards would not 
adequately account for the risk; and (vi) assets or strategies that 
result in large and significant concentrations to sectors, risk 
factors, or counterparties. See id.
    \655\ See AFR et al. (Feb. 2012); Johnson & Prof. Stiglitz.
---------------------------------------------------------------------------

i. The Proposed Indicia
    As noted above, the proposal set forth certain indicia of bona fide 
market making-related activity in liquid and less liquid markets that 
the Agencies proposed to apply when evaluating whether a banking entity 
was eligible for the proposed exemption.\656\ Several commenters 
provided their views regarding the effectiveness of the proposed 
indicia.
---------------------------------------------------------------------------

    \656\ See supra Part IV.A.3.c.1.a.
---------------------------------------------------------------------------

    With respect to the proposed indicia for liquid markets, a few 
commenters expressed support for the proposed indicia.\657\ One of 
these commenters stated that while the proposed factors are reasonably 
consistent with bona fide market making, the Agencies should add two 
other factors: (i) A willingness to transact in reasonable quantities 
at quoted prices, and (ii) inventory turnover.\658\
---------------------------------------------------------------------------

    \657\ See Occupy; AFR et al. (Feb. 2012); NYSE Euronext 
(expressing support for the indicia set forth in the FSOC study, 
which are substantially the same as the indicia in the proposal); 
Alfred Brock.
    \658\ See AFR et al. (Feb. 2012).
---------------------------------------------------------------------------

    Other commenters, however, stated that the proposed use of factors 
from the SEC's analysis of bona fide market making under Regulation SHO 
was inappropriate in this context. In particular, these commenters 
represented that bona fide market making for purposes of Regulation SHO 
is a purposefully narrow concept that permits a subset of market makers 
to qualify for an exception from the ``locate'' requirement in Rule 203 
of Regulation SHO. The commenters further expressed the belief that the 
policy goals of section 13 of the BHC Act do not necessitate a 
similarly narrow interpretation of market making.\659\
---------------------------------------------------------------------------

    \659\ See Goldman (Prop. Trading); SIFMA et al. (Prop. Trading) 
(Feb. 2012).
---------------------------------------------------------------------------

    A few commenters expressed particular concern about how the factor 
regarding patterns of purchases and sales in roughly comparable amounts 
would apply to market making in exchange-traded funds (``ETFs''). 
According to these commenters, demonstrating this factor could be 
difficult because ETF market making involves a pattern of purchases and 
sales of groups of equivalent securities (i.e., the ETF shares and the 
basket of securities and cash that is exchanged for them), not a single 
security. In addition, the commenters were unsure whether this factor 
could be demonstrated in times of limited trading in ETF shares.\660\
---------------------------------------------------------------------------

    \660\ See ICI (Feb. 2012); ICI Global.
---------------------------------------------------------------------------

    The preamble to the proposed rule also provided certain proposed 
indicia of bona fide market making-related activity in less liquid 
markets.\661\ As discussed above, commenters had differing views about 
whether the exemption for market making-related activity should permit 
banking entities to engage in market making in some or all illiquid 
markets. Thus, with respect to the proposed indicia for market making 
in less liquid markets, commenters generally stated that the indicia 
should be broader or narrower, depending on the commenter's overall 
view on the issue of market making in illiquid markets. One commenter 
stated that the proposed indicia are effective.\662\
---------------------------------------------------------------------------

    \661\ See supra Part IV.A.3.c.1.a.
    \662\ See Alfred Brock.
---------------------------------------------------------------------------

    The first proposed factor of market making-related activity in less 
liquid markets was holding oneself out as willing and available to 
provide liquidity by providing quotes on a regular (but not necessarily 
continuous) basis. As noted above, several commenters expressed concern 
about a requirement that market makers provide regular quotations in 
less liquid instruments, including in fixed income markets and bespoke, 
customized derivatives.\663\ With respect to the interaction between 
the rule language requiring ``regular'' quoting and the proposal's 
language permitting trading by appointment under certain circumstances, 
some of these commenters expressed uncertainty about how a market maker 
trading only by appointment would be able to satisfy the proposed 
rule's regular quotation

[[Page 5588]]

requirement.\664\ In addition, another commenter stated that the 
proposal's recognition of trading by appointment does not alleviate 
concerns about applying the ``regular'' quotation requirement to market 
making in less liquid instruments in markets that are not, as a whole, 
highly illiquid, such as credit and interest rate markets.\665\
---------------------------------------------------------------------------

    \663\ See supra note 629 accompanying text. With respect to this 
factor, one commenter requested that the Agencies delete the 
parenthetical of ``but not necessarily continuous'' from the 
proposed factor as part of a broader effort to recognize the 
relative illiquidity of swap markets. See ISDA (Feb. 2012).
    \664\ See SIFMA et al. (Prop. Trading) (Feb. 2012); CIEBA. These 
commenters requested greater clarity or guidance on the meaning of 
``regular'' in the instance of a market maker trading only by 
appointment. See id.
    \665\ See Goldman (Prop. Trading).
---------------------------------------------------------------------------

    Other commenters expressed concern about only requiring a market 
maker to provide regular quotations or permitting trading by 
appointment to qualify for the market-making exemption. With respect to 
regular quotations, some commenters stated that such a requirement 
enables evasion of the prohibition on proprietary trading because a 
proprietary trader may post a quote at a time of little interest in a 
financial product or may post wide, out of context quotes on a regular 
basis with no real risk of execution.\666\ Several commenters stated 
that trading only by appointment should not qualify as market making 
for purposes of the proposed rule.\667\ Some of these commenters stated 
that there is no ``market'' for assets that trade only by appointment, 
such as customized, structured products and OTC derivatives.\668\
---------------------------------------------------------------------------

    \666\ See Public Citizen; Occupy. One of these commenters 
further noted that most markets lack a structural framework that 
would enable monitoring of compliance with this requirement. See 
Occupy.
    \667\ See, e.g., Sens. Merkley & Levin (Feb. 2012); Johnson & 
Prof. Stiglitz; John Reed; Public Citizen.
    \668\ See, e.g., John Reed; Public Citizen.
---------------------------------------------------------------------------

    The second proposed criterion for market making-related activity in 
less liquid markets was, with respect to securities, regularly 
purchasing securities from, or selling securities to, clients, 
customers, or counterparties in the secondary market. Two commenters 
expressed concern about this proposed factor.\669\ In particular, one 
of these commenters stated that the language is fundamentally 
inconsistent with market making because it contemplates that only 
taking one side of the market is sufficient, rather than both buying 
and selling an instrument.\670\ The other commenter expressed concern 
that banking entities would be allowed to accumulate a significant 
amount of illiquid risk because the indicia for market making-related 
activity in less liquid markets did not require a market maker to buy 
and sell in comparable amounts (as required by the indicia for liquid 
markets).\671\
---------------------------------------------------------------------------

    \669\ See AFR et al. (Feb. 2012); Occupy.
    \670\ See AFR et al. (Feb. 2012)
    \671\ See Occupy.
---------------------------------------------------------------------------

    Finally, the third proposed factor of market making in less liquid 
markets would consider transaction volumes and risk proportionate to 
historical customer liquidity and investment needs. A few commenters 
indicated that there may not be sufficient information available for a 
banking entity to conduct such an analysis.\672\ For example, one 
commenter stated that historical information may not necessarily be 
available for new businesses or developing markets in which a market 
maker may seek to establish trading operations.\673\ Another commenter 
expressed concern that this factor would not help differentiate market 
making from prohibited proprietary trading because most illiquid 
markets do not have a source for such historical risk and volume 
data.\674\
---------------------------------------------------------------------------

    \672\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman 
(Prop. Trading); Occupy.
    \673\ See Goldman (Prop. Trading).
    \674\ See Occupy.
---------------------------------------------------------------------------

ii. Treatment of Block Positioning Activity
    The proposal provided that the activity described in Sec.  --
--.4(b)(2)(ii) of the proposed rule would include block positioning if 
undertaken by a trading desk or other organizational unit of a banking 
entity for the purpose of intermediating customer trading.\675\
---------------------------------------------------------------------------

    \675\ See Joint Proposal, 76 FR 68,871.
---------------------------------------------------------------------------

    A number of commenters supported the general language in the 
proposal permitting block positioning, but expressed concern about the 
reference to the definition of ``qualified block positioner'' in SEC 
Rule 3b-8(c).\676\ With respect to using Rule 3b-8(c) as guidance under 
the proposed rule, these commenters represented that Rule 3b-8(c)'s 
requirement to resell block positions ``as rapidly as possible'' would 
cause negative results (e.g., fire sales) or create market uncertainty 
(e.g., when, if ever, a longer unwind would be permitted).\677\ 
According to one of these commenters, gradually disposing of a large 
long position purchased from a customer may be the best means of 
reducing near term price volatility associated with the supply shock of 
trying to sell the position at once.\678\ Another commenter expressed 
concern about the second requirement of Rule 3b-8(c), which provides 
that the dealer must determine in the exercise of reasonable diligence 
that the block cannot be sold to or purchased from others on equivalent 
or better terms. This commenter stated that this kind of determination 
would be difficult in less liquid markets because those markets do not 
have widely disseminated quotes that dealers can use for purposes of 
comparison.\679\
---------------------------------------------------------------------------

    \676\ See, e.g., RBC; SIFMA (Asset Mgmt.) (Feb. 2012); Goldman 
(Prop. Trading). See also infra note 735 (responding to these 
comments).
    \677\ See RBC (expressing concern about fire sales); SIFMA 
(Asset Mgmt.) (Feb. 2012) (expressing concern about fire sales, 
particularly in less liquid markets where a block position would 
overwhelm the market and undercut the price a market maker can 
obtain); Goldman (Prop. Trading) (representing that this requirement 
could create uncertainty about whether a longer unwind would be 
permissible and, if so, under what circumstances).
    \678\ See Goldman (Prop. Trading).
    \679\ See RBC.
---------------------------------------------------------------------------

    Beyond the reference to Rule 3b-8(c), a few commenters expressed 
more general concern about the proposed rule's application to block 
positioning activity.\680\ One commenter noted that the proposal only 
discussed block positioning in the context of the proposed requirement 
to hold oneself out, which implies that block positioning activity also 
must meet the other requirements of the market-making exemption. This 
commenter requested an explicit recognition that banking entities meet 
the requirements of the market-making exemption when they enter into 
block trades for customers, including related trades entered to support 
the block, such as hedging transactions.\681\ Finally, one commenter 
expressed concern that the inventory metrics in proposed Appendix A 
would make dealers reluctant to execute large, principal transactions 
because such trades would have a transparent impact on inventory 
metrics in the relevant asset class.\682\
---------------------------------------------------------------------------

    \680\ See SIFMA (Asset Mgmt.) (Feb. 2012); Fidelity (requesting 
that the Agencies explicitly recognize that block trades qualify for 
the market-making exemption); Oliver Wyman (Feb. 2012).
    \681\ See SIFMA (Asset Mgmt.) (Feb. 2012).
    \682\ See Oliver Wyman (Feb. 2012). This commenter estimated 
that investors trading out of large block positions on their own, 
without a market maker directly providing liquidity, would have to 
pay incremental transaction costs between $1.7 and $3.4 billion per 
year. This commenter estimated a block trading size of $850 billion, 
based on a haircut of total block trading volume reported for NYSE 
and Nasdaq. The commenter then estimated, based on market interviews 
and analysis of standard market impact models provided by dealers, 
that the market impact of executing large block orders without 
direct market maker liquidity provision would be the difference 
between the market impact costs of executing a block trade over a 5-
day period versus a 1-day period--which would be approximately 20 to 
50 basis points, depending on the size of the trade. See id.
---------------------------------------------------------------------------

iii. Treatment of Anticipatory Market Making
    In the proposal, the Agencies proposed that ``bona fide market 
making-related activity may include taking positions in securities in

[[Page 5589]]

anticipation of customer demand, so long as any anticipatory buying or 
selling activity is reasonable and related to clear, demonstrable 
trading interest of clients, customers, or counterparties.'' \683\ Many 
commenters indicated that the language in the proposal is inconsistent 
with the statute's language regarding near term demands of clients, 
customers, or counterparties. According to these commenters, the 
statute's ``designed'' and ``reasonably expected'' language expressly 
acknowledges that a market maker may need to accumulate inventory 
before customer demand manifests itself. Commenters further represented 
that the proposed standard may unduly limit a banking entity's ability 
to accumulate inventory in anticipation of customer demand.\684\
---------------------------------------------------------------------------

    \683\ Joint Proposal, 76 FR 68,871; CFTC Proposal, 77 FR 8356-
8357.
    \684\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012) 
(expressing concern that requiring trades to be related to clear 
demonstrable trading interest could curtail the market-making 
function by removing a market maker's discretion to develop 
inventory to best serve its customers and adversely restrict 
liquidity); Goldman (Prop. Trading); Chamber (Feb. 2012); Comm. on 
Capital Markets Regulation. See also Morgan Stanley (requesting 
certain revisions to more closely track the statute); SIFMA (Asset 
Mgmt.) (Feb. 2012) (expressing general concern that the standard 
creates limitations on a market maker's inventory). These comments 
are addressed in Part IV.A.3.c.2., infra.
---------------------------------------------------------------------------

    In addition, two commenters expressed concern that the proposal's 
language would effectively require a banking entity to engage in 
impermissible front running.\685\ One of these commenters indicated 
that the Agencies should not restrict anticipatory trading to such a 
short time period.\686\ To the contrary, the other commenter stated 
that anticipatory accumulation of inventory should be considered to be 
prohibited proprietary trading.\687\ A few commenters noted that the 
standard in the proposal explicitly refers to securities and requested 
that the reference be changed to encompass the full scope of financial 
instruments covered by the rule to avoid ambiguity.\688\ Several 
commenters recommended that the language be eliminated \689\ or 
modified \690\ to address the concerns discussed above.
---------------------------------------------------------------------------

    \685\ See Goldman (Prop. Trading); Occupy. See also Public 
Citizen (expressing general concern that accumulating positions in 
anticipation of demand opens issues of front running).
    \686\ See Goldman (Prop. Trading).
    \687\ See Occupy.
    \688\ See Goldman (Prop. Trading); ISDA (Feb. 2012); SIFMA et 
al. (Prop. Trading) (Feb. 2012).
    \689\ See BoA (stating that a market maker must acquire 
inventory in advance of express customer demand and customers expect 
a market maker's inventory to include not only the financial 
instruments in which customers have previously traded, but also 
instruments that the banking entity believes they may want to 
trade); Occupy.
    \690\ See Morgan Stanley (suggesting a new standard providing 
that a purchase or sale must be ``reasonably consistent with 
observable customer demand patterns and, in the case of new asset 
classes or markets, with reasonably expected future developments on 
the basis of the trading unit's client relationships''); Chamber 
(Feb. 2012) (requesting that the final rule permit market makers to 
make individualized assessments of anticipated customer demand based 
on their expertise and experience in the markets and make trades 
according to those assessments); Goldman (Prop. Trading) 
(recommending that the Agencies instead focus on how trading 
activities are ``designed'' to meet the reasonably expected near 
term demands of clients over time, rather than whether those demands 
have actually manifested themselves at a given point in time); ISDA 
(Feb. 2012) (stating that the Agencies should clarify this language 
to recognize differences between liquid and illiquid markets and 
noting that illiquid and low volume markets necessitate that swap 
dealers take a longer and broader view than dealers in liquid 
markets).
---------------------------------------------------------------------------

iv. High-Frequency Trading
    A few commenters stated that high-frequency trading should be 
considered prohibited proprietary trading under the rule, not permitted 
market making-related activity.\691\ For example, one commenter stated 
that the Agencies should not confuse high volume trading and market 
making. This commenter emphasized that algorithmic traders in general--
and high-frequency traders in particular--do not hold themselves out in 
the manner required by the proposed rule, but instead only offer to buy 
and sell when they think it is profitable.\692\ Another commenter 
suggested the Agencies impose a resting period on any order placed by a 
banking entity in reliance on any exemption in the rule by, for 
example, prohibiting a banking entity from buying and subsequently 
selling a position within a span of two seconds.\693\
---------------------------------------------------------------------------

    \691\ See, e.g., Better Markets (Feb. 2012); Occupy; Public 
Citizen.
    \692\ See Better Markets (Feb. 2012). See also infra note 742 
(addressing this issue).
    \693\ See Occupy.
---------------------------------------------------------------------------

c. Final Requirement To Routinely Stand Ready To Purchase And Sell
    Section ----.4(b)(2)(i) of the final rule provides that the trading 
desk that establishes and manages the financial exposure must routinely 
stand ready to purchase and sell one or more types of financial 
instruments related to its financial exposure and be willing and 
available to quote, buy and sell, or otherwise enter into long and 
short positions in those types of financial instruments for its own 
account, in commercially reasonable amounts and throughout market 
cycles, on a basis appropriate for the liquidity, maturity, and depth 
of the market for the relevant types of financial instruments. As 
discussed in more detail below, the standard of ``routinely'' standing 
ready to purchase and sell one or more types of financial instruments 
will be interpreted to account for differences across markets and asset 
classes. In addition, this requirement provides that a trading desk 
must be willing and available to provide quotations and transact in the 
particular types of financial instruments in commercially reasonable 
amounts and throughout market cycles. Thus, a trading desk's activities 
would not meet the terms of the market-making exemption if, for 
example, the trading desk only provides wide quotations on one or both 
sides of the market relative to prevailing market conditions or is only 
willing to trade on an irregular, intermittent basis.
    While this provision of the market-making exemption has some 
similarity to the requirement to hold oneself out in Sec.  --
--.4(b)(2)(ii) of the proposed rule, the Agencies have made a number of 
refinements in response to comments. Specifically, a number of 
commenters expressed concern that the proposed requirement did not 
sufficiently account for differences between markets and asset classes 
and would unduly limit certain types of market making by requiring 
``regular or continuous'' quoting in a particular instrument.\694\ The 
explanation of this requirement in the proposal was intended to address 
many of these concerns. For example, the Agencies stated that the 
proposed ``indicia cannot be applied at all times and under all 
circumstances because some may be inapplicable to the specific asset 
class or market in which the market-making activity is conducted.'' 
\695\ Nonetheless, the Agencies believe that certain modifications are 
warranted to clarify the rule and to prevent a potential chilling 
effect on market making-related activities conducted by banking 
entities.
---------------------------------------------------------------------------

    \694\ See supra Part IV.A.3.c.1.b. (discussing comments on this 
issue). The Agencies did not intend for the reference to ``covered 
financial position'' in the proposed rule to imply a single 
instrument, although commenters contended that the proposal may not 
have been sufficiently clear on this point.
    \695\ Joint Proposal, 76 FR 68,871; CFTC Proposal, 77 FR 8356.
---------------------------------------------------------------------------

    Commenters represented that the requirement that a trading desk 
hold itself out as being willing to buy and sell ``on a regular or 
continuous basis,'' as was originally proposed, was impossible

[[Page 5590]]

to meet or impractical in the context of many markets, especially less 
liquid markets.\696\ Accordingly, the final rule requires a trading 
desk that establishes and manages the financial exposure to 
``routinely'' stand ready to trade one or more types of financial 
instruments related to its financial exposure. As discussed below, the 
meaning of ``routinely'' will account for the liquidity, maturity, and 
depth of the market for a type of financial instrument, which should 
address commenter concern that the proposed standard would not work in 
less liquid markets and would have a chilling effect on banking 
entities' ability to act as market makers in less liquid markets. A 
concept of market making that is applicable across securities, 
commodity futures, and derivatives markets has not previously been 
defined by any of the Agencies. Thus, while this standard is based 
generally on concepts from the securities laws and is consistent with 
the CFTC's and SEC's description of market making in swaps,\697\ the 
Agencies note that it is not directly based on an existing definition 
of market making.\698\ Instead, the approach taken in the final rule is 
intended to take into account and accommodate the conditions in the 
relevant market for the financial instrument in which the banking 
entity is making a market.
---------------------------------------------------------------------------

    \696\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); 
Morgan Stanley; Barclays; Goldman (Prop. Trading); ABA; Chamber 
(Feb. 2012); BDA (Feb. 2012); Fixed Income Forum/Credit Roundtable; 
ACLI (Feb. 2012); T. Rowe Price; PUC Texas; PNC; MetLife; RBC; SSgA 
(Feb. 2012). Some commenters suggested alternative criteria, such as 
providing prices upon request, using a historical test of market 
making, or a purely guidance-based approach. See SIFMA et al. (Prop. 
Trading) (Feb. 2012); Goldman (Prop. Trading); FTN; Flynn & 
Fusselman; JPMC. The Agencies are not adopting a requirement that 
the trading desk only provide prices upon request because the 
Agencies believe it would be inconsistent with market making in 
liquid exchange-traded instruments where market makers regularly or 
continuously post quotes on an exchange. With respect to one 
commenter's suggested approach of a historical test of market 
making, this commenter did not provide enough information about how 
such a test would work for the Agencies' consideration. Finally, the 
final rule does not adopt a purely guidance-based approach because, 
as discussed further above, the Agencies believe it could lead to an 
increased risk of evasion.
    \697\ See Further Definition of ``Swap Dealer,'' ``Security-
Based Swap Dealer,'' ``Major Swap Participant,'' ``Major Security-
Based Swap Participant'' and ``Eligible Contract Participant'', 77 
FR 30596, 30609 (May 23, 2012) (describing market making in swaps as 
``routinely standing ready to enter into swaps at the request or 
demand of a counterparty'').
    \698\ As a result, activity that is considered market making 
under this final rule may not necessarily be considered market 
making for purposes of other laws or regulations, such as the U.S. 
securities laws, the rules and regulations thereunder, or self-
regulatory organization rules. In addition, the Agencies note that a 
banking entity acting as an underwriter would continue to be treated 
as an underwriter for purposes of the securities laws and the 
regulations thereunder, including any liability arising under the 
securities laws as a result of acting in such capacity, regardless 
of whether it is able to meet the terms of the market-making 
exemption for its activities. See Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------

i. Definition of ``Trading Desk''
    The Agencies are adopting a market-making exemption with 
requirements that generally focus on a financial exposure managed by a 
``trading desk'' of a banking entity and such trading desk's market-
maker inventory. The market-making exemption as originally proposed 
would have applied to ``a trading desk or other organizational unit'' 
of a banking entity. In addition, for purposes of the proposed 
requirement to report and record certain quantitative measurements, the 
proposal defined the term ``trading unit'' as each of the following 
units of organization of a banking entity: (i) Each discrete unit that 
is engaged in the coordinated implementation of a revenue-generation 
strategy and that participates in the execution of any covered trading 
activity; (ii) each organizational unit that is used to structure and 
control the aggregate risk-taking activities and employees of one or 
more trading units described in paragraph (i); and (iii) all trading 
operations, collectively.\699\
---------------------------------------------------------------------------

    \699\ See Joint Proposal, 76 FR 68,957; CFTC Proposal, 77 FR 
8436.
---------------------------------------------------------------------------

    The Agencies received few comments regarding the organizational 
level at which the requirements of the market-making exemption should 
apply, and many of the commenters that addressed this issue did not 
describe their suggested approach in detail.\700\ One commenter 
suggested that the market-making exemption apply to each ``trading 
unit'' of a banking entity, defined as ``each organizational unit that 
is used to structure and control the aggregate risk-taking activities 
and employees that are engaged in the coordinated implementation of a 
customer-facing revenue generation strategy and that participate in the 
execution of any covered trading activity.'' \701\ This suggested 
approach is substantially similar to the second prong of the Agencies' 
proposed definition of ``trading unit'' in Appendix A of the proposal. 
The Agencies described this prong as generally including management or 
reporting divisions, groups, sub-groups, or other intermediate units of 
organization used by the banking entity to manage one or more discrete 
trading units (e.g., ``North American Credit Trading,'' ``Global Credit 
Trading,'' etc.).\702\ The Agencies are concerned that this commenter's 
suggested approach, or any other approach applying the exemption's 
requirements to a higher level of organization than the trading desk, 
would impede monitoring of market making-related activity and detection 
of impermissible proprietary trading by combining a number of different 
trading strategies and aggregating a larger volume of trading 
activities.\703\ Further, key requirements in the market-making 
exemption, such as the required limits and risk management procedures, 
are generally used by banking entities for risk control and applied at 
the trading desk level. Thus, applying them at a broader organizational 
level than the trading desk would create a separate system for 
compliance with this exemption designed to permit a banking entity to 
aggregate disparate trading activities and apply limits more generally. 
Applying the conditions of the exemption at a more aggregated level 
would allow banking entities more flexibility in trading and could 
result in a higher volume of trading that could contribute modestly to 
liquidity.\704\ Instead of taking that approach, the Agencies have 
determined to permit a broader range of market making-related 
activities that can be effectively controlled by building on risk 
controls used by trading desks for business purposes. This will allow 
an individual trader to use instruments or strategies within limits 
established in the compliance program to confidently trade in the type 
of financial instruments in which his or her trading desk makes a 
market. The Agencies believe this addresses concerns that uncertainty 
would negatively impact liquidity. It also addresses concerns that 
applying the market-making exemption at a higher level of organization 
would reduce the effectiveness of the requirements in the final rule 
aimed at ensuring that the quality and character of trading is 
consistent with market

[[Page 5591]]

making-related activity and would increase the risk of evasion. 
Moreover, several provisions of the final rule are intended to account 
for the liquidity, maturity, and depth of the market for a given type 
of financial instrument in which the trading desk makes a market. The 
final rule takes account of these factors to, among other things, 
respond to commenters' concerns about the proposed rule's potential 
impact on market making in less liquid markets. Applying these 
requirements at an organizational level above the trading desk would be 
more likely to result in aggregation of trading in various types of 
instruments with differing levels of liquidity, which would make it 
more difficult for these market factors to be taken into account for 
purposes of the exemption (for example, these factors are considered 
for purposes of tailoring the analysis of reasonably expected near term 
demands of customers and establishing risk, inventory, and duration 
limits).
---------------------------------------------------------------------------

    \700\ See Wellington; SIFMA et al. (Prop. Trading) (Feb. 2012).
    \701\ Morgan Stanley.
    \702\ See Joint Proposal, 76 FR 68,957 n.2.
    \703\ See, e.g., Occupy (expressing concern that, with respect 
to the proposed definition of ``trading unit,'' an ``oversized'' 
unit could combine significantly unrelated trading desks, which 
would impede detection of proprietary trading activity).
    \704\ The Agencies recognize that the proposed rule's 
application to a trading desk ``or other organizational unit'' would 
have provided banking entities with this type of flexibility to 
determine the level of organization at which the market-making 
exemption should apply based on the entity's particular business 
structure and trading strategies, which would likely reduce the 
burdens of this aspect of the final rule. However, for the reasons 
noted above regarding application of this exemption to a higher 
organizational level than the trading desk, the Agencies are not 
adopting the ``or other organizational unit'' language.
---------------------------------------------------------------------------

    Thus, the Agencies continue to believe that certain requirements of 
the exemption should apply to a relatively granular level of 
organization within a banking entity (or across two or more affiliated 
banking entities). These requirements of the final market-making 
exemption have been formulated to best reflect the nature of activities 
at the trading desk level of granularity.
    As explained below, the Agencies are applying certain requirements 
to a ``trading desk'' of a banking entity and adopting a definition of 
this term in the final rule.\705\ The definition of ``trading desk'' is 
similar to the first prong of the proposed definition of ``trading 
unit.'' The Agencies are not adopting the proposed ``or other 
organizational unit'' language because the Agencies are concerned that 
approach would have provided banking entities with too much discretion 
to independently determine the organizational level at which the 
requirements should apply, including a more aggregated level of 
organization, which could lead to evasion of the general prohibition on 
proprietary trading and the other concerns noted above. The Agencies 
believe that adopting an approach focused on the trading desk level 
will allow banking entities and the Agencies to better distinguish 
between permitted market making-related activities and trading that is 
prohibited by section 13 of the BHC Act and, thus, will prevent evasion 
of the statutory requirements, as discussed in more detail below. 
Further, as discussed below, the Agencies believe that applying 
requirements at the trading desk level is balanced by the financial 
exposure-based approach, which will address commenters' concerns about 
the burdens of trade-by-trade analyses.
---------------------------------------------------------------------------

    \705\ See final rule Sec.  ----.3(e)(13).
---------------------------------------------------------------------------

    In the final rule, trading desk is defined to mean the smallest 
discrete unit of organization of a banking entity that buys or sells 
financial instruments for the trading account of the banking entity or 
an affiliate thereof. The Agencies expect that a trading desk would be 
managed and operated as an individual unit and should reflect the level 
at which the profit and loss of market-making traders is 
attributed.\706\ The geographic location of individual traders is not 
dispositive for purposes of the analysis of whether the traders may 
comprise a single trading desk. For instance, a trading desk making 
markets in U.S. investment grade telecom corporate credits may use 
trading personnel in both New York (to trade U.S. dollar-denominated 
bonds issued by U.S.-incorporated telecom companies) and London (to 
trade Euro-denominated bonds issued by the same type of companies). 
This approach allows more effective management of risks of trading 
activity by requiring the establishment of limits, management 
oversight, and accountability at the level where trading activity 
actually occurs. It also allows banking entities to tailor the limits 
and procedures to the type of instruments traded and markets served by 
each trading desk.
---------------------------------------------------------------------------

    \706\ For example, the Agencies expect a banking entity may 
determine the foreign exchange options desk to be a trading desk; 
however, the Agencies do not expect a banking entity to consider an 
individual Japanese Yen options trader (i.e., the trader in charge 
of all Yen-based options trades) as a trading desk, unless the 
banking entity manages its profit and loss, market making, and 
hedging in Japanese Yen options independently of all other financial 
instruments.
---------------------------------------------------------------------------

    In response to comments, and as discussed below in the context of 
the ``financial exposure'' definition, a trading desk may manage a 
financial exposure that includes positions in different affiliated 
legal entities.\707\ Similarly, a trading desk may include employees 
working on behalf of multiple affiliated legal entities or booking 
trades in multiple affiliated entities. Using the previous example, the 
U.S. investment grade telecom corporate credit trading desk may include 
traders working for or booking into a broker-dealer entity (for 
corporate bond trades), a security-based swap dealer entity (for 
single-name CDS trades), and/or a swap dealer entity (for index CDS or 
interest rate swap hedges). To clarify this issue, the definition of 
``trading desk'' specifically provides that the desk can buy or sell 
financial instruments ``for the trading account of a banking entity or 
an affiliate thereof.'' Thus, a trading desk need not be constrained to 
a single legal entity, although it is permissible for a trading desk to 
only trade for a single legal entity. A trading desk booking positions 
in different affiliated legal entities must have records that identify 
all positions included in the trading desk's financial exposure and 
where such positions are held, as discussed below.\708\
---------------------------------------------------------------------------

    \707\ See infra note 724 and accompanying text. Several 
commenters noted that market-making activities may be conducted 
across separate affiliated legal entities. See, e.g., SIFMA et al. 
(Prop. Trading) (Feb. 2012); Goldman (Prop. Trading).
    \708\ See infra note 727 and accompanying text.
---------------------------------------------------------------------------

    The Agencies believe that establishing a defined organizational 
level at which many of the market-making exemption's requirements apply 
will address potential evasion concerns. Applying certain requirements 
of the market-making exemption at the trading desk level will 
strengthen their effectiveness and prevent evasion of the exemption by 
ensuring that the aggregate trading activities of a relatively limited 
group of traders on a single desk are conducted in a manner that is 
consistent with the exemption's standards. In particular, because many 
of the requirements in the market-making exemption look to the specific 
type(s) of financial instruments in which a market is being made, and 
such requirements are designed to take into account differences among 
markets and asset classes, the Agencies believe it is important that 
these requirements be applied to a discrete and identifiable unit 
engaged in, and operated by personnel whose responsibilities relate to, 
making a market in a specific set or type of financial instruments. 
Further, applying requirements at the trading desk level should 
facilitate banking entity monitoring and review of compliance with the 
exemption by limiting the aggregate trading volume that must be 
reviewed, as well as allowing consideration of the particular facts and 
circumstances of the desk's trading activities (e.g., the liquidity, 
maturity, and depth of the market for the relevant types of financial 
instruments). As discussed above, the Agencies believe that applying 
the requirements of the market-making exemption to a higher level of 
organization would reduce the ability to consider the liquidity, 
maturity, and depth of the market for a type of financial instrument, 
would impede effective monitoring and compliance reviews, and would 
increase the risk of evasion.

[[Page 5592]]

ii. Definitions of ``Financial Exposure'' and ``Market-Maker 
Inventory''
    Certain requirements of the proposed market-making exemption 
referred to a ``purchase or sale of a [financial instrument].'' \709\ 
Even though the Agencies did not intend to require a trade-by-trade 
review, a significant number of commenters expressed concern that this 
language could be read to require compliance with the proposed market-
making exemption on a transaction-by-transaction basis.\710\ In 
response to these concerns, the Agencies are modifying the exemption to 
clarify the manner in which compliance with certain provisions will be 
assessed. In particular, rather than a transaction-by-transaction 
focus, the market-making exemption in the final rule focuses on two 
related aspects of market-making activity: A trading desk's ``market-
maker inventory'' and its overall ``financial exposure.'' \711\
---------------------------------------------------------------------------

    \709\ See proposed rule Sec.  ----.4(b).
    \710\ Some commenters also contended that language in proposed 
Appendix B raised transaction-by-transaction implications. See supra 
notes 517 to 524 and accompanying text (discussing commenters' 
transaction-by-transaction concerns).
    \711\ The Agencies are not adopting a transaction-by-transaction 
approach because the Agencies are concerned that such an approach 
would be unduly burdensome or impractical and inconsistent with the 
manner in which bona fide market making-related activity is 
conducted. Additionally, the Agencies are concerned that the burdens 
of such an approach would cause banking entities to significantly 
reduce or cease market making-related activities, which would cause 
negative market impacts harmful to both investors and issuers, as 
well as the financial system generally.
---------------------------------------------------------------------------

    The Agencies are adopting an approach that focuses on both a 
trading desk's financial exposure and market-maker inventory in 
recognition that market making-related activity is best viewed in a 
holistic manner and that, during a single day, a trading desk may 
engage in a large number of purchases and sales of financial 
instruments. While all these transactions must be conducted in 
compliance with the market-making exemption, the Agencies recognize 
that they involve financial instruments for which the trading desk acts 
as market maker (i.e., by standing ready to purchase and sell that type 
of financial instrument) and instruments that are acquired to manage 
the risks of positions in financial instruments for which the desk acts 
as market maker, but in which the desk is not itself a market 
maker.\712\
---------------------------------------------------------------------------

    \712\ See Joint Proposal, 76 FR 68,870 n.146 (``The Agencies 
note that a market maker may often make a market in one type of 
[financial instrument] and hedge its activities using different 
[financial instruments] in which it does not make a market.''); CFTC 
Proposal, 77 FR 8356 n.152.
---------------------------------------------------------------------------

    The final rule requires that activity by a trading desk under the 
market-making exemption be evaluated by a banking entity through 
monitoring and setting limits for the trading desk's market-maker 
inventory and financial exposure. The market-maker inventory of a 
trading desk includes the positions in financial instruments, including 
derivatives, in which the trading desk acts as market maker. The 
financial exposure of the trading desk includes the aggregate risks of 
financial instruments in the market-maker inventory of the trading desk 
plus the financial instruments, including derivatives, that are 
acquired to manage the risks of the positions in financial instruments 
for which the trading desk acts as a market maker, but in which the 
trading desk does not itself make a market, as well as any associated 
loans, commodities, and foreign exchange that are acquired as incident 
to acting as a market maker. In addition, the trading desk generally 
must maintain its market-maker inventory and financial exposure within 
its market-maker inventory limit and its financial exposure limit, 
respectively and, to the extent that any limit of the trading desk is 
exceeded, the trading desk must take action to bring the trading desk 
into compliance with the limits as promptly as possible after the limit 
is exceeded.\713\ Thus, if market movements cause a trading desk's 
financial exposure to exceed one or more of its risk limits, the 
trading desk must promptly take action to reduce its financial exposure 
or obtain approval for an increase to its limits through the required 
escalation procedures, detailed below. A trading desk may not, however, 
enter into a trade that would cause it to exceed its limits without 
first receiving approval through its escalation procedures.\714\
---------------------------------------------------------------------------

    \713\ See final rule Sec.  ----.4(b)(2)(iv).
    \714\ See final rule Sec.  ----.4(b)(2)(iii)(E).
---------------------------------------------------------------------------

    Under the final rule, the term market-maker inventory is defined to 
mean all of the positions, in the financial instruments for which the 
trading desk stands ready to make a market in accordance with paragraph 
(b)(2)(i) of this section, that are managed by the trading desk, 
including the trading desk's open positions or exposures arising from 
open transactions.\715\ Those financial instruments in which a trading 
desk acts as market maker must be identified in the trading desk's 
compliance program under Sec.  ----.4(b)(2)(iii)(A) of the final rule. 
As used throughout this SUPPLEMENTARY INFORMATION, the term 
``inventory'' refers to both the retention of financial instruments 
(e.g., securities) and, in the context of derivatives trading, the risk 
exposures arising out of market-making related activities.\716\ 
Consistent with the statute, the final rule requires that the market-
maker inventory of a trading desk be designed not to exceed, on an 
ongoing basis, the reasonably expected near term demands of clients, 
customers, or counterparties.
---------------------------------------------------------------------------

    \715\ See final rule Sec.  ----.4(b)(5).
    \716\ As noted in the proposal, certain types of market making-
related activities, such as market making in derivatives, involves 
the retention of principal exposures rather than the retention of 
actual financial instruments. See Joint Proposal, 76 FR 68,869 
n.143; CFTC Proposal, 77 FR 8354 n.149. This type of activity would 
be included under the concept of ``inventory'' in the final rule.
---------------------------------------------------------------------------

    The financial exposure concept is broader in scope than market-
maker inventory and reflects the aggregate risks of the financial 
instruments (as well as any associated loans, spot commodities, or spot 
foreign exchange or currency) the trading desk manages as part of its 
market making-related activities.\717\ Thus, a trading desk's financial 
exposure will take into account a trading desk's positions in 
instruments for which it does not act as a market maker, but which are 
established as part of its market making-related activities, which 
includes risk mitigation and hedging. For instance, a trading desk that 
acts as a market maker in Euro-denominated corporate bonds may, in 
addition to Euro-denominated bonds, enter into credit default swap 
transactions on individual European corporate bond issuers or an index 
of European corporate bond issuers in order to hedge its exposure 
arising from its corporate bond inventory, in accordance with its 
documented hedging policies and procedures. Though only the corporate 
bonds would be considered as part of the trading desk's market-maker 
inventory, its overall financial exposure would also include the credit 
default swaps used for hedging purposes.
---------------------------------------------------------------------------

    \717\ The Agencies recognize that under the statute a banking 
entity's positions in loans, spot commodities, and spot foreign 
exchange or currency are not subject to the final rule's 
restrictions on proprietary trading. Thus, a banking entity's 
trading in these instruments does not need to comply with the 
market-making exemption or any other exemption to the prohibition on 
proprietary trading. A banking entity may, however, include 
exposures in loans, spot commodities, and spot foreign exchange or 
currency that are related to the desk's market-making activities in 
determining the trading desk's financial exposure and in turn, the 
desk' s financial exposure limits under the market-making exemption. 
The Agencies believe this will provide a more accurate picture of 
the trading desk's financial exposure. For example, a market maker 
in foreign exchange forwards or swaps may mitigate the risks of its 
market-maker inventory with spot foreign exchange.
---------------------------------------------------------------------------

    As noted above, the Agencies believe the extent to which a trading 
desk is engaged in permitted market making-related activities is best 
determined by

[[Page 5593]]

evaluating both the financial exposure that results from the desk's 
trading activity and the amount, types, and risks of the financial 
instruments in the desk's market-maker inventory. Both concepts are 
independently valuable and will contribute to the effectiveness of the 
market-making exemption. Specifically, a trading desk's financial 
exposure will highlight the net exposure and risks of its positions 
and, along with an analysis of the actions the trading desk will take 
to demonstrably reduce or otherwise significantly mitigate promptly the 
risks of that exposure consistent with its limits, the extent to which 
it is appropriately managing the risk of its market-maker inventory 
consistent with applicable limits, all of which are significant to an 
analysis of whether a trading desk is engaged in market making-related 
activities. An assessment of the amount, types, and risks of the 
financial instruments in a trading desk's market-maker inventory will 
identify the aggregate amount of the desk's inventory in financial 
instruments for which it acts as market maker, the types of these 
financial instruments that the desk holds at a particular time, and the 
risks arising from such holdings. Importantly, an analysis of a trading 
desk's market-maker inventory will inform the extent to which this 
inventory is related to the reasonably expected near term demands of 
clients, customers, or counterparties.
    Because the market-maker inventory concept is more directly related 
to the financial instruments that a trading desk buys and sells from 
customers than the financial exposure concept, the Agencies believe 
that requiring review and analysis of a trading desk's market-maker 
inventory, as well as its financial exposure, will enhance compliance 
with the statute's near-term customer demand requirement. While the 
amount, types, and risks of a trading desk's market-maker inventory are 
constrained by the near-term customer demand requirement, any other 
positions in financial instruments managed by the trading desk as part 
of its market making-related activities (i.e., those reflected in the 
trading desk's financial exposure, but not included in the trading 
desk's market-maker inventory) are also constrained because they must 
be consistent with the market-maker inventory or, if taken for hedging 
purposes, designed to reduce the risks of the trading desk's market-
maker inventory.
    The Agencies note that disaggregating the trading desk's market-
maker inventory from its other exposures also allows for better 
identification of the trading desk's hedging positions in instruments 
for which the trading desk does not make a market. As a result, a 
banking entity's systems should be able to readily identify and monitor 
the trading desk's hedging positions that are not in its market-maker 
inventory. As discussed in Part IV.A.3.c.3., a trading desk must have 
certain inventory and risk limits on its market-maker inventory, the 
products, instruments, and exposures the trading desk may use for risk 
management purposes, and its financial exposure that are designed to 
facilitate the trading desk's compliance with the exemption and that 
are based on the nature and amount of the trading desk's market making-
related activities, including analyses regarding the reasonably 
expected near term demands of customers.\718\
---------------------------------------------------------------------------

    \718\ See infra Part IV.A.3.c.2.c.; final rule Sec.  --
--.4(b)(2)(iii)(C).
---------------------------------------------------------------------------

    The final rule also requires these policies and procedures to 
contain escalation procedures if a trade would exceed the limits set 
for the trading desk. However, the final rule does not permit a trading 
desk to exceed the limits solely based on customer demand. Rather, 
before executing a trade that would exceed the desk's limits or 
changing the desk's limits, a trading desk must first follow the 
relevant escalation procedures, which may require additional approval 
within the banking entity and provide demonstrable analysis that the 
basis for any temporary or permanent increase in limits is consistent 
with the reasonably expected near term demands of customers.
    Due to these considerations, the Agencies believe the final rule 
should result in more efficient compliance analyses on the part of both 
banking entities and Agency supervisors and examiners and should be 
less costly for banking entities to implement than a transaction-by-
transaction or instrument-by-instrument approach. For example, the 
Agencies believe that some banking entities already compute and monitor 
most trading desks' financial exposures for risk management or other 
purposes.\719\ The Agencies also believe that focusing on the financial 
exposure and market-maker inventory of a trading desk, as opposed to 
each separate individual transaction, is consistent with the statute's 
goal of reducing proprietary trading risk in the banking system and its 
exemption for market making-related activities. The Agencies recognize 
that banking entities may not currently disaggregate trading desks' 
market-maker inventory from their financial exposures and that, to the 
extent banking entities do not currently separately identify trading 
desks' market-maker inventory, requiring such disaggregation for 
purposes of this rule will impose certain costs. In addition, the 
Agencies understand that an approach focused solely on the aggregate of 
all the unit's trading positions, as suggested by some commenters, 
would present fewer burdens.\720\ However, for the reasons discussed 
above, the Agencies believe such disaggregation is necessary to give 
full effect to the statute's near term customer demand requirement.
---------------------------------------------------------------------------

    \719\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012) 
(stating that modern trading units generally view individual 
positions as a bundle of characteristics that contribute to their 
complete portfolio). See also Federal Reserve Board, Trading and 
Capital-Markets Activities Manual Sec.  2000.1 (Feb. 1998) (``The 
risk-measurement system should also permit disaggregation of risk by 
type and by customer, instrument, or business unit to effectively 
support the management and control of risks.'').
    \720\ See ACLI (Feb. 2012); Fixed Income Forum/Credit 
Roundtable; SIFMA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------

    The Agencies note that whether a financial instrument or exposure 
stemming from a derivative is considered to be market-maker inventory 
is based only on whether the desk makes a market in the financial 
instrument, regardless of the type of counterparty or the purpose of 
the transaction. Thus, the Agencies believe that banking entities 
should be able to develop a standardized methodology for identifying a 
trading desk's positions and exposures in the financial instruments for 
which it acts as a market maker. As further discussed in this Part, a 
trading desk's financial exposure must reflect the aggregate risks 
managed by the trading desk as part of its market making-related 
activities,\721\ and a banking entity should be able to demonstrate 
that the financial exposure of a trading desk is related to its market-
making activities.
---------------------------------------------------------------------------

    \721\ See final rule Sec.  ----.4(b)(4).
---------------------------------------------------------------------------

    The final rule defines ``financial exposure'' to mean the 
``aggregate risks of one or more financial instruments and any 
associated loans, commodities, or foreign exchange or currency, held by 
a banking entity or its affiliate and managed by a particular trading 
desk as part of the trading desk's market making-related activities.'' 
\722\ In this context, the term ``aggregate'' does not imply that a 
long exposure in one instrument can be combined with a short exposure 
in a similar or related

[[Page 5594]]

instrument to yield a total exposure of zero. Instead, such a 
combination may reduce a trading desk's economic exposure to certain 
risk factors that are common to both instruments, but it would still 
retain any basis risk between those financial instruments or 
potentially generate a new risk exposure in the case of purposeful 
hedging.
---------------------------------------------------------------------------

    \722\ Final rule Sec.  ----.4(b)(4). For example, in the case of 
derivatives, a trading desk's financial position will be the 
residual risks of the trading desk's open positions. For instance, 
an options desk may have thousands of open trades at any given time, 
including hedges, but the desk will manage, among other risk 
factors, the trading desk's portfolio delta, gamma, rho, and 
volatility.
---------------------------------------------------------------------------

    With respect to the frequency with which a trading desk should 
determine its financial exposure and the amount, types, and risks of 
the financial instruments in its market-maker inventory, a trading 
desk's financial exposure and market-maker inventory should be 
evaluated and monitored at a frequency that is appropriate for the 
trading desk's trading strategies and the characteristics of the 
financial instruments the desk trades, including historical intraday 
volatility. For example, a trading desk that repeatedly acquired and 
then terminated significant financial exposures throughout the day but 
that had little or no financial exposure at the end of the day should 
assess its financial exposure based on its intraday activities, not 
simply its end-of-day financial exposure. The frequency with which a 
trading desk's financial exposure and market-maker inventory will be 
monitored and analyzed should be specified in the trading desk's 
compliance program.
    A trading desk's financial exposure reflects its aggregate risk 
exposures. The types of ``aggregate risks'' identified in the trading 
desk's financial exposure should reflect consideration of all 
significant market factors relevant to the financial instruments in 
which the trading desk acts as market maker or that the desk uses for 
risk management purposes pursuant to this exemption, including the 
liquidity, maturity, and depth of the market for the relevant types of 
financial instruments. Thus, market factors reflected in a trading 
desk's financial exposure should include all significant and relevant 
factors associated with the products and instruments in which the desk 
trades as market maker or for risk management purposes, including basis 
risk arising from such positions.\723\ Similarly, an assessment of the 
risks of the trading desk's market-maker inventory must reflect 
consideration of all significant market factors relevant to the 
financial instruments in which the trading desk makes a market. 
Importantly, a trading desk's financial exposure and the risks of its 
market-maker inventory will change based on the desk's trading activity 
(e.g., buying an instrument that it did not previously hold, increasing 
its position in an instrument, or decreasing its position in an 
instrument) as well as changing market conditions related to 
instruments or positions managed by the trading desk.
---------------------------------------------------------------------------

    \723\ As discussed in Part IV.A.3.c.3., a banking entity must 
establish, implement, maintain, and enforce policies and procedures, 
internal controls, analysis, and independent testing regarding the 
financial instruments each trading desk stands ready to purchase and 
sell and the products, instruments, or exposures each trading desk 
may use for risk management purposes. See final rule Sec.  --
--.4(b)(2)(iii).
---------------------------------------------------------------------------

    Because the final rule defines ``trading desk'' based on 
operational functionality rather than corporate formality, a trading 
desk's financial exposure may include positions that are booked in 
different affiliated legal entities.\724\ The Agencies understand that 
positions may be booked in different legal entities for a variety of 
reasons, including regulatory reasons. For example, a trading desk that 
makes a market in corporate bonds may book its corporate bond positions 
in an SEC-registered broker-dealer and may book index CDS positions 
acquired for hedging purposes in a CFTC-registered swap dealer. A 
financial exposure that reflects both the corporate bond position and 
the index CDS position better reflects the economic reality of the 
trading desk's risk exposure (i.e., by showing that the risk of the 
corporate bond position has been reduced by the index CDS position).
---------------------------------------------------------------------------

    \724\ Other statutory or regulatory requirements, including 
those based on prudential safety and soundness concerns, may prevent 
or limit a banking entity from booking hedging positions in a legal 
entity other than the entity taking the underlying position.
---------------------------------------------------------------------------

    In addition, a trading desk engaged in market making-related 
activities in compliance with the final rule may direct another 
organizational unit of the banking entity or an affiliate to execute a 
risk-mitigating transaction on the trading desk's behalf.\725\ The 
other organizational unit may rely on the market-making exemption for 
these purposes only if: (i) The other organizational unit acts in 
accordance with the trading desk's risk management policies and 
procedures established in accordance with Sec.  ----.4(b)(2)(iii) of 
the final rule; and (ii) the resulting risk-mitigating position is 
attributed to the trading desk's financial exposure (and not the other 
organizational unit's financial exposure) and is included in the 
trading desk's daily profit and loss calculation. If another 
organizational unit of the banking entity or an affiliate establishes a 
risk-mitigating position for the trading desk on its own accord (i.e., 
not at the direction of the trading desk) or if the risk-mitigating 
position is included in the other organizational unit's financial 
exposure or daily profit and loss calculation, then the other 
organizational unit must comply with the requirements of the hedging 
exemption for such activity.\726\ It may not rely on the market-making 
exemption under these circumstances. If a trading desk engages in a 
risk-mitigating transaction with a second trading desk of the banking 
entity or an affiliate that is also engaged in permissible market 
making-related activities, then the risk-mitigating position would be 
included in the first trading desk's financial exposure and the contra-
risk would be included in the second trading desk's market-maker 
inventory and financial exposure. The Agencies believe the net effect 
of the final rule is to allow individual trading desks to efficiently 
manage their own hedging and risk mitigation activities on a holistic 
basis, while only allowing for external hedging directed by staff 
outside of the trading desk under the additional requirements of the 
hedging exemption.
---------------------------------------------------------------------------

    \725\ See infra Part IV.A.3.c.4.
    \726\ Under these circumstances, the other organizational unit 
would also be required to meet the hedging exemption's documentation 
requirement for the risk-mitigating transaction. See final rule 
Sec.  ----.5(c).
---------------------------------------------------------------------------

    To include in a trading desk's financial exposure either positions 
held at an affiliated legal entity or positions established by another 
organizational unit on the trading desk's behalf, a banking entity must 
be able to provide supervisors or examiners of any Agency that has 
regulatory authority over the banking entity pursuant to section 
13(b)(2)(B) of the BHC Act with records, promptly upon request, that 
identify any related positions held at an affiliated entity that are 
being included in the trading desk's financial exposure for purposes of 
the market-making exemption. Similarly, the supervisors and examiners 
of any Agency that has supervisory authority over the banking entity 
that holds financial instruments that are being included in another 
trading desk's financial exposure for purposes of the market-making 
exemption must have the same level of access to the records of the 
trading desk.\727\ Banking entities should be prepared to provide all 
records that identify all positions included in a trading desk's 
financial exposure and where such positions are held.
---------------------------------------------------------------------------

    \727\ A banking entity must be able to provide such records when 
a related position is held at an affiliate, even if the affiliate 
and the banking entity are not subject to the same Agency's 
regulatory jurisdiction.

---------------------------------------------------------------------------

[[Page 5595]]

    As an example of how a trading desk's market-maker inventory and 
financial exposure will be analyzed under the market-making exemption, 
assume a trading desk makes a market in a variety of U.S. corporate 
bonds and hedges its aggregated positions with a combination of 
exposures to corporate bond indexes and specific name CDS in which the 
desk does not make a market. To qualify for the market-making 
exemption, the trading desk would have to demonstrate, among other 
things, that: (i) The desk routinely stands ready to purchase and sell 
the U.S. corporate bonds, consistent with the requirement of Sec.  --
--.4(b)(2)(i) of the final rule, and these instruments (or category of 
instruments) are identified in the trading desk's compliance program; 
(ii) the trading desk's market-maker inventory in U.S. corporate bonds 
is designed not to exceed, on an ongoing basis, the reasonably expected 
near term demands of clients, customers, or counterparties, consistent 
with the analysis and limits established by the banking entity for the 
trading desk; (iii) the trading desk's exposures to corporate bond 
indexes and single name CDS are designed to mitigate the risk of its 
financial exposure, are consistent with the products, instruments, or 
exposures and the techniques and strategies that the trading desk may 
use to manage its risk effectively (and such use continues to be 
effective), and do not exceed the trading desk's limits on the amount, 
types, and risks of the products, instruments, and exposures the 
trading desk uses for risk management purposes; and (iv) the aggregate 
risks of the trading desk's exposures to U.S. corporate bonds, 
corporate bond indexes, and single name CDS do not exceed the trading 
desk's limits on the level of exposures to relevant risk factors 
arising from its financial exposure.
    Our focus on the financial exposure of a trading desk, rather than 
a trade-by-trade requirement, is designed to give banking entities the 
flexibility to acquire not only market-maker inventory, but positions 
that facilitate market making, such as positions that hedge market-
maker inventory.\728\ As commenters pointed out, a trade-by-trade 
requirement would view trades in isolation and could fail to recognize 
that certain trades that are not customer-facing are nevertheless 
integral to market making and financial intermediation.\729\ The 
Agencies understand that the risk-reducing effects of combining large 
diverse portfolios could, in certain instances, mask otherwise 
prohibited proprietary trading.\730\ However, the Agencies do not 
believe that taking a transaction-by-transaction approach is necessary 
to address this concern. Rather, the Agencies believe that the broader 
definitions of ``financial exposure'' and ``market-maker inventory'' 
coupled with the tailored definition of ``trading desk'' facilitates 
the analysis of aggregate risk exposures and positions in a manner best 
suited to apply and evaluate the market-making exemption.
---------------------------------------------------------------------------

    \728\ The Agencies believe it is appropriate to apply the 
requirements of the exemption to the financial exposure of a 
``trading desk,'' rather than the portfolio of a higher level of 
organization, for the reasons discussed above, including our concern 
that aggregating a large number of disparate positions and exposures 
across a range of trading desks could increase the risk of evasion. 
See supra Part IV.A.3.c.1.c.i. (discussing the determination to 
apply requirements at the trading desk level).
    \729\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012).
    \730\ See, e.g., Occupy.
---------------------------------------------------------------------------

    In short, this approach is designed to mitigate the costs of a 
trade-by-trade analysis identified by commenters. The Agencies 
recognize, however, that this approach is only effective at achieving 
the goals of the section 13 of the BHC Act--promoting financial 
intermediation and limiting speculative risks within banking entities--
if there are limits on a trading desk's financial exposure. That is, a 
permissive market-making exemption that gives banking entities maximum 
discretion in acquiring positions to provide liquidity runs the risk of 
also allowing banking entities to engage in speculative trades. As 
discussed more fully in the following Parts of this SUPPLEMENTARY 
INFORMATION, the final market-making exemption provides a number of 
controls on a trading desk's financial exposure. These controls 
include, among others, a provision requiring that a trading desk's 
market-maker inventory be designed not to exceed, on an ongoing basis, 
the reasonably expected near term demands of customers and that any 
other financial instruments managed by the trading desk be designed to 
mitigate the risk of such desk's market-maker inventory. In addition, 
the final market-making exemption requires the trading desk's 
compliance program to include appropriate risk and inventory limits 
tied to the near term demand requirement, as well as escalation 
procedures if a trade would exceed such limits. The compliance program, 
which includes internal controls and independent testing, is designed 
to prevent instances where transactions not related to providing 
financial intermediation services are part of a desk's financial 
exposure.
iii. Routinely Standing Ready To Buy and Sell
    The requirement to routinely stand ready to buy and sell a type of 
financial instrument in the final rule recognizes that market making-
related activities differ based on the liquidity, maturity, and depth 
of the market for the relevant type of financial instrument. For 
example, a trading desk acting as a market maker in highly liquid 
markets would engage in more regular quoting activity than a market 
maker in less liquid markets. Moreover, the Agencies recognize that the 
maturity and depth of the market also play a role in determining the 
character of a market maker's activity.
    As noted above, the standard of ``routinely'' standing ready to buy 
and sell will differ across markets and asset classes based on the 
liquidity, maturity, and depth of the market for the type of financial 
instrument. For instance, a trading desk that is a market maker in 
liquid equity securities generally should engage in very regular or 
continuous quoting and trading activities on both sides of the market. 
In less liquid markets, a trading desk should engage in regular quoting 
activity across the relevant type(s) of financial instruments, although 
such quoting may be less frequent than in liquid equity markets.\731\ 
Consistent with the CFTC's and SEC's interpretation of market making in 
swaps and security-based swaps for purposes of the definitions of 
``swap dealer'' and ``security-based swap dealer,'' ``routinely'' in 
the swap market context means that the trading desk should stand ready 
to enter into swaps or security-based swaps at the request or demand of 
a counterparty more frequently than occasionally.\732\ The Agencies 
note that a trading desk may routinely stand ready to enter into 
derivatives on both sides of the market, or it may routinely stand 
ready to enter into derivatives on either side of the market and then 
enter into one or more offsetting positions in the derivatives market 
or another market, particularly in the case of relatively less liquid 
derivatives. While a trading desk may respond to requests to trade 
certain

[[Page 5596]]

products, such as custom swaps, even if it does not normally quote in 
the particular product, the trading desk should hedge against the 
resulting exposure in accordance with its financial exposure and 
hedging limits.\733\ Further, the Agencies continue to recognize that 
market makers in highly illiquid markets may trade only intermittently 
or at the request of particular customers, which is sometimes referred 
to as trading by appointment.\734\ A trading desk's block positioning 
activity would also meet the terms of this requirement provided that, 
from time to time, the desk engages in block trades (i.e., trades of a 
large quantity or with a high dollar value) with customers.\735\
---------------------------------------------------------------------------

    \731\ Indeed, in the most specialized situations, such 
quotations may only be provided upon request. See infra note 735 and 
accompanying text (discussing permissible block positioning).
    \732\ The Agencies will consider factors similar to those 
identified by the CFTC and SEC in connection with this standard. See 
Further Definition of ``Swap Dealer,'' ``Security-Based Swap 
Dealer,'' ``Major Swap Participant,'' ``Major Security-Based Swap 
Participant'' and ``Eligible Contract Participant'', 77 FR 30596, 
30609 (May 23, 2012)
    \733\ The Agencies recognize that, as noted by commenters, 
preventing a banking entity from conducting customized transactions 
with customers may impact customers' risk exposures or transaction 
costs. See Goldman (Prop. Trading); SIFMA (Asset Mgmt.) (Feb. 2012). 
The Agencies are not prohibiting this activity under the final rule, 
as discussed in this Part.
    \734\ The Agencies have considered comments on the issue of 
whether trading by appointment should be permitted under the final 
market-making exemption. The Agencies believe it is appropriate to 
permit trading by appointment to the extent that there is customer 
demand for liquidity in the relevant products.
    \735\ As noted in the preamble to the proposed rule, the size of 
a block will vary among different asset classes. The Agencies also 
stated in the proposal that the SEC's definition of ``qualified 
block positioner'' in Rule 3b-8(c) under the Exchange Act may serve 
as guidance for determining whether block positioning activity 
qualifies for the market-making exemption. In referencing that rule 
as guidance, the Agencies did not intend to imply that a banking 
entity engaged in block positioning activity would be required to 
meet all terms of the ``qualified block positioner'' definition at 
all times. Nonetheless, a number of commenters indicated that it was 
unclear when a banking entity would need to act as a qualified block 
positioner in accordance with Rule 3b-8(c) and expressed concern 
that uncertainty could have a chilling effect on a banking entity's 
willingness to facilitate customer block trades. See, e.g., RBC; 
SIFMA (Asset Mgmt.) (Feb. 2012); Goldman (Prop. Trading). For 
example, a few commenters stated that certain requirements in Rule 
3b-8(c) could cause fire sales or general market uncertainty. See 
id. After considering comments, the Agencies have decided that the 
reference to Rule 3b-8(c) is unnecessary for purposes of the final 
rule. In particular, the Agencies believe that the requirements in 
the market-making exemption provide sufficient safeguards, and the 
additional requirements of the ``qualified block positioner'' 
definition may present unnecessary burdens or redundancies with the 
rule, as adopted. For example, the Agencies believe that there is 
some overlap between Sec.  ----.4(b)(2)(ii) of the exemption, which 
provides that the amount, types, and risks of the financial 
instruments in the trading desk's market-maker inventory must be 
designed not to exceed the reasonably expected near term demands of 
clients, customers, or counterparties, and Rule 3b-8(c)(iii), which 
requires the sale of the shares comprising the block as rapidly as 
possible commensurate with the circumstances. In other words, the 
market-making exemption would require a banking entity to 
appropriately manage its inventory when engaged in block positioning 
activity, but would not speak directly to the timing element given 
the diversity of markets to which the exemption applies.
    As noted above, one commenter analyzed the potential market 
impact of a complete restriction on a market maker's ability to 
provide direct liquidity to help a customer execute a large block 
trade. See supra note 682 and accompanying text. Because the 
Agencies are not restricting a banking entity's ability to engage in 
block positioning in the manner suggested by this commenter, the 
Agencies do not believe that the final rule will cause the cited 
market impact of incremental transaction costs between $1.7 and $3.4 
billion per year. The Agencies address this commenter's concern 
about the impact of inventory metrics on a banking entity's 
willingness to engage in block trading in Part IV.C.3. (discussing 
the metrics requirement in the final rule and noting that metrics 
will not be used to determine compliance with the rule but, rather, 
will be monitored for patterns over time to identify activities that 
may warrant further review).
    One commenter appeared to request that block trading activity 
not be subject to all requirements of the market-making exemption. 
See SIFMA (Asset Mgmt.) (Feb. 2012). Any activity conducted in 
reliance on the market-making exemption, including block trading 
activity, must meet the requirements of the market-making exemption. 
The Agencies believe the requirements in the final rule are workable 
for block positioning activity and do not believe it would be 
appropriate to subject block positioning to lesser requirements than 
general market-making activity. For example, trading in large block 
sizes can expose a trading desk to greater risk than market making 
in smaller sizes, particularly absent risk management requirements. 
Thus, the Agencies believe it is important for block positioning 
activity to be subject to the same requirements, including the 
requirements to establish risk limits and risk management 
procedures, as general market-making activity.
---------------------------------------------------------------------------

    Regardless of the liquidity, maturity, and depth of the market for 
a particular type of financial instrument, a trading desk should have a 
pattern of providing price indications on either side of the market and 
a pattern of trading with customers on each side of the market. In 
particular, in the case of relatively illiquid derivatives or 
structured instruments, it would not be sufficient to demonstrate that 
a trading desk on occasion creates a customized instrument or provides 
a price quote in response to a customer request. Instead, the trading 
desk would need to be able to demonstrate a pattern of taking these 
actions in response to demand from multiple customers with respect to 
both long and short risk exposures in identified types of instruments.
    This requirement of the final rule applies to a trading desk's 
activity in one or more ``types'' of financial instruments.\736\ The 
Agencies recognize that, in some markets, such as the corporate bond 
market, a market maker may regularly quote a subset of instruments 
(generally the more liquid instruments), but may not provide regular 
quotes in other related but less liquid instruments that the market 
maker is willing and available to trade. Instead, the market maker 
would provide a price for those instruments upon request.\737\ The 
trading desk's activity, in the aggregate for a particular type of 
financial instrument, indicates whether it is engaged in activity that 
is consistent with Sec.  ----.4(b)(2)(i) of the final rule.
---------------------------------------------------------------------------

    \736\ This approach is generally consistent with commenters' 
requested clarification that a trading desk's quoting activity will 
not be assessed on an instrument-by-instrument basis, but rather 
across a range of similar instruments for which the trading desk 
acts as a market maker. See, e.g., RBC; SIFMA et al. (Prop. Trading) 
(Feb. 2012); CIEBA; Goldman (Prop. Trading).
    \737\ See, e.g., Goldman (Prop. Trading); Morgan Stanley; RBC; 
SIFMA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------

    Notably, this requirement provides that the types of financial 
instruments for which the trading desk routinely stands ready to 
purchase and sell must be related to its authorized market-maker 
inventory and it authorized financial exposure. Thus, the types of 
financial instruments for which the desk routinely stands ready to buy 
and sell should compose a significant portion of its overall financial 
exposure. The only other financial instruments contributing to the 
trading desk's overall financial exposure should be those designed to 
hedge or mitigate the risk of the financial instruments for which the 
trading desk is making a market. It would not be consistent with the 
market-making exemption for a trading desk to hold only positions in, 
or be exposed to, financial instruments for which the trading desk is 
not a market maker.\738\
---------------------------------------------------------------------------

    \738\ The Agencies recognize that there could be limited 
circumstances under which a trading desk's financial exposure does 
not relate to the types of financial instruments that it is standing 
ready to buy and sell for a short period of time. However, the 
Agencies would expect for such occurrences to be minimal. For 
example, this scenario could occur if a trading desk unwinds a hedge 
position after the market-making position has already been unwound 
or if a trading desk acquires an anticipatory hedge position prior 
to acquiring a market-making position. As discussed more thoroughly 
in Part IV.A.3.c.3., a banking entity must establish written 
policies and procedures, internal controls, analysis, and 
independent testing that establish appropriate parameters around 
such activities.
---------------------------------------------------------------------------

    A trading desk's routine presence in the market for a particular 
type of financial instrument would not, on its own, be sufficient 
grounds for relying on the market-making exemption. This is because the 
frequency at which a trading desk is active in a particular market 
would not, on its own, distinguish between permitted market making-
related activity and impermissible proprietary trading. In response to 
comments, the final rule provides that a trading desk also must be 
willing and available to quote, buy and sell, or otherwise enter into 
long and short positions in the relevant type(s) of financial 
instruments for its

[[Page 5597]]

own account in commercially reasonable amounts and throughout market 
cycles.\739\ Importantly, a trading desk would not meet the terms of 
this requirement if it provides wide quotations relative to prevailing 
market conditions and is not engaged in other activity that evidences a 
willingness or availability to provide intermediation services.\740\ 
Under these circumstances, a trading desk would not be standing ready 
to purchase and sell because it is not genuinely quoting or trading 
with customers.
---------------------------------------------------------------------------

    \739\ See, e.g., Occupy; Better Markets (Feb. 2012).
    \740\ One commenter expressed concern that a banking entity may 
be able to rely on the market-making exemption when it is providing 
only wide, out of context quotes. See Occupy.
---------------------------------------------------------------------------

    In the context of this requirement, ``commercially reasonable 
amounts'' means that the desk generally must be willing to quote and 
trade in sizes requested by other market participants.\741\ For trading 
desks that engage in block trading, this would include block trades 
requested by customers, and this language is not meant to restrict a 
trading desk from acting as a block positioner. Further, a trading desk 
must act as a market maker on an appropriate basis throughout market 
cycles and not only when it is most favorable for it to do so.\742\ For 
example, a trading desk should be facilitating customer needs in both 
upward and downward moving markets.
---------------------------------------------------------------------------

    \741\ As discussed below, this may include providing quotes in 
the interdealer trading market.
    \742\ Algorithmic trading strategies that only trade when market 
factors are favorable to the strategy's objectives or that otherwise 
frequently exit the market would not be considered to be standing 
ready to purchase or sell a type of financial instrument throughout 
market cycles and, thus, would not qualify for the market-making 
exemption. The Agencies believe this addresses commenters' concerns 
about high-frequency trading activities that are only active in the 
market when it is believed to be profitable, rather than to 
facilitate customers. See, e.g., Better Markets (Feb. 2012). The 
Agencies are not, however, prohibiting all high-frequency trading 
activities under the final rule or otherwise limiting high-frequency 
trading by banking entities by imposing a resting period on their 
orders, as requested by certain commenters. See, e.g., Better 
Markets (Feb. 2012); Occupy; Public Citizen.
---------------------------------------------------------------------------

    As discussed further in Part IV.A.3.c.3., the financial instruments 
the trading desk stands ready to buy and sell must be identified in the 
trading desk's compliance program.\743\ Certain requirements in the 
final exemption apply to the amount, types, and risks of these 
financial instruments that a trading desk can hold in its market-maker 
inventory, including the near term customer demand requirement \744\ 
and the need to have certain risk and inventory limits.\745\
---------------------------------------------------------------------------

    \743\ See final rule Sec.  ----.4(b)(2)(iii)(A).
    \744\ See final rule Sec.  ----.4(b)(2)(ii).
    \745\ See final rule Sec.  ----.4(b)(2)(iii)(C).
---------------------------------------------------------------------------

    In response to the proposed requirement that a trading desk or 
other organizational unit hold itself out, some commenters requested 
that the Agencies limit the availability of the market-making exemption 
to trading in particular asset classes or trading on particular venues 
(e.g., organized trading platforms). The Agencies are not limiting the 
availability of the market-making exemption in the manner requested by 
these commenters.\746\ Provided there is customer demand for liquidity 
in a type of financial instrument, the Agencies do not believe the 
availability of the market-making exemption should depend on the 
liquidity of that type of financial instrument or the ability to trade 
such instruments on an organized trading platform. The Agencies see no 
basis in the statutory text for either approach and believe that the 
likely harms to investors seeking to trade affected instruments (e.g., 
reduced ability to purchase or sell a particular instrument, 
potentially higher transaction costs) and market quality (e.g., reduced 
liquidity) that would arise under such an approach would not be 
justified,\747\ particularly in light of the minimal benefits that 
might result from restricting or eliminating a banking entity's ability 
to hold less liquid assets in connection with its market making-related 
activities. The Agencies believe these commenters' concerns are 
adequately addressed by the final rule's requirements in the market-
making exemption that are designed to ensure that a trading desk cannot 
hold risk in excess of what is appropriate to provide intermediation 
services designed not to exceed, on an ongoing basis, the reasonably 
expected near term demands of clients, customers, or counterparties.
---------------------------------------------------------------------------

    \746\ For example, a few commenters requested that the rule 
prohibit banking entities from market making in assets classified as 
Level 3 under FAS 157. See supra note 651 and accompanying text. The 
Agencies continue to believe that it would be inappropriate to 
incorporate accounting standards in the rule because accounting 
standards could change in the future without consideration of the 
potential impact on the final rule. See Joint Proposal, 76 FR 68,859 
n.101 (explaining why the Agencies declined to incorporate certain 
accounting standards in the proposed rule); CFTC Proposal, 77 FR 
8344 n.107.
    Further, a few commenters suggested that the exemption should 
only be available for trading on an organized trading facility. This 
type of limitation would require significant and widespread market 
structure changes (with associated systems and infrastructure costs) 
in a relatively short period of time, as market making in certain 
assets is primarily or wholly conducted in the OTC market, and 
organized trading platforms may not currently exist for these 
assets. The Agencies do not believe that the costs of such market 
structure changes would be warranted for purposes of this rule.
    \747\ As discussed above, a number of commenters expressed 
concern about the potential market impacts of the perceived 
restrictions on market making under the proposed rule, particularly 
with respect to less liquid markets, such as the corporate bond 
market. See, e.g., Prof. Duffie; Wellington; BlackRock; ICI.
---------------------------------------------------------------------------

    In response to comments on the proposed interpretation regarding 
anticipatory position-taking,\748\ the Agencies note that the near term 
demand requirement in the final rule addresses when a trading desk may 
take positions in anticipation of reasonably expected near term 
customer demand.\749\ The Agencies believe this approach is generally 
consistent with the comments the Agencies received on this issue.\750\ 
In addition, the Agencies note that modifications to the proposed near 
term demand requirement in the final rule also address commenters 
concerns on this issue.\751\
---------------------------------------------------------------------------

    \748\ Joint Proposal, 76 FR 68,871 (stating that ``bona fide 
market making-related activity may include taking positions in 
securities in anticipation of customer demand, so long as any 
anticipatory buying or selling activity is reasonable and related to 
clear, demonstrable trading interest of clients, customers, or 
counterparties''); CFTC Proposal, 77 FR 8356-8357; See also Morgan 
Stanley (requesting certain revisions to more closely track the 
statute); SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. 
Trading); Chamber (Feb. 2012); Comm. on Capital Markets Regulation; 
SIFMA (Asset Mgmt.) (Feb. 2012).
    \749\ See final rule Sec.  ----.4(b)(2)(ii); infra Part 
IV.A.3.c.2.c.
    \750\ See BoA; SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman 
(Prop. Trading); Morgan Stanley; Chamber (Feb. 2012); Comm. on 
Capital Markets Regulation; SIFMA (Asset Mgmt.) (Feb. 2012).
    \751\ For example, some commenters suggested that the final rule 
allow market makers to make individualized assessments of 
anticipated customer demand, based on their expertise and 
experience, and account for differences between liquid and less 
liquid markets. See Chamber (Feb. 2012); ISDA (Feb. 2012). The final 
rule allows such assessments, based on historical customer demand 
and other relevant factors, and recognizes that near term demand may 
differ based on the liquidity, maturity, and depth of the market for 
a particular type of financial instrument. See infra Part 
IV.A.3.c.2.c.iii.
---------------------------------------------------------------------------

2. Near Term Customer Demand Requirement
a. Proposed Near Term Customer Demand Requirement
    Consistent with the statute, the proposed rule required that the 
trading desk or other organizational unit's market making-related 
activities be, with respect to the financial instrument, designed not 
to exceed the reasonably expected near term demands of clients, 
customers, or counterparties.\752\ This requirement is intended to 
prevent a trading desk from taking a speculative proprietary position 
that is unrelated to customer needs as part of the desk's

[[Page 5598]]

purported market making-related activities.\753\
---------------------------------------------------------------------------

    \752\ See proposed rule Sec.  ----.4(b)(2)(iii).
    \753\ See Joint Proposal, 76 FR 68,871; CFTC Proposal, 77 FR 
8357.
---------------------------------------------------------------------------

    In the proposal, the Agencies stated that a banking entity's 
expectations of near term customer demand should generally be based on 
the unique customer base of the banking entity's specific market-making 
business lines and the near term demand of those customers based on 
particular factors, beyond a general expectation of price appreciation. 
The Agencies further stated that they would not expect the activities 
of a trading desk or other organizational unit to qualify for the 
market-making exemption if the trading desk or other organizational 
unit is engaged wholly or principally in trading that is not in 
response to, or driven by, customer demands, regardless of whether 
those activities promote price transparency or liquidity. The proposal 
stated that, for example, a trading desk or other organizational unit 
of a banking entity that is engaged wholly or principally in arbitrage 
trading with non-customers would not meet the terms of the proposed 
rule's market-making exemption.\754\
---------------------------------------------------------------------------

    \754\ See id.
---------------------------------------------------------------------------

    With respect to market making in a security that is executed on an 
exchange or other organized trading facility, the proposal provided 
that a market maker's activities are generally consistent with 
reasonably expected near term customer demand when such activities 
involve passively providing liquidity by submitting resting orders that 
interact with the orders of others in a non-directional or market-
neutral trading strategy and the market maker is registered, if the 
exchange or organized trading facility registers market makers. Under 
the proposal, activities on an exchange or other organized trading 
facility that primarily take liquidity, rather than provide liquidity, 
would not qualify for the market-making exemption, even if conducted by 
a registered market maker.\755\
---------------------------------------------------------------------------

    \755\ See Joint Proposal, 76 FR 68,871-68,872; CFTC Proposal, 77 
FR 8357.
---------------------------------------------------------------------------

b. Comments Regarding the Proposed Near Term Customer Demand 
Requirement
    As noted above, the proposed near term customer demand requirement 
would implement language found in the statute's market-making 
exemption.\756\ Some commenters expressed general support for this 
requirement.\757\ For example, these commenters emphasized that the 
proposed near term demand requirement is an important component that 
restricts disguised position-taking or market making in illiquid 
markets.\758\ Several other commenters expressed concern that the 
proposed requirement is too restrictive \759\ because, for example, it 
may impede a market maker's ability to build or retain inventory \760\ 
or may impact a market maker's willingness to engage in block 
trading.\761\ Comments on particular aspects of this proposed 
requirement are discussed below, including the proposed interpretation 
of this requirement in the proposal, the requirement's potential impact 
on market maker inventory, potential differences in this standard 
across asset classes, whether it is possible to predict near term 
customer demand, and whether the terms ``client,'' ``customer,'' or 
``counterparty'' should be defined for purposes of the exemption.
---------------------------------------------------------------------------

    \756\ See supra Part IV.A.3.c.2.a.
    \757\ See, e.g., Sens. Merkley & Levin (Feb. 2012); Flynn & 
Fusselman; Better Markets (Feb. 2012).
    \758\ See Better Markets (Feb. 2012); Sens. Merkley & Levin 
(Feb. 2012).
    \759\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); 
Chamber (Feb. 2012); T. Rowe Price; SIFMA (Asset Mgmt.) (Feb. 2012); 
ACLI (Feb. 2012); MetLife; Comm. on Capital Markets Regulation; 
CIEBA; Credit Suisse (Seidel); SSgA (Feb. 2012); IAA (stating that 
the proposed requirement is too subjective and would be difficult to 
administer in a range of scenarios); Barclays; Prof. Duffie.
    \760\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); T. 
Rowe Price; CIEBA; Credit Suisse (Seidel); Barclays; Wellington; 
MetLife; Chamber (Feb. 2012); RBC; Prof. Duffie; ICI (Feb. 2012); 
SIFMA (Asset Mgmt.) (Feb. 2012). The Agencies respond to these 
comments in Part IV.A.3.c.2.c., infra. For a discussion of comments 
regarding inventory management activity conducted in connection with 
market making, See Part IV.A.3.c.2.b.vi., infra.
    \761\ See, e.g., ACLI (Feb. 2012); MetLife; Comm. on Capital 
Markets Regulation (noting that a market maker may need to hold 
significant inventory to accommodate potential block trade 
requests). Two of these commenters stated that a market maker may 
provide a worse price or may be unwilling to intermediate a large 
customer position if the market maker has to determine whether 
holding such position will meet the near term demand requirement, 
particularly if the market maker would be required to sell the block 
position over a short period of time. See ACLI (Feb. 2012); MetLife. 
These comments are addressed in Part IV.A.3.c.2.c.iii., infra.
---------------------------------------------------------------------------

i. The Proposed Guidance for Determining Compliance With the Near Term 
Customer Demand Requirement
    As discussed in more detail above, the proposal set forth proposed 
guidance on how a banking entity may comply with the proposed near term 
customer demand requirement.\762\ With respect to the language 
indicating that a banking entity's determination of near term customer 
demand should generally be based on the unique customer base of a 
specific market-making business line (and not merely an expectation of 
future price appreciation), one commenter stated that it is unclear how 
a banking entity would be able to make such determinations in markets 
where trades occur infrequently and customer demand is hard to 
predict.\763\
---------------------------------------------------------------------------

    \762\ See supra Part IV.A.3.c.2.a.
    \763\ See SIFMA et al. (Prop. Trading) (Feb. 2012). Another 
commenter suggested that the Agencies ``establish clear criteria 
that reflect appropriate revenue from changes in the bid-ask 
spread,'' noting that a legitimate market maker should be both 
selling and buying in a rising market (or, likewise, in a declining 
market). Public Citizen.
---------------------------------------------------------------------------

    Several commenters expressed concern about the proposal's statement 
that a trading desk or other organizational unit engaged wholly or 
principally in trading that is not in response to, or driven by, 
customer demands (e.g., arbitrage trading with non-customers) would not 
qualify for the exemption, regardless of whether the activities promote 
price transparency or liquidity.\764\ In particular, commenters stated 
that it would be difficult for a market-making business to try to 
divide its activities that are in response to customer demand (e.g., 
customer intermediation and hedging) from activities that promote price 
transparency and liquidity (e.g., interdealer trading to test market 
depth or arbitrage trading) in order to determine their 
proportionality.\765\ Another commenter stated that, as a matter of 
organizational efficiency, firms will often restrict arbitrage trading 
strategies to certain specific individual traders within the market-
making organization, who may sometimes be referred to as a ``desk,'' 
and expressed concern that this would be prohibited under the 
rule.\766\
---------------------------------------------------------------------------

    \764\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); 
Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); BoA; ICI 
(Feb. 2012); ICI Global; Vanguard; SSgA (Feb. 2012); See also infra 
Part IV.A.3.c.2.b.viii. (discussing comments on whether arbitrage 
trading should be permitted under the market-making exemption under 
certain circumstances).
    \765\ See Goldman (Prop. Trading); RBC. One of these commenters 
agreed, however, that a trading desk that is ``wholly'' engaged in 
trading that is unrelated to customer demand should not qualify for 
the proposed market-making exemption. See Goldman (Prop. Trading).
    \766\ See JPMC.
---------------------------------------------------------------------------

    In response to the proposed interpretation regarding market making 
on an exchange or other organized trading facility (and certain similar 
language in proposed Appendix B),\767\ several commenters indicated 
that the reference to passive submission of resting orders may be too 
restrictive and provided examples of scenarios where market makers may 
need to use market or marketable limit orders.\768\ For

[[Page 5599]]

example, many of these commenters stated that market makers may need to 
enter market or marketable limit orders to: (i) build or reduce 
inventory; \769\ (ii) address order imbalances on an exchange by, for 
example, using market orders to lessen volatility and restore pricing 
equilibrium; (iii) hedge market-making positions; (iv) create markets; 
\770\ (v) test the depth of the markets; (vi) ensure that ETFs, 
American depositary receipts (``ADRs''), options, and other instruments 
remain appropriately priced; \771\ and (vii) respond to movements in 
prices in the markets.\772\ Two commenters noted that distinctions 
between limit and market or marketable limit orders may not be workable 
in the international context, where exchanges may not use the same 
order types as U.S. trading facilities.\773\
---------------------------------------------------------------------------

    \767\ See Joint Proposal, 76 FR 68,871-68,872; CFTC Proposal, 77 
FR 8357.
    \768\ See, e.g., NYSE Euronext; SIFMA et al. (Prop. Trading) 
(Feb. 2012); Goldman (Prop. Trading); RBC. Comments on proposed 
Appendix B are discussed further in Part IV.A.3.c.8.b., infra. This 
issue is addressed in note 939 and its accompanying text, infra.
    \769\ Some commenters stated that market makers may need to use 
market or marketable limit orders to build inventory in anticipation 
of customer demand or in connection with positioning a block trade 
for a customer. See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; 
Goldman (Prop. Trading). Two of these commenters noted that these 
order types may be needed to dispose of positions taken into 
inventory as part of market making. See RBC; Goldman (Prop. 
Trading).
    \770\ See NYSE Euronext.
    \771\ See Goldman (Prop. Trading).
    \772\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \773\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman 
(Prop. Trading).
---------------------------------------------------------------------------

    A few commenters also addressed the proposed use of a market 
maker's exchange registration status as part of the analysis.\774\ Two 
commenters stated that the proposed rule should not require a market 
maker to be registered with an exchange to qualify for the proposed 
market-making exemption. According to these commenters, there are a 
large number of exchanges and organized trading facilities on which 
market makers may need to trade to maintain liquidity across the 
markets and to provide customers with favorable prices. These 
commenters indicated that any restrictions or burdens on such trading 
may decrease liquidity or make it harder to provide customers with the 
best price for their trade.\775\ One commenter, however, stated that 
the exchange registration requirement is reasonable and further 
supported adding a requirement that traders demonstrate adherence to 
the same or commensurate standards in markets where registration is not 
possible.\776\
---------------------------------------------------------------------------

    \774\ See NYSE Euronext; SIFMA et al. (Prop. Trading) (Feb. 
2012); Goldman (Prop. Trading); Occupy. See also infra notes 940 to 
941 and accompanying text (addressing these comments).
    \775\ See SIFMA et al. (Prop. Trading) (Feb. 2012) (stating that 
trading units may currently register as market makers with 
particular, primary exchanges on which they trade, but will serve in 
a market-making capacity on other trading venues from time to time); 
Goldman (Prop. Trading) (noting that there are more than 12 
exchanges and 40 alternative trading systems currently trading U.S. 
equities).
    \776\ See Occupy. In the alternative, this commenter would 
require all market making to be performed on an exchange or 
organized trading facility. See id.
---------------------------------------------------------------------------

    Some commenters recommended certain modifications to the proposed 
analysis. For example, a few commenters requested that the rule presume 
that a trading unit is engaged in permitted market making-related 
activity if it is registered as a market maker on a particular exchange 
or organized trading facility.\777\ In support of this recommendation, 
one commenter represented that it would be warranted because registered 
market makers directly contribute to maintaining liquid and orderly 
markets and are subject to extensive regulatory requirements in that 
capacity.\778\ Another commenter suggested that the Agencies instead 
use metrics to compare, in the aggregate and over time, the liquidity 
that a market maker makes rather than takes as part of a broader 
consideration of the market-making character of the relevant trading 
activity.\779\
---------------------------------------------------------------------------

    \777\ See NYSE Euronext (recognizing that registration status is 
not necessarily conclusive of engaging in market making-related 
activities); SIFMA et al. (Prop. Trading) (Feb. 2012) (stating that 
to the extent a trading unit is registered on a particular exchange 
or organized trading facility for any type of financial instrument, 
all of its activities on that exchange or organized trading facility 
should be presumed to be market making); Goldman (Prop. Trading). 
See also infra note 940 (responding to these comments). Two 
commenters noted that certain exchange rules may require market 
makers to deal for their own account under certain circumstances in 
order to maintain fair and orderly markets. See NYSE Euronext 
(discussing NYSE rules); Goldman (Prop. Trading) (discussing NYSE 
and CBOE rules). For example, according to these commenters, NYSE 
Rule 104(f)(ii) requires a market maker to maintain fair and orderly 
markets, which may involve dealing for their own account when there 
is a lack of price continuity, lack of depth, or if a disparity 
between supply and demand exists or is reasonably anticipated. See 
id.
    \778\ See Goldman (Prop. Trading). This commenter further stated 
that trading activities of exchange market makers may be 
particularly difficult to evaluate with customer-facing metrics 
(because ``specialist'' market makers may not have ``customers''), 
so conferring a positive presumption of compliance on such market 
makers would ensure that they can continue to contribute to 
liquidity, which benefits customers. This commenter noted that, for 
example, NYSE designated market makers (``DMMs'') are generally 
prohibited from dealing with customers and companies must ``wall 
off'' any trading units that act as DMMs. See id. (citing NYSE Rule 
98).
    \779\ See id. (stating that spread-related metrics, such as 
Spread Profit and Loss, may be useful for this purpose).
---------------------------------------------------------------------------

ii. Potential Inventory Restrictions and Differences Across Asset 
Classes
    A number of commenters expressed concern that the proposed 
requirement may unduly restrict a market maker's ability to manage its 
inventory.\780\ Several of these commenters stated that limitations on 
inventory would be especially problematic for market making in less 
liquid markets, like the fixed-income market, where customer demand is 
more intermittent and positions may need to be held for a longer period 
of time.\781\ Some commenters stated that the Agencies' proposed 
interpretation of this requirement would restrict a market maker's 
inventory in a manner that is inconsistent with the statute. These 
commenters indicated that the ``designed'' and ``reasonably expected'' 
language of the statute seem to recognize that market makers must 
anticipate customer requests and accumulate sufficient inventory to 
meet those reasonably expected demands.\782\ In addition, one commenter 
represented that a market maker must have wide latitude and incentives 
for initiating trades, rather than merely reacting to customer requests 
for quotes, to properly risk manage its positions or to prepare for 
anticipated customer demand or supply.\783\ Many commenters requested 
certain modifications to the proposed requirement to limit its impact 
on market maker inventory.\784\

[[Page 5600]]

Commenters' views on the importance of permitting inventory management 
activity in connection with market making are discussed below in Part 
IV.A.3.c.2.b.vi.
---------------------------------------------------------------------------

    \780\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); T. 
Rowe Price; CIEBA; Credit Suisse (Seidel); Barclays; Wellington; 
MetLife; Chamber (Feb. 2012); RBC; Prof. Duffie; ICI (Feb. 2012); 
SIFMA (Asset Mgmt.) (Feb. 2012). These concerns are addressed in 
Part IV.A.3.c.2.c., infra.
    \781\ See, e.g., SIFMA (Asset Mgmt.) (Feb. 2012); T. Rowe Price; 
CIEBA; ICI (Feb. 2012); RBC.
    \782\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); 
Chamber (Feb. 2012).
    \783\ See Prof. Duffie. However, another commenter stated that a 
legitimate market maker should respond to customer demand rather 
than initiate transactions, which is indicative of prohibited 
proprietary trading. See Public Citizen.
    \784\ See Credit Suisse (Seidel) (suggesting that the rule allow 
market makers to build inventory in products where they believe 
customer demand will exist, regardless of whether the inventory can 
be tied to a particular customer in the near term or to historical 
trends in customer demand); Barclays (recommending the rule require 
that ``the market making-related activity is conducted by each 
trading unit such that its activities (including the maintenance of 
inventory) are designed not to exceed the reasonably expected near 
term demands of clients, customers, or counterparties consistent 
with the market and trading patterns of the relevant product, and 
consistent with the reasonable judgment of the banking entity where 
such demand cannot be determined with reasonable accuracy''); CIEBA. 
In addition, some commenters suggested an interpretation that would 
provide greater discretion to market makers to enter into trades 
based on factors such as experience and expertise dealing in the 
market and market exigencies. See SIFMA et al. (Prop. Trading) (Feb. 
2012); Chamber (Feb. 2012). Two commenters suggested that the 
proposed requirement should be interpreted to permit market-making 
activity as it currently exists. See MetLife; ACLI (Feb. 2012). One 
commenter requested that the proposed requirement be moved to 
Appendix B of the rule to provide greater flexibility to consider 
facts and circumstances of a particular activity. See JPMC.
---------------------------------------------------------------------------

    Several commenters requested that the Agencies recognize that near 
term customer demand may vary across different markets and asset 
classes and implement this requirement flexibly.\785\ In particular, 
many of these commenters emphasized that the concept of ``near term 
demand'' should be different for less liquid markets, where 
transactions may occur infrequently, and for liquid markets, where 
transactions occur more often.\786\ One commenter requested that the 
Agencies add the phrase ``based on the characteristics of the relevant 
market and asset class'' to the end of the requirement to explicitly 
acknowledge these differences.\787\
---------------------------------------------------------------------------

    \785\ See CIEBA; Morgan Stanley; RBC; ICI (Feb. 2012); ISDA 
(Feb. 2012); Comm. on Capital Markets Regulation; Alfred Brock. The 
Agencies respond to these comments in Part IV.A.3.c.2.c.ii., infra.
    \786\ See ICI (Feb. 2012); CIEBA (stating that, absent a 
different interpretation for illiquid instruments, market makers 
will err on the side of holding less inventory to avoid sanctions 
for violating the rule); RBC.
    \787\ See Morgan Stanley.
---------------------------------------------------------------------------

iii. Predicting Near Term Customer Demand
    Commenters provided views on whether and, if so how, a banking 
entity may be able to predict near term customer demand for purposes of 
the proposed requirement.\788\ For example, two commenters suggested 
ways in which a banking entity could predict near term customer 
demand.\789\ One of these commenters indicated that banking entities 
should be able to utilize current risk management tools to predict near 
term customer demand, although these tools may need to be adapted to 
comply with the rule's requirements. According to this commenter, 
dealers commonly assess the following factors across product lines, 
which can relate to expected customer demand: (i) Recent volumes and 
customer trends; (ii) trading patterns of specific customers; (iii) 
analysis of whether the firm has an ability to win new customer 
business; (iv) comparison of the current market conditions to prior 
similar periods; (v) liquidity of large investors; and (vi) the 
schedule of maturities in customers' existing positions.\790\ Another 
commenter stated that the reasonableness of a market maker's inventory 
can be measured by looking to the specifics of the particular market, 
the size of the customer base being served, and expected customer 
demand, which banking entities should be required to take into account 
in both their inventory practices and policies and their actual 
inventories. This commenter recommended that the rule permit a banking 
entity to assume a position under the market-making exemption if it can 
demonstrate a track record or reasonable expectation that it can 
dispose of a position in the near term.\791\
---------------------------------------------------------------------------

    \788\ See Wellington; MetLife; SIFMA et al. (Prop. Trading) 
(Feb. 2012); Sens. Merkley & Levin (Feb. 2012); Chamber (Feb. 2012); 
FTN; RBC; Alfred Brock. These comments are addressed in Part 
IV.A.3.c.2.c.iii., infra.
    \789\ See Sens. Merkley & Levin (Feb. 2012); FTN.
    \790\ See FTN. The commenter further indicated that errors in 
estimating customer demand are managed through kick-out rules and 
oversight by risk managers and committees, with latitude in 
decisions being closely related to expected or empirical costs of 
hedging positions until they result in trading with counterparties. 
See id.
    \791\ See Sens. Merkley & Levin (Feb. 2012) (stating that 
banking entities should be required to collect inventory data, 
evaluate the data, develop policies on how to handle particular 
positions, and make regular adjustments to ensure a turnover of 
assets commensurate with near term demand of customers). This 
commenter also suggested that the rule specify the types of 
inventory metrics that should be collected and suggested that the 
rate of inventory turnover would be helpful. See id.
---------------------------------------------------------------------------

    Some commenters, however, emphasized that reasonably expected near 
term customer demand cannot always be accurately predicted.\792\ 
Several of these commenters requested the Agencies clarify that banking 
entities will not be subject to regulatory sanctions if reasonably 
anticipated near term customer demand does not materialize.\793\ One 
commenter further noted that a banking entity entering a new market, or 
gaining or losing customers, may need greater flexibility in applying 
the near term demand requirement because its anticipated demand may 
fluctuate.\794\
---------------------------------------------------------------------------

    \792\ See MetLife; Chamber (Feb. 2012); RBC; CIEBA; Wellington; 
ICI (Feb. 2012); Alfred Brock. This issue is addressed in Part 
IV.A.3.c.2.c.iii., infra.
    \793\ See ICI (Feb. 2012); CIEBA; RBC; Wellington; Invesco.
    \794\ See CIEBA.
---------------------------------------------------------------------------

iv. Potential Definitions of ``Client,'' ``Customer,'' or 
``Counterparty''
    Appendix B of the proposal discussed the proposed meaning of the 
term ``customer'' in the context of permitted market making-related 
activity.\795\ In addition, the proposal inquired whether the terms 
``client,'' ``customer,'' or ``counterparty'' should be defined in the 
rule for purposes of the market-making exemption.\796\ Commenters 
expressed varying views on the proposed interpretations in the proposal 
and on whether these terms should be defined in the final rule.\797\
---------------------------------------------------------------------------

    \795\ See Joint Proposal, 76 FR 68,960; CFTC Proposal, 77 FR 
8439. More specifically, Appendix B stated: ``In the context of 
market making in a security that is executed on an organized trading 
facility or an exchange, a `customer' is any person on behalf of 
whom a buy or sell order has been submitted by a broker-dealer or 
any other market participant. In the context of market making in a 
[financial instrument] in an OTC market, a `customer' generally 
would be a market participant that makes use of the market maker's 
intermediation services, either by requesting such services or 
entering into a continuing relationship with the market maker with 
respect to such services.'' Id. On this last point, the proposal 
elaborated that in certain cases, depending on the conventions of 
the relevant market (e.g., the OTC derivatives market), such a 
``customer'' may consider itself or refer to itself more generally 
as a ``counterparty.'' See Joint Proposal, 76 FR 68,960 n.2; CFTC 
Proposal, 77 FR 8439 n.2.
    \796\ See Joint Proposal, 76 FR 68,874; CFTC Proposal, 77 FR 
8359. In particular, Question 99 states: ``Should the terms 
`client,' `customer,' or `counterparty' be defined for purposes of 
the market making exemption? If so, how should these terms be 
defined? For example, would an appropriate definition of `customer' 
be: (i) A continuing relationship in which the banking entity 
provides one or more financial products or services prior to the 
time of the transaction; (ii) a direct and substantive relationship 
between the banking entity and a prospective customer prior to the 
transaction; (iii) a relationship initiated by the banking entity to 
a prospective customer to induce transactions; or (iv) a 
relationship initiated by the prospective customer with a view to 
engaging in transactions?'' Id.
    \797\ Comments on this issue are addressed in Part 
IV.A.3.c.2.c.i., infra.
---------------------------------------------------------------------------

    With respect to the proposed interpretations of the term 
``customer'' in Appendix B, one commenter agreed with the proposed 
interpretations and expressed the belief that the interpretations will 
allow interdealer market making where brokers or other dealers act as 
customers. However, this commenter also requested that the Agencies 
expressly incorporate providing liquidity to other brokers and dealers 
into the rule text.\798\ Another commenter similarly stated that 
instead of focusing solely on customer demand, the rule should be 
clarified to reflect that demand can come from other dealers or future 
customers.\799\
---------------------------------------------------------------------------

    \798\ See SIFMA et al. (Prop. Trading) (Feb. 2012). See also 
Credit Suisse (Seidel); RBC (requesting that the Agencies recognize 
``wholesale'' market making as permissible and representing that 
``[i]t is irrelevant to an investor whether market liquidity is 
provided by a broker-dealer with whom the investor maintains a 
customer account, or whether that broker-dealer looks to another 
dealer for market liquidity'').
    \799\ See Comm. on Capital Markets Regulation.
---------------------------------------------------------------------------

    In response to the proposal's question about whether the terms 
``client,'' ``customer,'' and ``counterparty'' should be further 
defined, a few commenters stated that that the terms should not be 
defined in the rule.\800\ Other

[[Page 5601]]

commenters indicated that further definition of these terms would be 
appropriate.\801\ Some of these commenters suggested that there should 
be greater limitations on who can be considered a ``customer'' under 
the rule.\802\ These commenters generally indicated that a ``customer'' 
should be a person or institution with whom the banking entity has a 
continuing, or a direct and substantive, relationship prior to the time 
of the transaction.\803\ In the case of a new customer, some of these 
commenters suggested requiring a relationship initiated by the 
prospective customer with a view to engaging in transactions.\804\ A 
few commenters indicated that a party should not be considered a 
client, customer, or counterparty if the banking entity: (i) originates 
a financial product and then finds a counterparty to take the other 
side of the transaction; \805\ or (ii) engages in transactions driven 
by algorithmic trading strategies.\806\ Three commenters requested more 
permissive definitions of these terms.\807\ According to one of these 
commenters, because these terms are listed in the disjunctive in the 
statute, the broadest term--a ``counterparty''--should prevail.\808\
---------------------------------------------------------------------------

    \800\ See FTN; ISDA (Feb. 2012); Alfred Brock.
    \801\ See Japanese Bankers Ass'n.; Credit Suisse (Seidel); 
Occupy; AFR et al. (Feb. 2012); Public Citizen.
    \802\ See AFR et al. (Feb. 2012); Occupy; Public Citizen. One of 
these commenters also requested that the Agencies remove the terms 
``client'' and ``counterparty'' from the proposed near term demand 
requirement. See Occupy.
    \803\ See AFR et al. (Feb. 2012); Occupy; Public Citizen. These 
commenters stated that other banking entities should never be 
``customers'' under the rule. See id. In addition, one of these 
commenters would further prevent a banking entity's employees and 
covered funds from being ``customers'' under the rule. See AFR et 
al. (Feb. 2012).
    \804\ See AFR et al. (Feb. 2012) (providing a similar definition 
for the term ``client'' as well); Public Citizen.
    \805\ See AFR et al. (Feb. 2012); Public Citizen. See also Sens. 
Merkley & Levin (Feb. 2012) (stating that a banking entity's 
activities that involve attempting to sell clients financial 
instruments that it originated, rather than facilitating a secondary 
market for client trades in previously existing financial products, 
should be analyzed under the underwriting exemption, not the market-
making exemption; in addition, compiling inventory of financial 
instruments that the bank originated should be viewed as proprietary 
trading).
    \806\ See AFR et al. (Feb. 2012).
    \807\ See Credit Suisse (Seidel) (stating that ``customer'' 
should be explicitly defined to include any counterparty to whom a 
banking entity is providing liquidity); ISDA (Feb. 2012) 
(recommending that, if the Agencies decide to define these terms, a 
``counterparty'' should be defined as the entity on the other side 
of a transaction, and the terms ``client'' and ``customer'' should 
not be interpreted to require a relationship beyond the isolated 
provision of a transaction); Japanese Bankers Ass'n. (requesting 
that it be clearly noted that interbank participants can be 
customers for interbank market makers).
    \808\ See ISDA (Feb. 2012). This commenter's primary position 
was that further definitions are not required and could create 
additional and unnecessary complexity. See id.
---------------------------------------------------------------------------

v. Interdealer Trading and Trading for Price Discovery or To Test 
Market Depth
    With respect to interdealer trading, many commenters expressed 
concern that the proposed rule could be interpreted to restrict a 
market maker's ability to engage in interdealer trading.\809\ As a 
general matter, commenters attributed these concerns to statements in 
proposed Appendix B \810\ or to the Customer-Facing Trade Ratio metric 
in proposed Appendix A.\811\ A number of commenters requested that the 
rule be modified to clearly recognize interdealer trading as a 
component of permitted market making-related activity \812\ and 
suggested ways in which this could be accomplished (e.g., through a 
definition of ``customer'' or ``counterparty'').\813\
---------------------------------------------------------------------------

    \809\ See, e.g., JPMC; Morgan Stanley; Goldman (Prop. Trading); 
Chamber (Feb. 2012); MetLife; Credit Suisse (Seidel); BoA; ACLI 
(Feb. 2012); RBC; AFR et al. (Feb. 2012); ISDA (Feb. 2012); Oliver 
Wyman (Dec. 2011); Oliver Wyman (Feb. 2012). A few commenters noted 
that the proposed rule would permit a certain amount of interdealer 
trading. See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012) (citing 
statements in the proposal providing that a market maker's 
``customers'' vary depending on the asset class and market in which 
intermediation services are provided and interpreting such 
statements as allowing interdealer market making where brokers or 
other dealers act as ``customers'' within the proposed construct); 
Goldman (Prop. Trading) (stating that interdealer trading related to 
hedging or exiting a customer position would be permitted, but 
expressing concern that requiring each banking entity to justify 
each of its interdealer trades as being related to one of its own 
customers would be burdensome and would reduce the effectiveness of 
the interdealer market). Commenters' concerns regarding interdealer 
trading are addressed in Part IV.A.3.c.2.c.i., infra.
    \810\ See infra Part IV.A.3.c.8.
    \811\ See, e.g., JPMC; SIFMA et al. (Prop. Trading) (Feb. 2012); 
Oliver Wyman (Feb. 2012) (recognizing that the proposed rule did not 
include specific limits on interdealer trading, but expressing 
concern that explicit or implicit limits could be established by 
supervisors during or after the conformance period).
    \812\ See MetLife; SIFMA et al. (Prop. Trading) (Feb. 2012); 
RBC; Credit Suisse (Seidel); JPMC; BoA; ACLI (Feb. 2012); AFR et al. 
(Feb. 2012); ISDA (Feb. 2012); Goldman (Prop. Trading); Oliver Wyman 
(Feb. 2012).
    \813\ See RBC (suggesting that explicitly incorporating 
liquidity provision to other brokers and dealers in the market-
making exemption would be consistent with the statute's reference to 
meeting the needs of ``counterparties,'' in addition to the needs of 
clients and customers); AFR et al. (Feb. 2012) (recognizing that the 
ability to manage inventory through interdealer transactions should 
be accommodated in the rule, but recommending that this activity be 
conditioned on a market maker having an appropriate level of 
inventory after an interdealer transaction); Goldman (Prop. Trading) 
(representing that the Agencies could evaluate and monitor the 
amount of interdealer trading that is consistent with a particular 
trading unit's market making-related or hedging activity through the 
customer-facing activity category of metrics); Oliver Wyman (Feb. 
2012) (recommending removal or modification of any metrics or 
principles that would indicate that interdealer trading is not 
permitted).
---------------------------------------------------------------------------

    Commenters emphasized that interdealer trading provides certain 
market benefits, including increased market liquidity; \814\ more 
efficient matching of customer order flow; \815\ greater hedging 
options to reduce risks; \816\ enhanced ability to accumulate inventory 
for current or near term customer demand, work down concentrated 
positions arising from a customer trade, or otherwise exit a position 
acquired from a customer; \817\ and general price discovery among 
dealers.\818\ Regarding the impact of interdealer trading on a market 
maker's ability to intermediate customer needs, one commenter studied 
the potential impact of interdealer trading limits--in combination with 
inventory limits--on trading in the U.S. corporate bond market. 
According to this commenter, if interdealer trading had been prohibited 
and a market maker's inventory had been limited to the average daily 
volume of the market as a whole, 69 percent of customer trades would 
have been prevented.\819\ Some commenters stated that a banking entity 
would be less able or willing to provide market-making services to 
customers if it could not engage in interdealer trading.\820\
---------------------------------------------------------------------------

    \814\ See Prof. Duffie; MetLife; ACLI (Feb. 2012); BDA (Feb. 
2012).
    \815\ See Oliver Wyman (Dec. 2011); Oliver Wyman (Feb. 2012); 
MetLife; ACLI (Feb. 2012). See also Thakor Study (stating that, when 
a market maker provides immediacy to a customer, it relies on being 
able to unwind its positions at opportune times by trading with 
other market makers, who may have knowledge about impending orders 
form their own customers that may induce them to trade with the 
market maker).
    \816\ See MetLife; ACLI (Feb. 2012); Goldman (Prop. Trading); 
Morgan Stanley; Oliver Wyman (Dec. 2011); Oliver Wyman (Feb. 2012).
    \817\ See Goldman (Prop. Trading); Chamber (Feb. 2012). See also 
Prof. Duffie (stating that a market maker acquiring a position from 
a customer may wish to rebalance its inventory relatively quickly 
through the interdealer network, which is often more efficient than 
requesting immediacy from another customer or waiting for another 
customer who wants to take the opposite side of the trade).
    \818\ See Chamber (Feb. 2012); Goldman (Prop. Trading).
    \819\ See Oliver Wyman (Feb. 2012) (basing its finding on data 
from 2009). This commenter also represented that the natural level 
of interdealer volume in the U.S. corporate bond market made up 16 
percent of total trading volume in 2010. See id.
    \820\ See Goldman (Prop. Trading); Morgan Stanley. See also BDA 
(Feb. 2012) (stating that if dealers in the fixed-income market are 
not able to trade with other dealers to ``cooperate with each other 
to provide adequate liquidity to the market as a whole,'' an 
essential source of liquidity will be eliminated from the market and 
existing values of fixed income securities will decline and become 
volatile, harming both investors who currently hold such positions 
and issuers, who will experience increased interest costs).

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[[Page 5602]]

    As noted above, a few commenters stated that market makers may use 
interdealer trading for price discovery purposes.\821\ Some commenters 
separately discussed the importance of this activity and requested 
that, when conducted in connection with market-making activity, trading 
for price discovery be considered permitted market making-related 
activity under the rule.\822\ Commenters indicated that price 
discovery-related trading results in certain market benefits, including 
enhancing the accuracy of prices for customers,\823\ increasing price 
efficiency, preventing market instability,\824\ improving market 
liquidity, and reducing overall costs for market participants.\825\ As 
a converse, one of these commenters stated that restrictions on such 
activity could result in market makers setting their prices too high, 
exposing them to significant risk and causing a reduction of market-
making activity or widening of spreads to offset the risk.\826\ One 
commenter further requested that trading to test market depth likewise 
be permitted under the market-making exemption.\827\ This commenter 
represented that the Agencies would be able to evaluate the extent to 
which trading for price discovery and market depth are consistent with 
market making-related activities for a particular market through a 
combination of customer-facing activity metrics, including the 
Inventory Risk Turnover metric, and knowledge of a banking entity's 
trading business developed by regulators as part of the supervisory 
process.\828\
---------------------------------------------------------------------------

    \821\ See Chamber (Feb. 2012); Goldman (Prop. Trading).
    \822\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Chamber 
(Feb. 2012); Goldman (Prop. Trading). One commenter provided the 
following example of such activity: If Security A and Security B 
have some price correlation but neither trades regularly, then a 
trader may execute a trade in Security A for price discovery 
purposes, using the price of Security A to make an informed bid-ask 
market to a customer in Security B. See SIFMA et al. (Prop. Trading) 
(Feb. 2012).
    \823\ See Goldman (Prop. Trading); Chamber (Feb. 2012) (stating 
that this type of trading is necessary in more illiquid markets); 
SIFMA et al. (Prop. Trading) (Feb. 2012).
    \824\ See Goldman (Prop. Trading).
    \825\ See Chamber (Feb. 2012).
    \826\ See id.
    \827\ See Goldman (Prop. Trading). This commenter represented 
that market makers often make trades with other dealers to test the 
depth of the markets at particular price points and to understand 
where supply and demand exist (although such trading is not 
conducted exclusively with other dealers). This commenter stated 
that testing the depth of the market is necessary to provide 
accurate prices to customers, particularly when customers Seeks to 
enter trades in amounts larger than the amounts offered by dealers 
who have sent indications to inter-dealer brokers. See id.
    \828\ See id.
---------------------------------------------------------------------------

vi. Inventory Management
    Several commenters requested that the rule provide banking entities 
with greater discretion to manage their inventories in connection with 
market making-related activity, including acquiring or disposing of 
positions in anticipation of customer demand.\829\ Commenters 
represented that market makers need to be able to build, manage, and 
maintain inventories to facilitate customer demand. These commenters 
further stated that the rule needs to provide some degree of 
flexibility for inventory management activities, as inventory needs may 
differ based on market conditions or the characteristics of a 
particular instrument.\830\ A few commenters cited legislative history 
in support of allowing banking entities to hold and manage inventory in 
connection with market making-related activities.\831\ Several 
commenters noted benefits that are associated with a market maker's 
ability to appropriately manage its inventory, including being able to 
meet reasonably anticipated future client, customer, or counterparty 
demand; \832\ accommodating customer transactions more quickly and at 
favorable prices; reducing near term price volatility (in the case of 
selling a customer block position); \833\ helping maintain an orderly 
market and provide the best price to customers (in the case of 
accumulating long or short positions in anticipation of a large 
customer sale or purchase); \834\ ensuring that markets continue to 
have sufficient liquidity; \835\ fostering a two-way market; and 
establishing a market-making presence.\836\ Some commenters noted that 
market makers may need to accumulate inventory to meet customer demand 
for certain products or under certain trading scenarios, such as to 
create units of structured products (e.g., ETFs and asset-backed 
securities) \837\ and in anticipation of an index rebalance.\838\
---------------------------------------------------------------------------

    \829\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); 
Credit Suisse (Seidel); Goldman (Prop. Trading); MFA; RBC. Inventory 
management is addressed in Part IV.A.3.c.2.c., infra.
    \830\ See, e.g., MFA (stating that it is critical for banking 
entities to continue to be able to maintain sufficient levels of 
inventory, which is dynamic in nature and requires some degree of 
flexibility in application); RBC (requesting that the Agencies 
explicitly acknowledge that, depending on market conditions or the 
characteristics of a particular security, it may be appropriate or 
necessary for a firm to maintain inventories over extended periods 
of time in the course of market making-related activities).
    \831\ See, e.g., RBC; NYSE Euronext; Fidelity. These commenters 
cited a colloquy in the Congressional Record between Senator Bayh 
and Senator Dodd, in which Senator Bayh stated: ``With respect to 
[section 13 of the BHC Act], the conference report states that 
banking entities are not prohibited from purchasing and disposing of 
securities and other instruments in connection with underwriting or 
market-making activities, provided that activity does not exceed the 
reasonably expected near-term demands of clients, customers, or 
counterparties. I want to clarify this language would allow banks to 
maintain an appropriate dealer inventory and residual risk 
positions, which are essential parts of the market-making function. 
Without that flexibility, market makers would not be able to provide 
liquidity to markets.'' 156 Cong. Rec. S5906 (daily ed. July 15, 
2010) (statement of Sen. Bayh).
    \832\ See, e.g., RBC.
    \833\ See Goldman (Prop. Trading).
    \834\ See id.
    \835\ See MFA.
    \836\ See RBC.
    \837\ See Goldman (Prop. Trading); BoA.
    \838\ See Oliver Wyman (Feb. 2012). As this commenter explained, 
some mutual funds and ETFs track major equity indices and, when the 
composition of an index changes (e.g., due to the addition or 
removal of a security or to rising or falling values of listed 
shares), an announcement is made and all funds tracking the index 
need to rebalance their portfolios. According to the commenter, 
banking entities may need to step in to provide liquidity for 
rebalances of less liquid indices because trades executed on the 
open market would substantially affect share prices. The commenter 
estimated that if market makers are not able to provide direct 
liquidity for rebalance trades, investors tracking these indices 
could potentially pay incremental costs of $600 million to $1.8 
billion every year. This commenter identified the proposed inventory 
metrics in Appendix A as potentially limiting a banking entity's 
willingness or ability to facilitate index rebalance trades. See id. 
Two other commenters also discussed the index rebalancing scenario. 
See Prof. Duffie; Thakor Study. Index rebalancing is addressed in 
note 931, infra.
---------------------------------------------------------------------------

    Commenters also expressed views with respect to how much discretion 
a banking entity should have to manage its inventory under the 
exemption and how to best monitor inventory levels. For example, one 
commenter recommended that the rule allow market makers to build 
inventory in products where they believe customer demand will exist, 
regardless of whether the inventory can be tied to a particular 
customer in the near term or to historical trends in customer 
demand.\839\ A few commenters suggested that the Agencies provide 
banking entities with greater discretion to accumulate inventory, but 
discourage market makers from holding inventory for long periods of 
time by imposing increasingly higher capital requirements on aged 
inventory.\840\ One commenter

[[Page 5603]]

represented that a trading unit's inventory management practices could 
be monitored with the Inventory Risk Turnover metric, in conjunction 
with other metrics.\841\
---------------------------------------------------------------------------

    \839\ See Credit Suisse (Seidel).
    \840\ See CalPERS; Vanguard. These commenters represented that 
placing increasing capital requirements on aged inventory would ease 
the rule's impact on investor liquidity, allow banking entities to 
internalize the cost of continuing to hold a position at the expense 
of its ability to take on new positions, and potentially decrease 
the possibility of a firm realizing a loss on a position by 
decreasing the time such position is held. See id. One commenter 
noted that some banking entities already use this approach to manage 
risk on their market-making desks. See Vanguard. See also Capital 
Group (suggesting that one way to implement the statutory exemption 
would be to charge a trader or a trading desk for positions held on 
its balance sheet beyond set time periods and to increase the charge 
at set intervals). These comments are addressed in note 923, infra.
    \841\ See Goldman (Prop. Trading) (representing that the 
Inventory Risk Turnover metric will allow the Agencies to evaluate 
the length of time that a trading unit tends to hold risk positions 
in inventory and whether that holding time is consistent with market 
making-related activities in the relevant market).
---------------------------------------------------------------------------

vii. Acting as an Authorized Participant or Market Maker in Exchange-
Traded Funds
    With respect to ETF trading, commenters generally requested 
clarification that a banking entity can serve as an authorized 
participant (``AP'') to an ETF issuer or can engage in ETF market 
making under the proposed exemption.\842\ According to commenters, APs 
may engage in the following types of activities with respect to ETFs: 
(i) trading directly with the ETF issuer to create or redeem ETF 
shares, which involves trading in ETF shares and the underlying 
components; \843\ (ii) trading to maintain price alignment between the 
ETF shares and the underlying components; \844\ (iii) traditional 
market-making activity; \845\ (iv) ``seeding'' a new ETF by entering 
into several initial creation transactions with an ETF issuer and 
holding the ETF shares, possibly for an extended period of time, until 
the ETF establishes regular trading and liquidity in the secondary 
markets; \846\ (v) ``create to lend'' transactions, where an AP enters 
a creation transaction with the ETF issuer and lends the ETF shares to 
an investor; \847\ and (vi) hedging.\848\ A few commenters noted that 
an AP may not engage in traditional market-making activity in the 
relevant ETF and expressed concern that the proposed rule may limit a 
banking entity's ability to act in an AP capacity.\849\ One commenter 
estimated that APs that are banking entities make up between 20 percent 
to 100 percent of creation and redemption activity for individual ETFs, 
with an average of approximately 35 percent of creation and redemption 
activity across all ETFs attributed to banking entities. This commenter 
expressed the view that, if the rule limits banking entities' ability 
to serve as APs, then individual investors' investments in ETFs will 
become more expensive due to higher premiums and discounts versus the 
ETF's NAV.\850\
---------------------------------------------------------------------------

    \842\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); 
Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); BoA; ICI 
(stating that an AP may trade with the ETF issuer in different 
capacities--in connection with traditional market-making activity, 
on behalf of customers, or for the AP's own account); ICI Global 
(discussing non-U.S. ETFs specifically); Vanguard; SSgA (Feb. 2012). 
One commenter represented that an AP's transactions in ETFs do not 
create risks associated with proprietary trading because, when an AP 
trades with an ETF issuer for its own account, the AP typically 
enters into an offsetting transaction in the underlying portfolio of 
securities, which cancels out investment risk and limits the AP's 
exposure to the difference between the market price for ETF shares 
and the ETF's net asset value (``NAV''). See Vanguard.
    With respect to market-making activity in an ETF, several 
commenters noted that market makers play an important role in 
maintaining price alignment by engaging in arbitrage transactions 
between the ETF shares and the shares of the underlying components. 
See, e.g., JPMC; Goldman (Prop. Trading) (making similar statement 
with respect to ADRs as well); SSgA (Feb. 2012); SIFMA et al. (Prop. 
Trading) (Feb. 2012); Credit Suisse (Seidel); RBC. AP and market 
maker activity in ETFs are addressed in Part IV.A.3.c.2.c.i., infra.
    \843\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; ICI 
(Feb. 2012) ICI Global; Vanguard; SSgA (Feb. 2012).
    \844\ See JPMC; Goldman (Prop. Trading); SIFMA et al. (Prop. 
Trading) (Feb. 2012); SSgA (Feb. 2012); ICI (Feb. 2012) ICI Global.
    \845\ See ICI Global; ICI (Feb. 2012) SIFMA et al. (Prop. 
Trading) (Feb. 2012); BoA.
    \846\ See BoA; ICI (Feb. 2012); ICI Global.
    \847\ See BoA (stating that lending the ETF shares to an 
investor gives the investor a more efficient way to hedge its 
exposure to assets correlated with those underlying the ETF).
    \848\ See ICI Global; ICI (Feb. 2012).
    \849\ See, e.g., Vanguard (noting that APs may not engage in 
market-making activity in the ETF and expressing concern that if AP 
activities are not separately permitted, banking entities may exit 
or not enter the ETF market); SSgA (Feb. 2012) (stating that APs are 
under no obligation to make markets in ETF shares and requiring such 
an obligation would discourage banking entities from acting as APs); 
ICI (Feb. 2012).
    \850\ See SSgA (Feb. 2012). This commenter further stated that 
as of 2011, an estimated 3.5 million--or 3 percent--of U.S. 
households owned ETFs and, as of September 2011, ETFs represented 
assets of approximately $951 billion. See id.
---------------------------------------------------------------------------

    A number of commenters stated that certain requirements of the 
proposed exemption may limit a banking entity's ability to serve as AP 
to an ETF, including the proposed near term customer demand 
requirement,\851\ the proposed source of revenue requirement,\852\ and 
language in the proposal regarding arbitrage trading.\853\ With respect 
to the proposed near term customer demand requirement, a few commenters 
noted that this requirement could prevent an AP from building inventory 
to assemble creation units.\854\ Two other commenters expressed the 
view that the ETF issuer would be the banking entity's ``counterparty'' 
when the banking entity trades directly with the ETF issuer, so this 
trading and inventory accumulation would meet the terms of the proposed 
requirement.\855\ To permit banking entities to act as APs, two 
commenters suggested that trading in the capacity of an AP should be 
deemed permitted market making-related activity, regardless of whether 
the AP is acting as a traditional market maker.\856\
---------------------------------------------------------------------------

    \851\ See BoA; Vanguard (stating that this determination may be 
particularly difficult in the case of a new ETF).
    \852\ See BoA. This commenter noted that the proposed source of 
revenue requirement could be interpreted to prevent a banking entity 
acting as AP from entering into creation and redemption 
transactions, ``Seeding'' an ETF, engaging in ``create to lend'' 
transactions, and performing secondary market making in an ETF 
because all of these activities require an AP to build an 
inventory--either in ETF shares or the underlying components--which 
often result in revenue attributable to price movements. See id.
    \853\ Commenters noted that this language would restrict an AP 
from engaging in price arbitrage to maintain efficient markets in 
ETFs. See Vanguard; RBC; Goldman (Prop. Trading); JPMC; SIFMA et al. 
(Prop. Trading) (Feb. 2012). See supra Part IV.A.3.c.2.a. 
(discussing the proposal's proposed interpretation regarding 
arbitrage trading).
    \854\ See BoA; Vanguard (stating that this determination may be 
particularly difficult in the case of a new ETF).
    \855\ See ICI Global; ICI (Feb. 2012).
    \856\ See ICI (Feb. 2012) ICI Global. These commenters provided 
suggested rule text on this issue and suggested that the Agencies 
could require a banking entity's compliance policies and internal 
controls to take a comprehensive approach to the entirety of an AP's 
trading activity, which would facilitate easy monitoring of the 
activity to ensure compliance. See id.
---------------------------------------------------------------------------

viii. Arbitrage or Other Activities That Promote Price Transparency and 
Liquidity
    In response to a question in the proposal,\857\ a number of 
commenters stated that certain types of arbitrage activity should be 
permitted under the market-making exemption.\858\ For example, some 
commenters stated that a banking entity's arbitrage activity should be 
considered market making to the extent the activity is driven by 
creating markets for customers tied to the price differential (e.g., 
``box'' strategies, ``calendar spreads,'' merger arbitrage, ``Cash and 
Carry,'' or basis trading) \859\ or to the extent that demand is 
predicated on specific price relationships between instruments (e.g., 
ETFs, ADRs) that market makers must

[[Page 5604]]

maintain.\860\ Similarly, another commenter suggested that arbitrage 
activity that aligns prices should be permitted, such as index 
arbitrage, ETF arbitrage, and event arbitrage.\861\ One commenter noted 
that many markets, such as futures and options markets, rely on 
arbitrage activities of market makers for liquidity purposes and to 
maintain convergence with underlying instruments for cash-settled 
options, futures, and index-based products.\862\ Commenters stated that 
arbitrage trading provides certain market benefits, including enhanced 
price transparency,\863\ increased market efficiency,\864\ greater 
market liquidity,\865\ and general benefits to customers.\866\ A few 
commenters noted that certain types of hedging activity may appear to 
have characteristics of arbitrage trading.\867\
---------------------------------------------------------------------------

    \857\ See Joint Proposal, 76 FR 68,873 (question 91) (inquiring 
whether the proposed exemption should be modified to permit certain 
arbitrage trading activities engaged in by market makers that 
promote liquidity or price transparency but do not service client, 
customer, or counterparty demand); CFTC Proposal, 77 FR 8359.
    \858\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); 
Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); FTN; RBC; 
ISDA (Feb. 2012). Arbitrage trading is further discussed in Part 
IV.A.3.c.2.c.i., infra.
    \859\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \860\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.
    \861\ See Credit Suisse (Seidel).
    \862\ See RBC.
    \863\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \864\ See Credit Suisse (Seidel); RBC.
    \865\ See RBC.
    \866\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; FTN; 
ISDA (Feb. 2012) (stating that arbitrage activities often yield 
positions that are ultimately put to use in serving customer demand 
and representing that the process of consistently trading makes a 
dealer ready and available to serve customers on a competitive 
basis).
    \867\ See JPMC (stating that firms commonly organize their 
market-making activities so that risks delivered to client-facing 
desks are aggregated and transferred by means of internal 
transactions to a single utility desk (which hedges all of the risks 
in the aggregate), and this may optically bear some characteristics 
of arbitrage, although the commenter requested that such activity be 
recognized as permitted market making-related activity under the 
rule); ISDA (Feb. 2012) (stating that in some swaps markets, dealers 
hedge through multiple instruments, which can give an impression of 
arbitrage in a function that is risk reducing; for example, a dealer 
in a broad index equity swap may simultaneously hedge in baskets of 
stocks, futures, and ETFs). But See Sens. Merkley & Levin (Feb. 
2012) (``When banks use complex hedging techniques or otherwise 
engage in trading that is suggestive of arbitrage, regulators should 
require them to provide evidence and analysis demonstrating what 
risk is being reduced.'').
---------------------------------------------------------------------------

    Commenters suggested certain methods for permitting and monitoring 
arbitrage trading under the exemption. For example, one commenter 
suggested a framework for permitting certain arbitrage within the 
market-making exemption, with requirements such as: (i) Common 
personnel with market-making activity; (ii) policies that cover the 
timing and appropriateness of arbitrage positions; (iii) time limits on 
arbitrage positions; and (iv) compensation that does not reward 
successful arbitrage, but instead pools any such revenues with market-
making profits and losses.\868\ A few commenters represented that, if 
permitted under the rule, the Agencies would be able to monitor 
arbitrage activities for patterns of impermissible proprietary trading 
through the use of metrics, as well as compliance and examination 
tools.\869\
---------------------------------------------------------------------------

    \868\ See FTN.
    \869\ See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; Goldman 
(Prop. Trading). One of these commenters stated that the customer-
facing activity category of metrics, as well as other metrics, would 
be available to evaluate whether the trading unit is engaged in a 
directly customer-facing business and the extent to which its 
activities are consistent with the market-making exemption. See 
Goldman (Prop. Trading).
---------------------------------------------------------------------------

    Other commenters stated that the exemption should not permit 
certain types of arbitrage. One commenter stated that the rule should 
ensure that relative value and complex arbitrage strategies cannot be 
conducted.\870\ Another commenter expressed the view that the market-
making exemption should not permit any type of arbitrage transactions. 
This commenter stated that, in the event that liquidity or transparency 
is inhibited by a lack of arbitrage trading, a market maker should be 
able to find a customer who would seek to benefit from it.\871\
---------------------------------------------------------------------------

    \870\ See Johnson & Prof. Stiglitz. See also AFR et al. (Feb. 
2012) (noting that arbitrage, spread, or carry trades are a classic 
type of proprietary trade).
    \871\ See Occupy.
---------------------------------------------------------------------------

ix. Primary Dealer Activities
    A number of commenters requested that the market-making exemption 
permit banking entities to meet their primary dealer obligations in 
foreign jurisdictions, particularly if trading in foreign sovereign 
debt is not separately exempted in the final rule.\872\ According to 
commenters, a banking entity may be obligated to perform the following 
activities in its capacity as a primary dealer: undertaking to maintain 
an orderly market, preventing or correcting any price 
dislocations,\873\ and bidding on each issuance of the relevant 
jurisdiction's sovereign debt.\874\ Commenters expressed concern that a 
banking entity's trading activity as primary dealer may not comply with 
the proposed near term customer demand requirement \875\ or the 
proposed source of revenue requirement.\876\ To address the first 
issue, one commenter stated that the final rule should clarify that a 
banking entity acting as a primary dealer of foreign sovereign debt is 
engaged in primary dealer activity in response to the near term demands 
of the sovereign, which should be considered a client, customer, or 
counterparty of the banking entity.\877\ Another commenter suggested 
that the Agencies permit primary dealer activities through commentary 
stating that fulfilling primary dealer obligations will not be included 
in determinations of whether the market-making exemption applies to a 
trading unit.\878\
---------------------------------------------------------------------------

    \872\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012) 
(stating that permitted activities should include trading necessary 
to meet the relevant jurisdiction's primary dealer and other 
requirements); JPMC (indicating that the exemption should cover all 
of a firm's activities that are necessary or reasonably incidental 
to its acting as a primary dealer in a foreign government's debt 
securities); Goldman (Prop. Trading); Banco de M[eacute]xico; IIB/
EBF. See infra notes 905 to 906 and accompanying text (addressing 
these comments).
    \873\ See Goldman (Prop. Trading).
    \874\ See Banco de M[eacute]xico.
    \875\ See JPMC; Banco de M[eacute]xico. These commenters stated 
that a primary dealer is required to assume positions in foreign 
sovereign debt even when near term customer demand is unpredictable. 
See id.
    \876\ See Banco de M[eacute]xico (stating that primary dealers 
need to be able to profit from their positions in sovereign debt, 
including by holding significant positions in anticipation of future 
price movements, so that the primary dealer business is financially 
attractive); IIB/EBF (stating that primary dealers may actively Seek 
to profit from price and interest rate movements based on their debt 
holdings, which governments support as providing much-needed 
liquidity for securities that are otherwise purchased largely 
pursuant to buy-and-hold strategies of institutional investors and 
other entities Seeking safe returns and liquidity buffers).
    \877\ See Goldman (Prop. Trading).
    \878\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------

x. New or Bespoke Products or Customized Hedging Contracts
    Several commenters indicated that the proposed exemption does not 
adequately address market making in new or bespoke products, including 
structured, customer-driven transactions, and requested that the rule 
be modified to clearly permit such activity.\879\ Many of these 
commenters emphasized the role such transactions play in helping 
customers hedge the unique risks they face.\880\ Commenters stated 
that, as a result, limiting a banking entity's ability to conduct such 
transactions would subject customers to increased risks and greater 
transaction costs.\881\ One commenter suggested that the Agencies 
explicitly state that a banking entity's general willingness to engage 
in bespoke transactions is sufficient to make it a market maker in 
unique products for purposes of the rule.\882\
---------------------------------------------------------------------------

    \879\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); 
Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); SIFMA (Asset 
Mgmt.) (Feb. 2012). This issue is addressed in Part 
IV.A.3.c.1.c.iii., supra, and Part IV.A.3.c.2.c.iii., infra.
    \880\ See Credit Suisse (Seidel); Goldman (Prop. Trading); SIFMA 
(Asset Mgmt.) (Feb. 2012).
    \881\ See Goldman (Prop. Trading); SIFMA (Asset Mgmt.) (Feb. 
2012).
    \882\ See SIFMA (Asset Mgmt.) (Feb. 2012).
---------------------------------------------------------------------------

    Other commenters stated that banking entities should be limited in 
their ability to rely on the market-making exemption to conduct 
transactions in bespoke or

[[Page 5605]]

customized derivatives.\883\ For example, one commenter suggested that 
a banking entity be required to disaggregate such derivatives into 
liquid risk elements and illiquid risk elements, with liquid risk 
elements qualifying for the market-making exemption and illiquid risk 
elements having to be conducted on a riskless principal basis under 
Sec.  ----.6(b)(1)(ii) of the proposed rule. According to this 
commenter, such an approach would not impact the end user 
customer.\884\ Another commenter stated that a banking entity making a 
market in bespoke instruments should be required both to hold itself 
out in accordance with Sec.  ----.4(b)(2)(ii) of the proposed rule and 
to demonstrate the purchase and the sale of such an instrument.\885\
---------------------------------------------------------------------------

    \883\ See AFR et al. (Feb. 2012); Public Citizen.
    \884\ See AFR et al. (Feb. 2012).
    \885\ See Public Citizen.
---------------------------------------------------------------------------

c. Final Near Term Customer Demand Requirement
    Consistent with the statute, Sec.  ----.4(b)(2)(ii) of the final 
rule's market-making exemption requires that the amount, types, and 
risks of the financial instruments in the trading desk's market-maker 
inventory be designed not to exceed, on an ongoing basis, the 
reasonably expected near term demands of clients, customers, or 
counterparties, based on certain market factors and analysis.\886\ As 
discussed above in Part IV.A.3.c.1.c.ii., the trading desk's market-
maker inventory consists of positions in financial instruments in which 
the trading desk stands ready to purchase and sell consistent with the 
final rule.\887\ The final rule requires the financial instruments to 
be identified in the trading desk's compliance program. Thus, this 
requirement focuses on a trading desk's positions in financial 
instruments for which it acts as market maker. These positions of a 
trading desk are more directly related to the demands of customers than 
positions in financial instruments used for risk management purposes, 
but in which the trading desk does not make a market. As noted above, a 
position or exposure that is included in a trading desk's market-maker 
inventory will remain in its market-maker inventory for as long as the 
position or exposure is managed by the trading desk. As a result, the 
trading desk must continue to account for that position or exposure, 
together with other positions and exposures in its market-maker 
inventory, in determining whether the amount, types, and risks of its 
market-maker inventory are designed not to exceed, on an ongoing basis, 
the reasonably expected near term demands of customers.
---------------------------------------------------------------------------

    \886\ The final rule includes certain refinements to the 
proposed standard, which would have required that the market making-
related activities of the trading desk or other organizational unit 
that conducts the purchase or sale are, with respect to the 
financial instrument, designed not to exceed the reasonably expected 
near term demands of clients, customers, or counterparties. See 
proposed rule Sec.  ----.4(b)(2)(iii).
    \887\ See supra Part IV.A.3.c.1.c.ii.; final rule Sec.  --
--.4(b)(5).
---------------------------------------------------------------------------

    While the near term customer demand requirement directly applies 
only to the trading desk's market-maker inventory, this does not mean a 
trading desk may establish other positions, outside its market-maker 
inventory, that exceed what is needed to manage the risks of the 
trading desk's market making-related activities and inventory. Instead, 
a trading desk must have limits on its market-maker inventory, the 
products, instruments, and exposures the trading desk may use for risk 
management purposes, and its aggregate financial exposure that are 
based on the factors set forth in the near term customer demand 
requirement, as well as other relevant considerations regarding the 
nature and amount of the trading desk's market making-related 
activities. A banking entity must establish, implement, maintain, and 
enforce a limit structure, as well as other compliance program elements 
(e.g., those specifying the instruments a trading desk trades as a 
market maker or may use for risk management purposes and providing for 
specific risk management procedures), for each trading desk that are 
designed to prevent the trading desk from engaging in trading activity 
that is unrelated to making a market in a particular type of financial 
instrument or managing the risks associated with making a market in 
that type of financial instrument.\888\
---------------------------------------------------------------------------

    \888\ See infra Part IV.A.3.c.3. (discussing the compliance 
program requirements); final rule Sec.  ----.4(b)(2)(iii).
---------------------------------------------------------------------------

    To clarify the application of this standard in response to 
comments,\889\ the final rule provides two factors for assessing 
whether the amount, types, and risks of the financial instruments in 
the trading desk's market-maker inventory are designed not to exceed, 
on an ongoing basis, the reasonably expected near term demands of 
clients, customers, or counterparties. Specifically, the following must 
be considered under the revised standard: (i) The liquidity, maturity, 
and depth of the market for the relevant type of financial 
instrument(s),\890\ and (ii) demonstrable analysis of historical 
customer demand, current inventory of financial instruments, and market 
and other factors regarding the amount, types, and risks of or 
associated with positions in financial instruments in which the trading 
desk makes a market, including through block trades. Under the final 
rule, a banking entity must account for these considerations when 
establishing risk and inventory limits for each trading desk.\891\
---------------------------------------------------------------------------

    \889\ See supra Part IV.A.3.c.2.b.i.
    \890\ This language has been added to the final rule to respond 
to commenters' concerns that the proposed near term demand 
requirement would be unworkable in less liquid markets or would 
otherwise restrict a market maker's ability to hold and manage its 
inventory in less liquid markets. See supra Part IV.A.3.c.2.b.ii. In 
addition, this provision is substantially similar to one commenter's 
suggested approach of adding the phrase ``based on the 
characteristics of the relevant market and asset class'' to the 
proposed requirement, but the Agencies have added more specificity 
about the relevant characteristics that should be taken into 
consideration. See Morgan Stanley.
    \891\ See infra Part IV.A.3.c.3.
---------------------------------------------------------------------------

    For purposes of this provision, ``demonstrable analysis'' means 
that the analysis for determining the amount, types, and risks of 
financial instruments a trading desk may manage in its market-maker 
inventory, in accordance with the near term demand requirement, must be 
based on factors that can be demonstrated in a way that makes the 
analysis reviewable. This may include, among other things, the normal 
trading records of the trading desk and market information that is 
readily available and retrievable. If the analysis cannot be supported 
by the banking entity's books and records and available market data, on 
their own, then the other factors utilized must be identified and 
documented and the analysis of those factors together with the facts 
gathered from the trading and market records must be identified in a 
way that makes it possible to test the analysis.
    Importantly, a determination of whether a trading desk's market-
maker inventory is appropriate under this requirement will take into 
account reasonably expected near term customer demand, including 
historical levels of customer demand, expectations based on market 
factors, and current demand. For example, at any particular time, a 
trading desk may acquire a position in a financial instrument in 
response to a customer's request to sell the financial instrument or in 
response to reasonably expected customer buying interest for such 
instrument in the near term.\892\ In addition, as discussed below, this 
requirement is not intended to impede a trading desk's ability to 
engage in

[[Page 5606]]

certain market making-related activities that are consistent with and 
needed to facilitate permissible trading with its clients, customers, 
or counterparties, such as inventory management and interdealer 
trading. These activities must, however, be consistent with the 
analysis conducted under the final rule and the trading desk's limits 
discussed below.\893\ Moreover, as explained below, the banking entity 
must also have in place escalation procedures to address, analyze, and 
document trades made in response to customer requests that would exceed 
one of a trading desk's limits.
---------------------------------------------------------------------------

    \892\ As discussed further below, acquiring a position in a 
financial instrument in response to reasonably expected customer 
demand would not include creating a structured product for which 
there is no current customer demand and, instead, soliciting 
customer demand during or after its creation. See infra note 938 and 
accompanying text; Sens. Merkley & Levin (Feb. 2012).
    \893\ The formation of structured finance products and 
securitizations is discussed in detail in Part IV.B.2.b. of this 
SUPPLEMENTARY INFORMATION.
---------------------------------------------------------------------------

    The near term demand requirement is an ongoing requirement that 
applies to the amount, types, and risks of the financial instruments in 
the trading desk's market-maker inventory. For instance, a trading desk 
may acquire exposures as a result of entering into market-making 
transactions with customers that are within the desk's market-marker 
inventory and financial exposure limits. Even if the trading desk is 
appropriately managing the risks of its market-maker inventory, its 
market-maker inventory still must be consistent with the analysis of 
the reasonably expected near term demands of clients, customers, and 
counterparties and the liquidity, maturity and depth of the market for 
the relevant instruments in the inventory. Moreover, the trading desk 
must take action to ensure that its financial exposure does not exceed 
its financial exposure limits.\894\ A trading desk may not maintain an 
exposure in its market-maker inventory, irrespective of customer 
demand, simply because the exposure is hedged and the resulting 
financial exposure is below the desk's financial exposure limit. In 
addition, the amount, types, and risks of financial instruments in a 
trading desk's market-maker inventory would not be consistent with 
permitted market-making activities if, for example, the trading desk 
has a pattern or practice of retaining exposures in its market-maker 
inventory, while refusing to engage in customer transactions when there 
is customer demand for those exposures at commercially reasonable 
prices.
---------------------------------------------------------------------------

    \894\ See final rule Sec.  ----.4(b)(2)(iii)(B), (C).
---------------------------------------------------------------------------

    The following is an example of the interplay between a trading 
desk's market-maker inventory and financial exposure. An airline 
company customer may seek to hedge its long-term exposure to price 
fluctuations in jet fuel by asking a banking entity to create a 
structured ten-year, $1 billion jet fuel swap for which there is no 
liquid market. A trading desk that makes a market in energy swaps may 
service its customer's needs by executing a custom jet fuel swap with 
the customer and holding the swap in its market-maker inventory, if the 
resulting transaction does not cause the trading desk to exceed its 
market-maker inventory limit on the applicable class of instrument, or 
the trading desk has received approval to increase the limit in 
accordance with the authorization and escalation procedures under 
paragraph (b)(2)(iii)(E). In keeping with the market-making exemption 
as provided in the final rule, the trading desk would be required to 
hedge the risk from this swap, either individually or as part of a set 
of aggregated positions, if the trade would result in a financial 
exposure that exceeds the desk's financial exposure limits. The trading 
desk may hedge the risk of the swap, for example, by entering into one 
or more futures or swap positions that are identified as permissible 
hedging products, instruments, or exposures in the trading desk's 
compliance program and that analysis, including correlation analysis as 
appropriate, indicates would demonstrably reduce or otherwise 
significantly mitigate risks associated with the financial exposure 
from its market-making activities. Alternatively, if the trading desk 
also acts as a market maker in crude oil futures, then the desk's 
exposures arising from its market-making activities may naturally hedge 
the jet fuel swap (i.e., it may reduce its financial exposure levels 
resulting from such instruments).\895\ The trading desk must continue 
to appropriately manage risks of its financial exposure over time in 
accordance with its financial exposure limits.
---------------------------------------------------------------------------

    \895\ This natural hedge with futures would introduce basis risk 
which, like other risks of the trading desk, must be managed within 
the desk's limits.
---------------------------------------------------------------------------

    As discussed above, several commenters expressed concern that the 
near-term customer demand requirement is too restrictive and that it 
could impede a market maker's ability to build or retain inventory, 
particularly in less liquid markets where demand is intermittent.\896\ 
Because customer demand in illiquid markets can be difficult to predict 
with precision, market-maker inventory may not closely track customer 
order flow. The Agencies acknowledge that market makers will face costs 
associated with demonstrating that market-maker inventory is designed 
not to exceed, on an ongoing basis, the reasonably expected near term 
demands of customers, as required by the statute and the final rule 
because this is an analysis that banking entities may not currently 
undertake. However, the final rule includes certain modifications to 
the proposed rule that are intended to reduce the negative impacts 
cited by commenters, such as limitations on inventory management 
activity and potential restrictions on market making in less liquid 
instruments, which the Agencies believe should reduce the perceived 
burdens of the proposed near term demand requirement. For example, the 
final rule recognizes that liquidity, maturity, and depth of the market 
vary across asset classes. The Agencies expect that the express 
recognition of these differences in the rule should avoid unduly 
impeding a market maker's ability to build or retain inventory. More 
specifically, the Agencies recognize the relationship between market-
maker inventory and customer order flow can vary across asset classes 
and that an inflexible standard for demonstrating that inventory does 
not exceed reasonably expected near term demand could provide an 
incentive to stop making markets in illiquid asset classes.
---------------------------------------------------------------------------

    \896\ See SIFMA (Asset Mgmt.) (Feb. 2012); T. Rowe Price; CIEBA; 
ICI (Feb. 2012) RBC.
---------------------------------------------------------------------------

i. Definition of ``Client,'' ``Customer,'' and ``Counterparty''
    In response to comments requesting further definition of the terms 
``client,'' ``customer,'' and ``counterparty'' for purposes of this 
standard,\897\ the Agencies have defined these terms in the final rule. 
In particular, the final rule defines ``client,'' ``customer,'' and 
``counterparty'' as, on a collective or individual basis, ``market 
participants that make use of the banking entity's market making-
related services by obtaining such services, responding to quotations, 
or entering into a continuing relationship with respect to such 
services.'' \898\ However, for purposes of the analysis supporting the 
market-maker inventory held to meet the reasonably expected near-term 
demands of clients, customers and counterparties, a client, customer, 
or counterparty of the trading desk does not include a trading desk or 
other organizational unit of another entity if that entity has $50 
billion or more in total trading assets and liabilities, measured in 
accordance with Sec.  ----.20(d)(1),\899\ unless the

[[Page 5607]]

trading desk documents how and why such trading desk or other 
organizational unit should be treated as a customer or the transactions 
are conducted anonymously on an exchange or similar trading facility 
that permits trading on behalf of a broad range of market 
participants.\900\
---------------------------------------------------------------------------

    \897\ See Japanese Bankers Ass'n.; Credit Suisse (Seidel); 
Occupy; AFR et al. (Feb. 2012); Public Citizen.
    \898\ Final rule Sec.  ----.4(b)(3).
    \899\ See final rule Sec.  ----.4(b)(3)(i). The Agencies are 
using a $50 billion threshold for these purposes in recognition that 
firms engaged in substantial trading activity do not typically act 
as customers to other market makers, while smaller regional firms 
may Seek liquidity from larger firms as part of their market making-
related activities.
    \900\ See final rule Sec.  ----.4(b)(3)(i)(A), (B). In Appendix 
C of the proposed rule, a trading unit engaged in market making-
related activities would have been required to describe how it 
identifies its customers for purposes of the Customer-Facing Trading 
Ratio, if applicable, including documentation explaining when, how, 
and why a broker-dealer, swap dealer, security-based swap dealer, or 
any other entity engaged in market making-related activities, or any 
affiliate thereof, is considered to be a customer of the trading 
unit. See Joint Proposal, 76 FR 68,964. While the proposed approach 
would not have necessarily prevented any of these entities from 
being considered a customer of the trading desk, it would have 
required enhanced documentation and justification for treating any 
of these entities as a customer. The final rule's exclusion from the 
definition of client, customer, and counterparty is similar to the 
proposed approach, but is more narrowly focused on firms that have 
$50 billion or more trading assets and liabilities because, as noted 
above, the Agencies believe firms engaged in such substantial 
trading activity are less likely to act as customers to market 
makers than smaller regional firms.
---------------------------------------------------------------------------

    The Agencies believe this definition is generally consistent with 
the proposed interpretation of ``customer'' in the proposal. The 
proposal generally provided that, for purposes of market making on an 
exchange or other organized trading facility, a customer is any person 
on behalf of whom a buy or sell order has been submitted. In the 
context of the over-the-counter market, a customer was generally 
considered to be a market participant that makes use of the market 
maker's intermediation services, either by requesting such services or 
entering into a continuing relationship for such services.\901\ The 
definition of client, customer, and counterparty in the final rule 
recognizes that, in the context of market making in a financial 
instrument that is executed on an exchange or other organized trading 
facility, a client, customer, or counterparty would be any person whose 
buy or sell order executes against the banking entity's quotation 
posted on the exchange or other organized trading facility.\902\ Under 
these circumstances, the person would be trading with the banking 
entity in response to the banking entity's quotations and obtaining the 
banking entity's market making-related services. In the context of 
market making in a financial instrument in the OTC market, a client, 
customer, or counterparty generally would be a person that makes use of 
the banking entity's intermediation services, either by requesting such 
services (possibly via a request-for-quote on an established trading 
facility) or entering into a continuing relationship with the banking 
entity with respect to such services. For purposes of determining the 
reasonably expected near-term demands of customers, a client, customer, 
or counterparty generally would not include a trading desk or other 
organizational unit of another entity that has $50 billion or more in 
total trading assets except if the trading desk has a documented reason 
for treating the trading desk or other organizational unit of such 
entity as a customer or the trading desk's transactions are executed 
anonymously on an exchange or similar trading facility that permits 
trading on behalf of a broad range of market participants. The Agencies 
believe that this exclusion balances commenters' suggested alternatives 
of either defining as a client, customer, or counterparty anyone who is 
on the other side of a market maker's trade \903\ or preventing any 
banking entity from being a client, customer, or counterparty.\904\ The 
Agencies believe that the first alternative is overly broad and would 
not meaningfully distinguish between permitted market making-related 
activity and impermissible proprietary trading. For example, the 
Agencies are concerned that such an approach would allow a trading desk 
to maintain an outsized inventory and to justify such inventory levels 
as being tangentially related to expected market-wide demand. On the 
other hand, preventing any banking entity from being a client, 
customer, or counterparty under the final rule would result in an 
overly narrow definition that would significantly impact banking 
entities' ability to provide and access market making-related services. 
For example, most banks look to market makers to provide liquidity in 
connection with their investment portfolios.
---------------------------------------------------------------------------

    \901\ See Joint Proposal, 76 FR 68,960; CFTC Proposal, 77 FR 
8439.
    \902\ See, e.g., Goldman (Prop. Trading) (explaining generally 
how exchange-based market makers operate).
    \903\ See ISDA (Feb. 2012). In addition, a number of commenters 
suggested that the rule should not limit broker-dealers from being 
customers of a market maker. See SIFMA et al. (Prop. Trading) (Feb. 
2012); Credit Suisse (Seidel); RBC; Comm. on Capital Markets 
Regulation.
    \904\ See AFR et al. (Feb. 2012); Occupy; Public Citizen.
---------------------------------------------------------------------------

    The Agencies further note that, with respect to a banking entity 
that acts as a primary dealer (or functional equivalent) for a 
sovereign government, the sovereign government and its central bank are 
each a client, customer, or counterparty for purposes of the market-
making exemption as well as the underwriting exemption.\905\ The 
Agencies believe this interpretation, together with the modifications 
in the rule that eliminate the requirement to distinguish between 
revenues from spreads and price appreciation and the recognition that 
the market-making exemption extends to market making-related activities 
appropriately captures the unique relationship between a primary dealer 
and the sovereign government. Thus, generally a banking entity may rely 
on the market-making exemption for its activities as primary dealer (or 
functional equivalent) to the extent those activities are outside of 
the underwriting exemption.\906\
---------------------------------------------------------------------------

    \905\ A primary dealer is a firm that trades a sovereign 
government's obligations directly with the sovereign (in many cases, 
with the sovereign's central bank) as well as with other customers 
through market making. The sovereign government may impose 
conditions on a primary dealer or require that it engage in certain 
trading in the relevant government obligations (e.g., participate in 
auctions for the government obligation or maintain a liquid 
secondary market in the government obligations). Further, a 
sovereign government may limit the number of primary dealers that 
are authorized to trade with the sovereign. A number of countries 
use a primary dealer system, including Australia, Brazil, Canada, 
China-Hong Kong, France, Germany, Greece, India, Indonesia, Ireland, 
Italy, Japan, Mexico, Netherlands, Portugal, South Africa, South 
Korea, Spain, Turkey, the U.K., and the U.S. See, e.g., Oliver Wyman 
(Feb. 2012). The Agencies note that this standard would similarly 
apply to the relationship between a banking entity and a sovereign 
that does not have a formal primary dealer system, provided the 
sovereign's process functions like a primary dealer framework.
    \906\ See Goldman (Prop. Trading). See also supra Part 
IV.A.3.c.2.b.ix. (discussing commenters' concerns regarding primary 
dealer activity). Each suggestion regarding the treatment of primary 
dealer activity has not been incorporated into the rule. 
Specifically, the exemption for market making as applied to a 
primary dealer does not extend without limitation to primary dealer 
activities that are not conducted under the conditions of one of the 
exemptions. These interpretations would be inconsistent with 
Congressional intent for the statute, to limit permissible market-
making activity through the statute's near term demand requirement 
and, thus, does not permit trading without limitation. See SIFMA et 
al. (Prop. Trading) (Feb. 2012) (stating that permitted activities 
should include trading necessary to meet the relevant jurisdiction's 
primary dealer and other requirements); JPMC (indicating that the 
exemption should cover all of a firm's activities that are necessary 
or reasonably incidental to its acting as a primary dealer in a 
foreign government's debt securities); Goldman (Prop. Trading); 
Banco de M[eacute]xico; IIB/EBF. Rather, recognizing that market 
making by primary dealers is a key function, the limits and other 
conditions of the rule are flexible enough to permit necessary 
market making-related activities.
---------------------------------------------------------------------------

    For exchange-traded funds (``ETFs'') (and related structures), 
Authorized Participants (``APs'') are generally the conduit for market 
participants seeking to create or redeem shares of the fund

[[Page 5608]]

(or equivalent structure).\907\ For example, an AP may buy ETF shares 
from market participants who would like to redeem those shares for cash 
or a basket of instruments upon which the ETF is based. To provide this 
service, the AP may in turn redeem these shares from the ETF itself. 
Similarly, an AP may receive cash or financial instruments from a 
market participant seeking to purchase ETF shares, in which case the AP 
may use that cash or set of financial instruments to create shares from 
the ETF. In either case, for the purpose of the market-making 
exemption, such market participants as well as the ETF itself would be 
considered clients, customers, or counterparties of the AP.\908\ The 
inventory of ETF shares or underlying instruments held by the AP can 
therefore be evaluated under the criteria of the market-making 
exemption, such as how these holdings relate to reasonably expected 
near term customer demand.\909\ These criteria can be similarly applied 
to other activities of the AP, such as building inventory to ``seed'' a 
new ETF or engaging in ETF-loan related transactions.\910\ The Agencies 
recognize that banking entities currently conduct a substantial amount 
of AP creation and redemption activity in the ETF market and, thus, if 
the rule were to prevent or restrict a banking entity from acting as an 
AP for an ETF, then the rule would impact the functioning of the ETF 
market.\911\
---------------------------------------------------------------------------

    \907\ ETF sponsors enter into relationships with one or more 
financial institutions that become APs for the ETF. Only APs are 
permitted to purchase and redeem shares directly from the ETF, and 
they can do so only in large aggregations or blocks that are 
commonly called ``creation units.'' In response to a question in the 
proposal, a number of commenters expressed concern that the proposed 
market-making exemption may not permit certain AP and market maker 
activities in ETFs and requested clarification that these activities 
would be permitted under the market-making exemption. See Joint 
Proposal, 76 FR 68,873 (question 91) (``Do particular markets or 
instruments, such as the market for exchange-traded funds, raise 
particular issues that are not adequately or appropriately addressed 
in the proposal? If so, how could the proposal better address those 
instruments, markets or market features?''); CFTC Proposal, 77 FR 
8359 (question 91); supra Part IV.A.3.c.2.b.vii. (discussing 
comments on this issue).
    \908\ This is consistent with two commenters' request that an 
ETF issuer be considered a ``counterparty'' of the banking entity 
when it trades directly with the ETF issuer as an AP. See ICI 
Global; ICI (Feb. 2012). Further, this approach is intended to 
address commenters' concerns that the near term demand requirement 
may limit a banking entity's ability to act as AP for an ETF. See 
BoA; Vanguard. The Agencies believe that one commenter's concern 
about the impact of the proposed source of revenue requirement on AP 
activity should be addressed by the replacement of this proposed 
requirement with a metric-based focus on when a trading desk 
generates revenue from its trading activity. See BoA; infra Part 
IV.A.3.c.7.c. (discussing the new approach to assessing a trading 
desk's pattern of profit and loss).
    \909\ This does not imply that the AP must perfectly predict 
future customer demand, but rather that there is a demonstrable, 
statistical, or historical basis for the size of the inventory held, 
as more fully discussed below. Consider, for example, a fixed-income 
ETF with $500 million in assets. If, on a typical day, an AP 
generates requests for $10 to $20 million of creations or 
redemptions, then an inventory of $10 to $20 million in bonds upon 
which the ETF is based (or some small multiple thereof) could be 
construed as consistent with reasonably expected near term customer 
demand. On the other hand, if under the same circumstances an AP 
holds $1 billion of these bonds solely in its capacity as an AP for 
this ETF, it would be more difficult to justify this as needed for 
reasonably expected near term customer demand and may be indicative 
of an AP engaging in prohibited proprietary trading.
    \910\ In ETF loan transactions (also referred to as ``create-to-
lend'' transactions), an AP borrows the underlying instruments that 
form the creation basket of an ETF, submits the borrowed instruments 
to the ETF agent in exchange for a creation unit of ETF shares, and 
lends the resulting ETF shares to a customer that wants to borrow 
the ETF. At the end of the ETF loan, the borrower returns the ETF 
shares to the AP, and the AP redeems the ETF shares with the ETF 
agent in exchange for the underlying instruments that form the 
creation basket. The AP may return the underlying instruments to the 
parties from whom it borrowed them or may use them for another loan, 
as long as the AP is not obligated to return them at that time. For 
the term of the ETF loan transaction, the AP hedges against market 
risk arising from any rebalancing of the ETF, which would change the 
amount or type of underlying instruments the AP would receive in 
exchange for the ETF compared to the underlying instruments the AP 
borrowed and submitted to the ETF agent to create the ETF shares. 
See David J. Abner, The ETF Handbook, Ch. 12 (2010); Jean M. 
McLoughlin, Davis Polk & Wardwell LLP, to Division of Corporation 
Finance, U.S. Securities and Exchange Commission, dated Jan. 23, 
2013, available at http://www.sec.gov/divisions/corpfin/cf-noaction/2013/davis-polk-wardwell-llp-012813-16a.pdf.
    \911\ See SSgA (Feb. 2012).
---------------------------------------------------------------------------

    Some firms, whether or not an AP in a given ETF, may also actively 
engage in buying and selling shares of an ETF and its underlying 
instruments in the market to maintain price continuity between the ETF 
and its underlying instruments, which are exchangeable for one another. 
Sometimes these firms will register as market makers on an exchange for 
a given ETF, but other times they may not register as market maker. 
Regardless of whether or not the firm is registered as a market maker 
on any given exchange, this activity not only provides liquidity for 
ETFs, but also, and very importantly, helps keep the market price of an 
ETF in line with the NAV of the fund. The market-making exemption can 
be used to evaluate trading that is intended to maintain price 
continuity between these exchangeable instruments by considering how 
the firm quotes, maintains risk and exposure limits, manages its 
inventory and risk, and, in the case of APs, exercises its ability to 
create and redeem shares from the fund. Because customers take 
positions in ETFs with an expectation that the price relationship will 
be maintained, such trading can be considered to be market making-
related activity.\912\
---------------------------------------------------------------------------

    \912\ A number of commenters expressed concern that the proposed 
rule would limit market making or AP activity in ETFs because market 
makers and APs engage in trading to maintain a price relationship 
between ETFs and their underlying components, which promotes ETF 
market efficiency. See Vanguard; RBC; Goldman (Prop. Trading); JPMC; 
SIFMA et al. (Prop. Trading) (Feb. 2012); SSgA (Feb. 2012); Credit 
Suisse (Prop. Trading).
---------------------------------------------------------------------------

    After considering comments, the Agencies continue to take the view 
that a trading desk would not qualify for the market-making exemption 
if it is wholly or principally engaged in arbitrage trading or other 
trading that is not in response to, or driven by, the demands of 
clients, customers, or counterparties.\913\ The Agencies believe this 
activity, which is not in response to or driven by customer demand, is 
inconsistent with the Congressional intent that market making-related 
activity be designed not to exceed the reasonably expected near term 
demands of clients, customers, or counterparties. For example, a 
trading desk would not be permitted to engage in general statistical 
arbitrage trading between instruments that have some degree of 
correlation but where neither instrument has the capability of being 
exchanged, converted, or exercised for or into the other instrument. A 
trading desk may, however, act as market maker to a customer engaged in 
a statistical arbitrage trading strategy. Furthermore as suggested by 
some commenters,\914\ trading activity used by a market maker to 
maintain a price relationship that is expected and relied upon by 
clients, customers, and counterparties is permitted as it is related to 
the demands of clients, customers, or counterparties because the 
relevant instrument has the capability of being exchanged,

[[Page 5609]]

converted, or exercised for or into another instrument.\915\
---------------------------------------------------------------------------

    \913\ Some commenters suggested that a range of arbitrage 
trading should be permitted under the market-making exemption. See, 
e.g., Goldman (Prop. Trading); RBC; SIFMA et al. (Prop. Trading) 
(Feb. 2012); JPMC. Other commenters, however, stated that arbitrage 
trading should be prohibited under the final rule. See AFR et al. 
(Feb. 2012); Volcker; Occupy. In response to commenters representing 
that it would be difficult to comply with this standard because it 
requires a trading desk to determine the proportionality of its 
activities in response to customer demand compared to its activities 
that are not in response to customer demand, the Agencies believe 
that the statute requires a banking entity to distinguish between 
market making-related activities that are designed not to exceed the 
reasonably expected near term demands of customers and impermissible 
proprietary trading. See Goldman (Prop. Trading); RBC.
    \914\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.
    \915\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; 
Credit Suisse (Seidel). For example, customers have an expectation 
of general price alignment under these circumstances, both at the 
time they decide to invest in the instrument and for the remaining 
time they hold the instrument. To the contrary, general statistical 
arbitrage does not maintain a price relationship between related 
instruments that is expected and relied upon by customers and, thus, 
is not permitted under the market-making exemption. Firms engage in 
general statistical arbitrage to profit from differences in market 
prices between instruments, assets, or price or risk elements 
associated with instruments or assets that are thought to be 
statistically related, but which do not have a direct relationship 
of being exchangeable, convertible, or exercisable for the other.
---------------------------------------------------------------------------

    The Agencies recognize that a trading desk, in anticipating and 
responding to customer needs, may engage in interdealer trading as part 
of its inventory management activities and that interdealer trading 
provides certain market benefits, such as more efficient matching of 
customer order flow, greater hedging options to reduce risk, and 
enhanced ability to accumulate or exit customer-related positions.\916\ 
The final rule does not prohibit a trading desk from using the market-
making exemption to engage in interdealer trading that is consistent 
with and related to facilitating permissible trading with the trading 
desk's clients, customers, or counterparties.\917\ However, in 
determining the reasonably expected near term demands of clients, 
customers, or counterparties, a trading desk generally may not account 
for the expected trading interests of a trading desk or other 
organizational unit of an entity with aggregate trading assets and 
liabilities of $50 billion or greater (except if the trading desk 
documents why and how a particular trading desk or other organizational 
unit at such a firm should be considered a customer or the trading desk 
or conduct market-making activity anonymously on an exchange or similar 
trading facility that permits trading on behalf of a broad range of 
market participants).\918\
---------------------------------------------------------------------------

    \916\ See MetLife; ACLI (Feb. 2012); Goldman (Prop. Trading); 
Morgan Stanley; Chamber (Feb. 2012); Prof. Duffie; Oliver Wyman 
(Dec. 2011); Oliver Wyman (Feb. 2012).
    \917\ A number of commenters requested that the rule be modified 
to clearly recognize interdealer trading as a component of permitted 
market making-related activity. See MetLife; SIFMA et al. (Prop. 
Trading) (Feb. 2012); RBC; Credit Suisse (Seidel); JPMC; BoA; ACLI 
(Feb. 2012); AFR et al. (Feb. 2012); ISDA (Feb. 2012); Goldman 
(Prop. Trading); Oliver Wyman (Feb. 2012). One of these commenters 
analyzed the potential market impact of preventing interdealer 
trading, combined with inventory limits. See Oliver Wyman (Feb. 
2012). Because the final rule does not prohibit interdealer trading 
or limit inventory in the manner this commenter assumed for purposes 
of its analysis, the Agencies do not believe the final rule will 
have the market impact cited by this commenter.
    \918\ See AFR et al. (Feb. 2012) (recognizing that the ability 
to manage inventory through interdealer transactions should be 
accommodated in the rule, but recommending that this activity be 
conditioned on a market maker having an appropriate level of 
inventory after an interdealer transaction).
---------------------------------------------------------------------------

    A trading desk may engage in interdealer trading to: Establish or 
acquire a position to meet the reasonably expected near term demands of 
its clients, customers, or counterparties, including current demand; 
unwind or sell positions acquired from clients, customers, or 
counterparties; or engage in risk-mitigating or inventory management 
transactions.\919\ The Agencies believe that allowing a trading desk to 
continue to engage in customer-related interdealer trading is 
appropriate because it can help a trading desk appropriately manage its 
inventory and risk levels and can effectively allow clients, customers, 
or counterparties to access a larger pool of liquidity. While the 
Agencies recognize that effective intermediation of client, customer, 
or counterparty trading may require a trading desk to engage in a 
certain amount of interdealer trading, this is an activity that will 
bear some scrutiny by the Agencies and should be monitored by banking 
entities to ensure it reflects market-making activities and not 
impermissible proprietary trading.
---------------------------------------------------------------------------

    \919\ Provided it is consistent with the requirements of the 
market-making exemption, including the near term customer demand 
requirement, a trading desk may trade for purposes of determining 
how to price a financial instrument a customer Seeks to trade with 
the trading desk or to determine the depth of the market for a 
financial instrument a customer Seeks to trade with the trading 
desk. See Goldman (Prop. Trading).
---------------------------------------------------------------------------

ii. Impact of the Liquidity, Maturity, and Depth of the Market on the 
Analysis
    Several commenters expressed concern about the potential impact of 
the proposed near term demand requirement on market making in less 
liquid markets and requested that the Agencies recognize that near term 
customer demand may vary across different markets and asset 
classes.\920\ The Agencies understand that reasonably expected near 
term customer demand may vary based on the liquidity, maturity, and 
depth of the market for the relevant type of financial instrument(s) in 
which the trading desk acts as market maker.\921\ As a result, the 
final rule recognizes that these factors impact the analysis of 
reasonably expected near term demands of clients, customers, or 
counterparties and the amount, types, and risks of market-maker 
inventory needed to meet such demand.\922\ In particular, customer 
demand is likely to be more frequent in more liquid markets than in 
less liquid or illiquid markets. As a result, market makers in more 
liquid cash-based markets, such as liquid equity securities, should 
generally have higher rates of inventory turnover and less aged 
inventory than market makers in less liquid or illiquid markets.\923\ 
Market makers in less liquid cash-based markets are more likely to hold 
a particular position for a longer period of time due to intermittent 
customer demand. In the derivatives markets, market makers carry open 
positions and manage various risk factors, such as exposure to 
different points on a yield curve. These exposures are analogous to 
inventory in the cash-based markets. Further, it may be more difficult 
to reasonably predict near term customer demand in less mature markets 
due to, among other things, a lack of historical experience with 
client, customer, or counterparty demands for the relevant product. 
Under these circumstances, the Agencies encourage banking entities to 
consider their experience with similar products or other relevant 
factors.\924\
---------------------------------------------------------------------------

    \920\ See CIEBA (stating that, absent a different interpretation 
for illiquid instruments, market makers will err on the side of 
holding less inventory to avoid sanctions for violating the rule); 
Morgan Stanley; RBC; ICI (Feb. 2012) ISDA (Feb. 2012); Comm. on 
Capital Markets Regulation; Alfred Brock.
    \921\ See supra Part IV.A.3.c.2.b.ii. (discussing comments on 
this issue).
    \922\ See final rule Sec.  ----.4(b)(2)(ii)(A).
    \923\ The final rule does not impose additional capital 
requirements on aged inventory to discourage a trading desk from 
retaining positions in inventory, as suggested by some commenters. 
See CalPERS; Vanguard. The Agencies believe the final rule already 
limit a trading desk's ability to hold inventory over an extended 
period and do not See a need at this time to include additional 
capital requirements in the final rule. For example, a trading desk 
must have written policies and procedures relating to its inventory 
and must be able to demonstrate, as needed, its analysis of why the 
levels of its market-maker inventory are necessary to meet, or is a 
result of meeting, customer demand. See final rule Sec.  --
--.4(b)(2)(ii), (iii)(C).
    \924\ The Agencies agree, as suggested by one commenter, it may 
be appropriate for a market maker in a new asset class or market to 
look to reasonably expected future developments on the basis of the 
trading desk's customer relationships. See Morgan Stanley. As 
discussed further below, the Agencies recognize that a trading desk 
could encounter similar issues if it is a new entrant in an existing 
market.
---------------------------------------------------------------------------

iii. Demonstrable Analysis of Certain Factors
    In the proposal, the Agencies stated that permitted market making 
includes taking positions in securities in anticipation of customer 
demand, so long as any anticipatory buying or

[[Page 5610]]

selling activity is reasonable and related to clear, demonstrable 
trading interest of clients, customers, or counterparties.\925\ A 
number of commenters expressed concern about this proposed 
interpretation's impact on market makers' inventory management activity 
and represented that it was inconsistent with the statute's near term 
demand standard, which permits market-making activity that is 
``designed'' not to exceed the ``reasonably expected'' near term 
demands of customers.\926\ In response to comments, the Agencies are 
permitting a trading desk to take positions in reasonable expectation 
of customer demand in the near term based on a demonstrable analysis 
that the amount, types, and risks of the financial instruments in the 
trading desk's market-maker inventory are designed not to exceed, on an 
ongoing basis, the reasonably expected near term demands of customers.
---------------------------------------------------------------------------

    \925\ See Joint Proposal, 76 FR 68,871; CFTC Proposal, 77 FR 
8356-8357.
    \926\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); 
Goldman (Prop. Trading); Chamber (Feb. 2012); Comm. on Capital 
Markets Regulation. See also Morgan Stanley; SIFMA (Asset Mgmt.) 
(Feb. 2012).
---------------------------------------------------------------------------

    The proposal also stated that a banking entity's determination of 
near term customer demand should generally be based on the unique 
customer base of a specific market-making business line (and not merely 
an expectation of future price appreciation). Several commenters stated 
that it was unclear how such determinations should be made and 
expressed concern that near term customer demand cannot always be 
accurately predicted,\927\ particularly in markets where trades occur 
infrequently and customer demand is hard to predict \928\ or when a 
banking entity is entering a new market.\929\ To address these 
comments, the Agencies are providing additional information about how a 
banking entity can comply with the statute's near term customer demand 
requirement, including a new requirement that a banking entity conduct 
a demonstrable assessment of reasonably expected near term customer 
demand and several examples of factors that may be relevant for 
conducting such an assessment. The Agencies believe it is important to 
require such demonstrable analysis to allow determinations of 
reasonably expected near term demand and associated inventory levels to 
be monitored and tested to ensure compliance with the statute and the 
final rule.
---------------------------------------------------------------------------

    \927\ See SIFMA et al. (Prop. Trading) (Feb. 2012); MetLife; 
Chamber (Feb. 2012); RBC; CIEBA; Wellington; ICI (Feb. 2012) Alfred 
Brock.
    \928\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \929\ See CIEBA.
---------------------------------------------------------------------------

    The final rule provides that, to help determine the appropriate 
amount, types, and risks of the financial instruments in the trading 
desk's market-maker inventory and to ensure that such inventory is 
designed not to exceed, on an ongoing basis, the reasonably expected 
near term demands of client, customers, or counterparties, a banking 
entity must conduct demonstrable analysis of historical customer 
demand, current inventory of financial instruments, and market and 
other factors regarding the amount, types, and risks of or associated 
with financial instruments in which the trading desk makes a market, 
including through block trades. This analysis should not be static or 
fixed solely on current market or other factors. Instead, an 
appropriately conducted analysis under this provision will be both 
backward- and forward-looking by taking into account relevant 
historical trends in customer demand \930\ and any events that are 
reasonably expected to occur in the near term that would likely impact 
demand.\931\ Depending on the facts and circumstances, it may be proper 
for a banking entity to weigh these factors differently when conducting 
an analysis under this provision. For example, historical trends in 
customer demand may be less relevant when a trading desk is 
experiencing or expects to experience a change in the pattern of 
customer needs (e.g., requests for block positioning), adjustments to 
its business model (e.g., efforts to expand or contract its market 
shares), or changes in market conditions.\932\ On the other hand, 
absent these types of current or anticipated events, the amount, types, 
and risks of the financial instruments in the trading desk's market-
maker inventory should be relatively consistent with such trading 
desk's historical profile of market-maker inventory.\933\
---------------------------------------------------------------------------

    \930\ To determine an appropriate historical dataset, a banking 
entity should assess the relation between current or reasonably 
expected near term conditions and demand and those of prior market 
cycles.
    \931\ This analysis may, where appropriate, take into account 
prior and/or anticipated cyclicality to the demands of clients, 
customers, or counterparties, which may cause variations in the 
amounts, types, and risks of financial instruments needed to provide 
intermediation services at different points in a cycle. For example, 
the final rule recognizes that a trading desk may need to accumulate 
a larger-than-average amount of inventory in anticipation of an 
index rebalance. See supra note 838 (discussing a comment on this 
issue). The Agencies are aware that a trading desk engaged in block 
positioning activity may have a less consistent pattern of inventory 
because of the need to take on large block positions at the request 
of customers. See supra note 761 and accompanying text (discussing 
comments on this issue).
    Because the final rule does not prevent banking entities from 
providing direct liquidity for rebalance trades, the Agencies do not 
believe that the final rule will cause the market impacts that one 
commenter predicted would occur were such a restriction adopted. See 
Oliver Wyman (Feb. 2012) (estimating that if market makers are not 
able to provide direct liquidity for rebalance trades, investors 
tracking these indices could potentially pay incremental costs of 
$600 million to $1.8 billion every year).
    \932\ In addition, the Agencies recognize that a new entrant to 
a particular market or asset class may not have knowledge of 
historical customer demand in that market or asset class at the 
outset. See supra note 924 and accompanying text (discussing factors 
that may be relevant to new market entrants for purposes of 
determining the reasonably expected near term demands of clients, 
customers, or counterparties).
    \933\ One commenter suggested an approach that would allow 
market makers to build inventory in products where they believe 
customer demand will exist, regardless of whether inventory can be 
tied to a particular customer in the near term or to historical 
trends in customer demand. See Credit Suisse (Seidel). The Agencies 
believe an approach that does not provide for any consideration of 
historical trends could result in a heightened risk of evasion. At 
the same time, as discussed above, the Agencies recognize that 
historical trends may not always determine the amount of inventory a 
trading desk may need to meet reasonably expected near term demand 
and it may under certain circumstances be appropriate to build 
inventory in anticipation of a reasonably expected near term event 
that would likely impact customer demand. While the Agencies are not 
requiring that market-maker inventory be tied to a particular 
customer, The Agencies are requiring that a banking entity analyze 
and support its expectations for near term customer demand.
---------------------------------------------------------------------------

    Moreover, the demonstrable analysis required under Sec.  --
--.4(b)(2)(ii)(B) should account for, among other things, how the 
market factors discussed in Sec.  ----.4(b)(2)(ii)(A) impact the 
amount, types, and risks of market-maker inventory the trading desk may 
need to facilitate reasonably expected near term demands of clients, 
customers, or counterparties.\934\ Other potential factors that could 
be used to assess reasonably expected near term customer demand and the 
appropriate amount, types, and risks of financial instruments in the 
trading desk's market-maker inventory include, among others: (i) Recent 
trading volumes and customer trends; (ii) trading patterns of specific 
customers or other observable customer demand patterns; (iii) analysis 
of the banking entity's business plan and ability to win new customer 
business; (iv) evaluation of expected demand under current market 
conditions

[[Page 5611]]

compared to prior similar periods; (v) schedule of maturities in 
customers' existing portfolios; and (vi) expected market events, such 
as an index rebalancing, and announcements. The Agencies believe that 
some banking entities already analyze these and other relevant factors 
as part of their overall risk management processes.\935\
---------------------------------------------------------------------------

    \934\ The Agencies recognize that a trading desk could acquire 
either a long or short position in reasonable anticipation of near 
term demands of clients, customers, or counterparties. In 
particular, if it is expected that customers will want to buy an 
instrument in the near term, it may be appropriate for the desk to 
acquire a long position in such instrument. If it is expected that 
customers will want to sell the instrument, acquiring a short 
position may be appropriate under certain circumstances.
    \935\ See supra Part IV.A.3.c.2.b.iii. See FTN; Morgan Stanley 
(suggesting a standard that would require a position to be 
``reasonably consistent with observable customer demand patterns'').
---------------------------------------------------------------------------

    With respect to the creation and distribution of complex structured 
products, a trading desk may be able to use the market-making exemption 
to acquire some or all of the risk exposures associated with the 
product if the trading desk has evidence of customer demand for each of 
the significant risks associated with the product.\936\ To have 
evidence of customer demand under these circumstances, there must be 
prior express interest from customers in the specific risk exposures of 
the product. Without such express interest, a trading desk would not 
have sufficient information to support the required demonstrable 
analysis (e.g., information about historical customer demand or other 
relevant factors).\937\ The Agencies are concerned that, absent express 
interest in each significant risk associated with the product, a 
trading desk could evade the market-making exemption by structuring a 
deal with certain risk exposures, or amounts of risk exposures, for 
which there is no customer demand and that would be retained in the 
trading desk's inventory, potentially for speculative purposes. Thus, a 
trading desk would not be engaged in permitted market making-related 
activity if, for example, it structured a product solely to acquire a 
desired exposure and not to respond to customer demand.\938\ When a 
trading desk acquires risk exposures in these circumstances, the 
trading desk would be expected to enter into appropriate hedging 
transactions or otherwise mitigate the risks of these exposures, 
consistent with its hedging policies and procedures and risk limits.
---------------------------------------------------------------------------

    \936\ Complex structured products can contain a combination of 
several different types of risks, including, among others, market 
risk, credit risk, volatility risk, and prepayment risk.
    \937\ In contrast, a trading desk may respond to requests for 
customized transactions, such as custom swaps, provided that the 
trading desk is a market maker in the risk exposures underlying the 
swap or can hedge the underlying risk exposures, consistent with its 
financial exposure and hedging limits, and otherwise meets the 
requirements of the market-making exemption. For example, a trading 
desk may routinely make markets in underlying exposures and, thus, 
would meet the requirements for engaging in transactions in 
derivatives that reflect the same exposures. Alternatively, a 
trading desk might meet the requirements by routinely trading in the 
derivative and hedging in the underlying exposures. See supra Part 
IV.A.3.c.1.c.iii.
    \938\ See, e.g., Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------

    With regard to a trading desk that conducts its market-making 
activities on an exchange or other similar anonymous trading facility, 
the Agencies continue to believe that market-making activities are 
generally consistent with reasonably expected near term customer demand 
when such activities involve passively providing liquidity by 
submitting resting orders that interact with the orders of others in a 
non-directional or market-neutral trading strategy or by regularly 
responding to requests for quotes in markets where resting orders are 
not generally provided. This ensures that the trading desk has a 
pattern of providing, rather than taking, liquidity. However, this does 
not mean that a trading desk acting as a market maker on an exchange or 
other similar anonymous trading facility is only permitted to use these 
types of orders in connection with its market making-related 
activities. The Agencies recognize that it may be appropriate for a 
trading desk to enter market or marketable limit orders on an exchange 
or other similar anonymous trading facility, or to request quotes from 
other market participants, in connection with its market making-related 
activities for a variety of purposes including, among others, inventory 
management, addressing order imbalances on an exchange, and 
hedging.\939\ In response to comments, the Agencies are not requiring a 
banking entity to be registered as a market maker on an exchange or 
other similar anonymous trading facility, if the exchange or other 
similar anonymous trading facility registers market makers, for 
purposes of the final rule.\940\ The Agencies recognize, as noted by 
commenters, that there are a large number of exchanges and organized 
trading facilities on which market makers may need to trade to maintain 
liquidity across the markets and to provide customers with favorable 
prices and that requiring registration with each exchange or other 
trading facility may unnecessarily restrict or impose burdens on 
exchange market-making activities.\941\
---------------------------------------------------------------------------

    \939\ The Agencies are clarifying this point in response to 
commenters who expressed concern that the proposal would prevent an 
exchange market maker from using market or marketable limit orders 
under these circumstances. See, e.g., NYSE Euronext; SIFMA et al. 
(Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); RBC.
    \940\ See supra notes 774 to 779 and accompanying text 
(discussing commenters' response to statements in the proposal 
requiring exchange registration as a market maker under certain 
circumstances). Similarly, the final rule does not establish a 
presumption of compliance with the market-making exemption based on 
registration as a market maker with an exchange, as requested by a 
few commenters. See supra note 777 and accompanying text. As noted 
above, activity that is considered market making for purposes of 
this rule may not be considered market making for purposes of other 
rules, including self-regulatory organization rules, and vice versa. 
In addition, exchange requirements for registered market makers are 
subject to change without consideration of the impact on this rule. 
Although a banking entity is not required to be an exchange-
registered market maker under the final rule, a banking entity must 
be licensed or registered to engage in market making-related 
activities in accordance with applicable law. For example, a banking 
entity would be required to be an SEC-registered broker-dealer to 
engage in market making-related activities in securities in the U.S. 
unless the banking entity is exempt from registration or excluded 
from regulation as a dealer under the Exchange Act. See infra Part 
IV.A.3.c.6.; final rule Sec.  ----.4(b)(2)(vi).
    \941\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman 
(Prop. Trading) (noting that there are more than 12 exchanges and 40 
alternative trading systems currently trading U.S. equities).
---------------------------------------------------------------------------

    A banking entity is not required to conduct the demonstrable 
analysis under Sec.  ----.4(b)(2)(B) of the final rule on an 
instrument-by-instrument basis. The Agencies recognize that, in certain 
cases, customer demand may be for a particular type of exposure, and a 
customer may be willing to trade any one of a number of instruments 
that would provide the demanded exposure. Thus, an assessment of the 
amount, types, and risks of financial instruments that the trading desk 
may hold in market-maker inventory and that would be designed not to 
exceed, on an ongoing basis, the reasonably expected near term demands 
of clients, customers, or counterparties does not need to be made for 
each financial instrument in which the trading desk acts as market 
maker. Instead, the amount and types of financial instruments in the 
trading desk's market-maker inventory should be consistent with the 
types of financial instruments in which the desk makes a market and the 
amount and types of such instruments that the desk's customers are 
reasonably expected to be interested in trading.
    In response to commenters' concern that banking entities may be 
subject to regulatory sanctions if reasonably expected customer demand 
does not materialize,\942\ the Agencies recognize that predicting the 
reasonably expected near term demands of clients, customers, or 
counterparties is inherently subject to changes based on market and 
other factors that are difficult to predict with certainty. Thus, there 
may at times be differences between predicted demand and actual demand 
from clients, customers, or

[[Page 5612]]

counterparties. However, assessments of expected near term demand may 
not be reasonable if, in the aggregate and over longer periods of time, 
a trading desk exhibits a repeated pattern or practice of significant 
variation in the amount, types, and risks of financial instruments in 
its market-maker inventory in excess of what is needed to facilitate 
near term customer demand.
---------------------------------------------------------------------------

    \942\ See RBC; CIEBA; Wellington; ICI (Feb. 2012) Invesco.
---------------------------------------------------------------------------

iv. Relationship to Required Limits
    As discussed further below, a banking entity must establish limits 
for each trading desk on the amount, types, and risks of its market-
maker inventory, level of exposures to relevant risk factors arising 
from its financial exposure, and period of time a financial instrument 
may be held by a trading desk. These limits must be reasonably designed 
to ensure compliance with the market-making exemption, including the 
near term customer demand requirement, and must take into account the 
nature and amount of the trading desk's market making-related 
activities. Thus, the limits should account for and generally be 
consistent with the historical near term demands of the desk's clients, 
customers, or counterparties and the amount, types, and risks of 
financial instruments that the trading desk has historically held in 
market-maker inventory to meet such demands. In addition to the limits 
that a trading desk selects in managing its positions to ensure 
compliance with the market-making exemption set out in Sec.  ----.4(b), 
the Agencies are requiring, for banking entities that must report 
metrics in Appendix A, such limits include, at a minimum, ``Risk Factor 
Sensitivities'' and ``Value-at-Risk and Stress Value-at-Risk'' metrics 
as limits, except to the extent any of the ``Risk Factor 
Sensitivities'' or ``Value-at-Risk and Stress Value-at-Risk'' metrics 
are demonstrably ineffective for measuring and monitoring the risks of 
a trading desk based on the types of positions traded by, and risk 
exposures of, that desk.\943\ The Agencies believe that these metrics 
can be useful for measuring and managing many types of positions and 
trading activities and therefore can be useful in establishing a 
minimum set of metrics for which limits should be applied.\944\
---------------------------------------------------------------------------

    \943\ See Appendix A.
    \944\ The Agencies recognize that for some types of positions or 
trading strategies, the use of ``Risk Factor Sensitivities'' and 
``Value-at-Risk and Stress Value-at-Risk'' metrics may be 
ineffective and accordingly limits do not need to be set for those 
metrics if such ineffectiveness is demonstrated by the banking 
entity.
---------------------------------------------------------------------------

    As this requirement applies on an ongoing basis, a trade in excess 
of one or more limits set for a trading desk should not be permitted 
simply because it responds to customer demand. Rather, a banking 
entity's compliance program must include escalation procedures that 
require review and approval of any trade that would exceed one or more 
of a trading desk's limits, demonstrable analysis that the basis for 
any temporary or permanent increase to one or more of a trading desk's 
limits is consistent with the requirements of this near term demand 
requirement and with the prudent management of risk by the banking 
entity, and independent review of such demonstrable analysis and 
approval.\945\ The Agencies expect that a trading desk's escalation 
procedures will generally explain the circumstances under which a 
trading desk's limits can be increased, either temporarily or 
permanently, and that such increases must be consistent with reasonably 
expected near term demands of the desk's clients, customers, or 
counterparties and the amount and type of risks to which the trading 
desk is authorized to be exposed.
---------------------------------------------------------------------------

    \945\ See final rule Sec.  ----.4(b)(2)(iii); infra Part 
IV.A.3.c.3.c. (discussing the meaning of ``independent'' review for 
purposes of this requirement).
---------------------------------------------------------------------------

3. Compliance Program Requirement
a. Proposed Compliance Program Requirement
    To ensure that a banking entity relying on the market-making 
exemption had an appropriate framework in place to support its 
compliance with the exemption, Sec.  ----.4(b)(2)(i) of the proposed 
rule required a banking entity to establish an internal compliance 
program, as required by subpart D of the proposal, designed to ensure 
compliance with the requirements of the market-making exemption.\946\
---------------------------------------------------------------------------

    \946\ See proposed rule Sec.  ----.4(b)(2)(i); Joint Proposal, 
76 FR 68,870; CFTC Proposal, 77 FR 8355.
---------------------------------------------------------------------------

b. Comments on the Proposed Compliance Program Requirement
    A few commenters supported the proposed requirement that a banking 
entity establish a compliance program under Sec.  ----.20 of the 
proposed rule as effective.\947\ For example, one commenter stated that 
the requirement ``keeps a strong focus on the bank's own workings and 
allows banks to self-monitor.'' \948\ One commenter indicated that a 
comprehensive compliance program is a ``cornerstone of effective 
corporate governance,'' but cautioned against placing ``undue 
reliance'' on compliance programs.\949\ As discussed further below in 
Parts IV.C.1. and IV.C.3., many commenters expressed concern about the 
potential burdens of the proposed rule's compliance program 
requirement, as well as the proposed requirement regarding quantitative 
measurements. According to one commenter, the compliance burdens 
associated with these requirements may dissuade a banking entity from 
attempting to comply with the market-making exemption.\950\
---------------------------------------------------------------------------

    \947\ See Flynn & Fusselman; Morgan Stanley.
    \948\ See Flynn & Fusselman.
    \949\ See Occupy.
    \950\ See ICI (Feb. 2012).
---------------------------------------------------------------------------

c. Final Compliance Program Requirement
    Similar to the proposed exemption, the market-making exemption 
adopted in the final rule requires that a banking entity establish and 
implement, maintain, and enforce an internal compliance program 
required by subpart D that is reasonably designed to ensure the banking 
entity's compliance with the requirements of the market-making 
exemption, including reasonably designed written policies and 
procedures, internal controls, analysis, and independent testing.\951\ 
This provision further requires that the compliance program include 
particular written policies and procedures, internal controls, 
analysis, and independent testing identifying and addressing:
---------------------------------------------------------------------------

    \951\ The independent testing standard is discussed in more 
detail in Part IV.C., which discusses the compliance program 
requirement in Sec.  ----.20 of the final rule.
---------------------------------------------------------------------------

     The financial instruments each trading desk stands ready 
to purchase and sell as a market maker;
     The actions the trading desk will take to demonstrably 
reduce or otherwise significantly mitigate promptly the risks of its 
financial exposure consistent with the required limits; the products, 
instruments, and exposures each trading desk may use for risk 
management purposes; the techniques and strategies each trading desk 
may use to manage the risks of its market making-related activities and 
inventory; and the process, strategies, and personnel responsible for 
ensuring that the actions taken by the trading desk to mitigate these 
risks are and continue to be effective;
     Limits for each trading desk, based on the nature and 
amount of the trading desk's market making-related activities, that 
address the factors prescribed by the near term customer demand 
requirement of the final rule, on:
    [cir] The amount, types, and risks of its market-maker inventory;

[[Page 5613]]

    [cir] The amount, types, and risks of the products, instruments, 
and exposures the trading desk uses for risk management purposes;
    [cir] Level of exposures to relevant risk factors arising from its 
financial exposure; and
    [cir] Period of time a financial instrument may be held;
     Internal controls and ongoing monitoring and analysis of 
each trading desk's compliance with its required limits; and
     Authorization procedures, including escalation procedures 
that require review and approval of any trade that would exceed a 
trading desk's limit(s), demonstrable analysis that the basis for any 
temporary or permanent increase to a trading desk's limit(s) is 
consistent with the requirements of Sec.  ----.4(b)(2)(ii) of the final 
rule, and independent review (i.e., by risk managers and compliance 
officers at the appropriate level independent of the trading desk) of 
such demonstrable analysis and approval.\952\
---------------------------------------------------------------------------

    \952\ See final rule Sec.  ----.4(b)(2)(iii).
---------------------------------------------------------------------------

    The compliance program requirement in the proposed market-making 
exemption did not include specific references to all the compliance 
program elements now listed in the final rule. Instead, these elements 
were generally included in the compliance requirements of Appendix C of 
the proposed rule. The Agencies are moving certain of these 
requirements into the market-making exemption to ensure that critical 
components are made part of the compliance program for market making-
related activities. Further, placing these requirements within the 
market-making exemption emphasizes the important role they play in 
overall compliance with the exemption.\953\ Banking entities should 
note that these compliance procedures must be established, implemented, 
maintained, and enforced for each trading desk engaged in market 
making-related activities under the final rule. Each of the 
requirements in paragraphs (b)(2)(iii)(A) through (E) must be 
appropriately tailored to the individual trading activities and 
strategies of each trading desk on an ongoing basis.
---------------------------------------------------------------------------

    \953\ The Agencies note that a number of commenters requested 
that the Agencies place a greater emphasis on inventory limits and 
risk limits in the final exemption. See, e.g., Citigroup (suggesting 
that the market-making exemption utilize risk limits that would be 
set for each trading unit based on expected levels of customer 
trading--estimated by looking to historical results, target product 
and customer lists, and target market share--and an appropriate 
amount of required inventory to support that level of customer 
trading); Prof. Colesanti et al. (suggesting that the exemption 
include, among other things, a bright-line threshold of the amount 
of risk that can be retained (which cannot be in excess of the size 
and type required for market making), positions limits, and limits 
on holding periods); Sens. Merkley & Levin (Feb. 2012) (suggesting 
the use of specific parameters for inventory levels, along with a 
number of other criteria, to establish a safe harbor); SIFMA et al. 
(Prop. Trading) (Feb. 2012) (recommending the use of risk limits in 
combination with a guidance-based approach); Japanese Bankers Ass'n. 
(suggesting that the rule set risk allowances for market making-
related activities based on required capital for such activities). 
The Agencies are not establishing specific limits in the final rule, 
as some commenters appeared to recommend, in recognition of the fact 
that appropriate limits will differ based on a number of factors, 
including the size of the market-making operation and the liquidity, 
depth, and maturity of the market for the particular type(s) of 
financial instruments in which the trading desk is permitted to 
trade. See Sens. Merkley & Levin (Feb. 2012); Prof. Colesanti et al. 
However, banking entities relying on the market-making exemption 
must set limits and demonstrate how the specific limits and limit 
methodologies they have chosen are reasonably designed to limit the 
amount, types, and risks of the financial instruments in a trading 
desk's market-maker inventory consistent with the reasonably 
expected near term demands of the banking entity's clients, 
customers, and counterparties, subject to the market and conditions 
discussed above, and to commensurately control the desk's overall 
financial exposure.
---------------------------------------------------------------------------

    As a threshold issue, the compliance program must identify the 
products, instruments, and exposures the trading desk may trade as 
market maker or for risk management purposes.\954\ Identifying the 
relevant instruments in which a trading desk is permitted to trade will 
facilitate monitoring and oversight of compliance with the exemption by 
preventing an individual trader on a market-making desk from 
establishing positions in instruments that are unrelated to the desk's 
market-making function. Further, this identification of instruments 
helps form the basis for the specific types of inventory and risk 
limits that the banking entity must establish and is relevant to 
considerations throughout the exemption regarding the liquidity, depth, 
and maturity of the market for the relevant type of financial 
instrument. The Agencies note that a banking entity should be able to 
demonstrate the relationship between the instruments in which a trading 
desk may act as market maker and the instruments the desk may use to 
manage the risk of its market making-related activities and inventory 
and why the instruments the desk may use to manage its risk 
appropriately and effectively mitigate the risk of its market making-
related activities without generating an entirely new set of risks that 
outweigh the risks that are being hedged.
---------------------------------------------------------------------------

    \954\ See final rule Sec.  ----.4(b)(2)(iii)(A) (requiring 
written policies and procedures, internal controls, analysis, and 
independent testing regarding the financial instruments each trading 
desk stands ready to purchase and sell in accordance with Sec.  --
--.4(b)(2)(i) of the final rule); final rule Sec.  --
--.4(b)(2)(iii)(B) (requiring written policies and procedures, 
internal controls, analysis, and independent testing regarding the 
products, instruments, or exposures each trading desk may use for 
risk management purposes).
---------------------------------------------------------------------------

    The final rule provides that a banking entity must establish an 
appropriate risk management framework for each of its trading desks 
that rely on the market-making exemption.\955\ This includes not only 
the techniques and strategies that a trading desk may use to manage its 
risk exposures, but also the actions the trading desk will take to 
demonstrably reduce or otherwise significantly mitigate promptly the 
risks of its financial exposures consistent with its required limits, 
which are discussed in more detail below. While the Agencies do not 
expect a trading desk to hedge all of the risks that arise from its 
market making-related activities, the Agencies do expect each trading 
desk to take appropriate steps consistent with market-making activities 
to contain and limit risk exposures (such as by unwinding unneeded 
positions) and to follow reasonable procedures to monitor the trading 
desk's risk exposures (i.e., its financial exposure) and hedge risks of 
its financial exposure to remain within its relevant risk limits.\956\
---------------------------------------------------------------------------

    \955\ This standard addresses issues raised by commenters 
concerning: Certain language in proposed Appendix B regarding market 
making-related risk management; the market making-related hedging 
provision in Sec.  ----.4(b)(3) of the proposed rule; and, to some 
extent, the proposed source of revenue requirement in Sec.  --
--.4(b)(2)(v) of the proposed rule. See Joint Proposal, 76 FR 
68,960; CFTC Proposal, 77 FR 8439-8440; proposed rule Sec.  --
--.4(b)(3); Joint Proposal, 76 FR 68,873; CFTC Proposal, 77 FR 8358; 
Wellington; Credit Suisse (Seidel); Morgan Stanley; PUC Texas; 
CIEBA; SSgA (Feb. 2012); Alliance Bernstein; Investure; Invesco; 
Japanese Bankers Ass'n.; SIFMA et al. (Prop. Trading) (Feb. 2012); 
FTN; RBC; NYSE Euronext; MFA. As discussed in more detail above, a 
number of commenters emphasized that market making-related 
activities necessarily involve a certain amount of risk-taking to 
provide ``immediacy'' to customers. See, e.g., Prof. Duffie; Morgan 
Stanley; SIFMA et al. (Prop. Trading) (Feb. 2012). Commenters also 
represented that the amount of risk a market maker needs to retain 
may differ across asset classes and markets. See, e.g., Morgan 
Stanley; Credit Suisse (Seidel). The Agencies believe that the 
requirement we are adopting better recognizes that appropriate risk 
management will tailor acceptable position, risk and inventory 
limits based on the type(s) of financial instruments in which the 
trading desk is permitted to trade and the liquidity, maturity, and 
depth of the market for the relevant type of financial instrument.
    \956\ It may be more efficient for a banking entity to manage 
some risks at a higher organizational level than the trading desk 
level. As a result, a banking entity's written policies and 
procedures may delegate the responsibility to mitigate specific 
risks of the trading desk's financial exposure to an entity other 
than the trading desk, including another organizational unit of the 
banking entity or of an affiliate, provided that such organizational 
unit of the banking entity or of an affiliate is identified in the 
banking entity's written policies and procedures. Under these 
circumstances, the other organizational unit of the banking entity 
or of an affiliate must conduct such hedging activity in accordance 
with the requirements of the hedging exemption in Sec.  ----.5 of 
the final rule, including the documentation requirement in Sec.  --
--.5(c). As recognized in Part IV.A.4.d.4., hedging activity 
conducted by a different organizational unit than the unit 
responsible for the positions being hedged presents a greater risk 
of evasion. Further, the risks being managed by a higher 
organizational level than the trading desk may be generated by 
trading desks engaged in market making-related activity or by 
trading desks engaged in other permitted activities. Thus, it would 
be inappropriate for such hedging activity to be conducted in 
reliance on the market-making exemption.

---------------------------------------------------------------------------

[[Page 5614]]

    As discussed in Part IV.A.3.c.4.c., managing the risks associated 
with maintaining a market-maker inventory that is appropriate to meet 
the reasonably expected near-term demands of customers is an important 
part of market making.\957\ The Agencies understand that, in the 
context of market-making activities, inventory management includes 
adjustment of the amount and types of market-maker inventory to meet 
the reasonably expected near term demands of customers.\958\ 
Adjustments of the size and types of a financial exposure are also made 
to reduce or mitigate the risks associated with financial instruments 
held as part of a trading desk's market-maker inventory. A common 
strategy in market making is to establish market-maker inventory in 
anticipation of reasonably expected customer needs and then to reduce 
that market-maker inventory over time as customer demand 
materializes.\959\ If customer demand does not materialize, the market 
maker addresses the risks associated with its market-maker inventory by 
adjusting the amount or types of financial instruments in its inventory 
as well as taking steps otherwise to mitigate the risk associated with 
its inventory.
---------------------------------------------------------------------------

    \957\ See supra Part IV.A.3.c.2.c. (discussing the final near 
term demand requirement).
    \958\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); 
Credit Suisse (Seidel); Goldman (Prop. Trading); MFA; RBC.
    \959\ See, e.g., BoA; SIFMA et al. (Prop. Trading) (Feb. 2012); 
Chamber (Feb. 2012).
---------------------------------------------------------------------------

    The Agencies recognize that, to provide effective intermediation 
services, a trading desk engaged in permitted market making-related 
activities retains a certain amount of risk arising from the positions 
it holds in inventory and may hedge certain aspects of that risk. The 
requirements in the final rule establish controls around a trading 
desk's risk management activities, yet still recognize that a trading 
desk engaged in market making-related activities may retain a certain 
amount of risk in meeting the reasonably expected near term demands of 
clients, customers, or counterparties. As the Agencies noted in the 
proposal, where the purpose of a transaction is to hedge a market 
making-related position, it would appear to be market making-related 
activity of the type described in section 13(d)(1)(B) of the BHC 
Act.\960\ The Agencies emphasize that the only risk management 
activities that qualify for the market-making exemption--and that are 
not subject to the hedging exemption--are risk management activities 
conducted or directed by the trading desk in connection with its market 
making-related activities and in conformance with the trading desk's 
risk management policies and procedures.\961\ A trading desk engaged in 
market making-related activities would be required to comply with the 
hedging exemption or another available exemption for any risk 
management or other activity that is not in conformance with the 
trading desk's required market-making risk management policies and 
procedures.
---------------------------------------------------------------------------

    \960\ See Joint Proposal, 76 FR 68,873; CFTC Proposal, 77 FR 
8358.
    \961\ As discussed above, if a trading desk operating under the 
market-making exemption directs a different organizational unit of 
the banking entity or an affiliate to establish a hedge position on 
the desk's behalf, then the other organizational unit may rely on 
the market-making exemption to establish the hedge position as long 
as: (i) The other organizational unit's hedging activity is 
consistent with the trading desk's risk management policies and 
procedures (e.g., the hedge instrument, technique, and strategy are 
consistent with those identified in the trading desk's policies and 
procedures); and (ii) the hedge position is attributed to the 
financial exposure of the trading desk and is included in the 
trading desk's daily profit and loss. If a different organizational 
unit of the banking entity or of an affiliate establishes a hedge 
for the trading desk's financial exposure based on its own 
determination, or if such position was not established in accordance 
with the trading desk's required procedures or was included in that 
other organizational unit's financial exposure and/or daily profit 
and loss, then that hedge position must be established in compliance 
with the hedging exemption in Sec.  ----.5 of the rule, including 
the documentation requirement in Sec.  ----.5(c). See supra Part 
IV.A.3.c.1.c.ii.
---------------------------------------------------------------------------

    A banking entity's written policies and procedures, internal 
controls, analysis, and independent testing identifying and addressing 
the products, instruments, or exposures and the techniques and 
strategies that may be used by each trading desk to manage the risks of 
its market making-related activities and inventory must cover both how 
the trading desk may establish hedges and how such hedges are removed 
once the risk they were mitigating is unwound. With respect to 
establishing positions that hedge or otherwise mitigate the risk(s) of 
market making-related positions held by the trading desk, the written 
policies and procedures may consider the natural hedging and 
diversification that occurs in an aggregation of long and short 
positions in financial instruments for which the trading desk is a 
market maker,\962\ as it documents its specific risk-mitigating 
strategies that use instruments for which the desk is a market maker or 
instruments for which the desk is not a market maker. Further, the 
written policies and procedures identifying and addressing permissible 
hedging techniques and strategies must address the circumstances under 
which the trading desk may be permitted to engage in anticipatory 
hedging. Like the proposed rule's hedging exemption, a trading desk may 
establish an anticipatory hedge position before it becomes exposed to a 
risk that it is highly likely to become exposed to, provided there is a 
sound risk management rationale for establishing such an anticipatory 
hedge position.\963\ For example, a trading desk may hedge against 
specific positions promised to customers, such as volume-weighted 
average price (``VWAP'') orders or large block trades, to facilitate 
the customer trade.\964\ The amount of time that an anticipatory hedge 
may precede the establishment of the position to be hedged will depend 
on market factors, such as the liquidity of the hedging position.
---------------------------------------------------------------------------

    \962\ For example, this may occur if a U.S. corporate bond 
trading desk acquires a $100 million long position in the corporate 
bonds of one issuer from clients, customers, or counterparties and 
separately acquires a $50 million short position in another issuer 
in the same market sector in reasonable expectation of near term 
demand of clients, customers, or counterparties. Although both 
positions were acquired to facilitate customer demand, the positions 
may also naturally hedge each other, to some extent.
    \963\ See Joint Proposal, 76 FR 68,875; CFTC Proposal, 77 FR 
8361.
    \964\ Two commenters recommended that banking entities be 
permitted to establish hedges prior to acquiring the underlying risk 
exposure under these circumstances. See Credit Suisse (Seidel); BoA.
---------------------------------------------------------------------------

    Written policies and procedures, internal controls, analysis, and 
independent testing established pursuant to the final rule identifying 
and addressing permissible hedging techniques and strategies should be 
designed to prevent a trading desk from over-hedging its market-maker 
inventory or financial exposure. Over-hedging would occur if, for 
example, a trading desk established a position in a financial 
instrument for the purported purpose of reducing a risk associated with 
one or more market-making positions when, in fact, that risk had 
already been mitigated to the full extent possible. Over-hedging 
results in a new risk exposure that is unrelated to market-making 
activities and, thus, is not permitted under the market-making 
exemption.

[[Page 5615]]

    A trading desk's financial exposure generally would not be 
considered to be consistent with market making-related activities to 
the extent the trading desk is engaged in hedging activities that are 
inconsistent with the management of identifiable risks in its market-
maker inventory or maintains significant hedge positions after the 
underlying risk(s) of the market-maker inventory have been unwound. A 
banking entity's written policies and procedures, internal controls, 
analysis, and independent testing regarding the trading desk's 
permissible hedging techniques and strategies must be designed to 
prevent a trading desk from engaging in over-hedging or maintaining 
hedge positions after they are no longer needed.\965\ Further, the 
compliance program must provide for the process and personnel 
responsible for ensuring that the actions taken by the trading desk to 
mitigate the risks of its market making-related activities are and 
continue to be effective, which would include monitoring for and 
addressing any scenarios where a trading desk may be engaged in over-
hedging or maintaining unnecessary hedge positions or new significant 
risks have been introduced by the hedging activity.
---------------------------------------------------------------------------

    \965\ See final rule Sec.  ----.4(b)(2)(iii)(B).
---------------------------------------------------------------------------

    As a result of these limitations, the size and risks of the trading 
desk's hedging positions are naturally constrained by the size and 
risks of its market-maker inventory, which must be designed not to 
exceed the reasonably expected near term demands of clients, customers, 
or counterparties, as well as by the risk limits and controls 
established under the final rule. This ultimately constrains a trading 
desk's overall financial exposure since such position can only contain 
positions, risks, and exposures related to the market-maker inventory 
that are designed to meet current or near term customer demand and 
positions, risks and exposures designed to mitigate the risks in 
accordance with the limits previously established for the trading desk.
    The written policies and procedures identifying and addressing a 
trading desk's hedging techniques and strategies also must describe how 
and under what timeframe a trading desk must remove hedge positions 
once the underlying risk exposure is unwound. Similarly, the compliance 
program established by the banking entity to specify and control the 
trading desk's hedging activities in accordance with the final rule 
must be designed to prevent a trading desk from purposefully or 
inadvertently transforming its positions taken to manage the risk of 
its market-maker inventory under the exemption into what would 
otherwise be considered prohibited proprietary trading.
    Moreover, the compliance program must provide for the process and 
personnel responsible for ensuring that the actions taken by the 
trading desk to mitigate the risks of its market making-related 
activities and inventory--including the instruments, techniques, and 
strategies used for risk management purposes--are and continue to be 
effective. This includes ensuring that hedges taken in the context of 
market making-related activities continue to be effective and that 
positions taken to manage the risks of the trading desk's market-maker 
inventory are not purposefully or inadvertently transformed into what 
would otherwise be considered prohibited proprietary trading. If a 
banking entity's monitoring procedures find that a trading desk's risk 
management procedures are not effective, such deficiencies must be 
promptly escalated and remedied in accordance with the banking entity's 
escalation procedures. A banking entity's written policies and 
procedures must set forth the process for determining the circumstances 
under which a trading desk's risk management strategies may be 
modified. In addition, risk management techniques and strategies 
developed and used by a trading desk must be independently tested or 
verified by management separate from the trading desk.
    To control and limit the amount and types of financial instruments 
and risks that a trading desk may hold in connection with its market 
making-related activities, a banking entity must establish, implement, 
maintain, and enforce reasonably designed written policies and 
procedures, internal controls, analysis, and independent testing 
identifying and addressing specific limits on a trading desk's market-
maker inventory, risk management positions, and financial exposure. In 
particular, the compliance program must establish limits for each 
trading desk, based on the nature and amount of its market making-
related activities (including the factors prescribed by the near term 
customer demand requirement), on the amount, types, and risks of its 
market-maker inventory, the amount, types, and risks of the products, 
instruments, and exposures the trading desk may use for risk management 
purposes, the level of exposures to relevant risk factors arising from 
its financial exposure, and the period of time a financial instrument 
may be held.\966\ The limits would be set, as appropriate, and 
supported by an analysis for specific types of financial instruments, 
levels of risk, and duration of holdings, which would also be required 
by the compliance appendix. This approach will build on existing risk 
management infrastructure for market-making activities that subject 
traders to a variety of internal, predefined limits.\967\ Each of these 
limits is independent of the others, and a trading desk must maintain 
its aggregated market-making position within each of these limits, 
including by taking action to bring the trading desk into compliance 
with the limits as promptly as possible after the limit is 
exceeded.\968\ For example, if changing market conditions cause an 
increase in one or more risks within the trading desk's financial 
exposure and that increased risk causes the desk to exceed one or more 
of its limits, the trading desk must take prompt action to reduce its 
risk exposure (either by hedging the risk or unwinding its existing 
positions) or receive approval of a temporary or permanent increase to 
its limit through the required escalation procedures.
---------------------------------------------------------------------------

    \966\ See final rule Sec.  ----.4(b)(2)(iii)(C).
    \967\ See, e.g., Citigroup (Feb. 2012) (noting that its 
suggested approach to implementing the market-making exemption, 
which would focus on risk limits and risk architecture, would build 
on existing risk limits and risk management systems already present 
in institutions).
    \968\ See final rule Sec.  ----.4(b)(2)(iv).
---------------------------------------------------------------------------

    The Agencies recognize that trading desks' limits will differ 
across asset classes and acknowledge that trading desks engaged in 
market making-related activities in less liquid asset classes, such as 
corporate bonds, certain derivatives, and securitized products, may 
require different inventory, risk exposure, and holding period limits 
than trading desks engaged in market making-related activities in more 
liquid financial instruments, such as certain listed equity securities. 
Moreover, the types of risk factors for which limits are established 
should not be limited solely to market risk factors. Instead, such 
limits should also account for all risk factors that arise from the 
types of financial instruments in which the trading desk is permitted 
to trade. In addition, these limits should be sufficiently granular and 
focused on the particular types of financial instruments in which the 
desk may trade. For example, a trading desk that makes a market in 
derivatives would have exposures to counterparty risk, among others, 
and would need to have appropriate limits on such risk. Other types of 
limits that may be relevant for a trading desk include, among others,

[[Page 5616]]

position limits, sector limits, and geographic limits.
    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.\969\ Among other things, the banking entity's 
compliance program must provide for: (i) Written policies and 
procedures and internal controls establishing and monitoring specific 
limits for each trading desk; and (ii) analysis regarding how and why 
these limits are determined to be appropriate and consistent with the 
nature and amount of the desk's market making-related activities, 
including considerations related to the near term customer demand 
requirement. In making these determinations, a banking entity should 
take into account and be consistent with the type(s) of financial 
instruments the desk is permitted to trade, the desk's trading and risk 
management activities and strategies, the history and experience of the 
desk, and the historical profile of the desk's near term customer 
demand and market and other factors that may impact the reasonably 
expected near term demands of customers.
---------------------------------------------------------------------------

    \969\ See final rule Sec.  ----.4(b)(2)(iii)(C).
---------------------------------------------------------------------------

    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. 
A trading desk's market-maker inventory, risk management positions, or 
financial exposure would not, however, be permissible under the market-
making exemption merely because the market-maker inventory, risk 
management positions, or financial exposure happens to be within the 
desk's prescribed limits.\970\
---------------------------------------------------------------------------

    \970\ For example, if a U.S. corporate bond trading desk has a 
prescribed limit of $200 million net exposure to any single sector 
of related issuers, the desk's limits may permit it to acquire a net 
economic exposure of $400 million long to issuer ABC and a net 
economic exposure of $300 million short to issuer XYZ, where ABC and 
XYZ are in the same sector. This is because the trading desk's net 
exposure to the sector would only be $100 million, which is within 
its limits. Even though the net exposure to this sector is within 
the trading desk's prescribed limits, the desk would still need to 
be able to demonstrate how its net exposure of $400 million long to 
issuer ABC and $300 million short to issuer XYZ is related to 
customer demand.
---------------------------------------------------------------------------

    In addition, a banking entity must establish internal controls and 
ongoing monitoring and analysis of each trading desk's compliance with 
its limits, including the frequency, nature, and extent of a trading 
desk exceeding its limits and patterns regarding the portions of the 
trading desk's limits that are accounted for by the trading desk's 
activity.\971\ This may include the use of management and exception 
reports. Moreover, the compliance program must set forth a process for 
determining the circumstances under which a trading desk's limits may 
be modified on a temporary or permanent basis (e.g., due to market 
changes or modifications to the trading desk's strategy).\972\ This 
process must cover potential scenarios when a trading desk's limits 
should be raised, as well as potential scenarios when a trading desk's 
limits should be lowered. For example, if a trading desk experiences 
reduced customer demand over a period of time, that trading desk's 
limits should be decreased to address the factors prescribed by the 
near term demand requirement.
---------------------------------------------------------------------------

    \971\ See final rule Sec.  ----.4(b)(2)(iii)(D).
    \972\ For example, a banking entity may determine to permit 
temporary, short-term increases to a trading desk's risk limits due 
to an increase in short-term credit spreads or in response to 
volatility in instruments in which the trading desk makes a market, 
provided the increased limit is consistent with the reasonably 
expected near term demands of clients, customers, or counterparties. 
As noted above, other potential circumstances that could warrant 
changes to a trading desk's limits include: A change in the pattern 
of customer needs, adjustments to the market maker's business model 
(e.g., new entrants or existing market makers trying to expand or 
contract their market share), or changes in market conditions. See 
supra note 932 and accompanying text.
---------------------------------------------------------------------------

    A banking entity's compliance program must also include escalation 
procedures that require review and approval of any trade that would 
exceed one or more of a trading desk's limits, demonstrable analysis 
that the basis for any temporary or permanent increase to one or more 
of a trading desk's limits is consistent with the near term customer 
demand requirement, and independent review of such demonstrable 
analysis and approval of any increase to one or more of a trading 
desk's limits.\973\ Thus, in order to increase a limit of a trading 
desk--on either a temporary or permanent basis--there must be an 
analysis of why such increase would be appropriate based on the 
reasonably expected near term demands of clients, customers, or 
counterparties, including the factors identified in Sec.  --
--.4(b)(2)(ii) of the final rule, which must be independently reviewed. 
A banking entity also must maintain documentation and records with 
respect to these elements, consistent with the requirement of Sec.  --
--.20(b)(6).
---------------------------------------------------------------------------

    \973\ See final rule Sec.  ----.4(b)(2)(iii)(E).
---------------------------------------------------------------------------

    As already discussed, commenters have represented that the 
compliance costs associated with the proposed rule, including the 
compliance program and metrics requirements, may be significant and 
``may dissuade a banking entity from attempting to comply with the 
market making-related activities exemption.''\974\ The Agencies believe 
that a robust compliance program is necessary to ensure adherence to 
the rule and to prevent evasion, although, as discussed in Part 
IV.C.3., the Agencies are adopting a more tailored set of quantitative 
measurements to better focus on those that are most germane to 
evaluating market making-related activity. The Agencies acknowledge 
that the compliance program requirements for the market-making 
exemption, including reasonably designed written policies and 
procedures, internal controls, analysis, and independent testing, 
represent a new regulatory requirement for banking entities and the 
Agencies have thus been mindful that it may impose significant costs 
and may cause a banking entity to reconsider whether to conduct market 
making-related activities. Despite the potential costs of the 
compliance program, the Agencies believe they are warranted to ensure 
that the goals of the rule and statute will be met, such as promoting 
the safety and soundness of banking entities and the financial 
stability of the United States.
---------------------------------------------------------------------------

    \974\ See ICI (Feb. 2012).
---------------------------------------------------------------------------

4. Market Making-Related Hedging
a. Proposed Treatment of Market Making-Related Hedging
    In the proposal, certain hedging transactions related to market 
making were considered to be made in connection with a banking entity's 
market making-related activity for purposes of the market-making 
exemption. The Agencies explained that where the purpose of a 
transaction is to hedge a market making-related position, it would 
appear to be market making-related activity of the type described in

[[Page 5617]]

section 13(d)(1)(B) of the BHC Act.\975\ To qualify for the market-
making exemption, a hedging transaction would have been required to 
meet certain requirements under Sec.  ----.4(b)(3) of the proposed 
rule. This provision required that the purchase or sale of a financial 
instrument: (i) Be conducted to reduce the specific risks to the 
banking entity in connection with and related to individual or 
aggregated positions, contracts, or other holdings acquired pursuant to 
the market-making exemption; and (ii) meet the criteria specified in 
Sec.  ----.5(b) of the proposed hedging exemption and, where 
applicable, Sec.  ----.5(c) of the proposal.\976\ In the proposal, the 
Agencies noted that a market maker may often make a market in one type 
of financial instrument and hedge its activities using different 
financial instruments in which it does not make a market. The Agencies 
stated that this type of hedging transaction would meet the terms of 
the market-making exemption if the hedging transaction met the 
requirements of Sec.  ----.4(b)(3) of the proposed rule.\977\
---------------------------------------------------------------------------

    \975\ See Joint Proposal, 76 FR 68,873; CFTC Proposal, 77 FR 
8358.
    \976\ See proposed rule Sec.  ----.4(b)(3); Joint Proposal, 76 
FR 68,873; CFTC Proposal, 77 FR 8358.
    \977\ See Joint Proposal, 76 FR 68,870 n.146; CFTC Proposal, 77 
FR 8356 n.152.
---------------------------------------------------------------------------

b. Comments on the Proposed Treatment of Market Making-Related Hedging
    Several commenters recommended that the proposed market-making 
exemption be modified to establish a more permissive standard for 
market maker hedging.\978\ A few of these commenters stated that, 
rather than applying the standards of the risk-mitigating hedging 
exemption to market maker hedging, a market maker's hedge position 
should be permitted as long as it is designed to mitigate the risk 
associated with positions acquired through permitted market making-
related activities.\979\ Other commenters emphasized the need for 
flexibility to permit a market maker to choose the most effective 
hedge.\980\ In general, these commenters expressed concern that 
limitations on hedging market making-related positions may cause a 
reduction in liquidity, wider spreads, or increased risk and trading 
costs for market makers.\981\ For example, one commenter stated that 
``[t]he ability of market makers to freely offset or hedge positions is 
what, in most cases, makes them willing to buy and sell [financial 
instruments] to and from customers, clients or counterparties,'' so 
``[a]ny impediment to hedging market making-related positions will 
decrease the willingness of banking entities to make markets and, 
accordingly, reduce liquidity in the marketplace.'' \982\
---------------------------------------------------------------------------

    \978\ See, e.g., Japanese Bankers Ass'n.; SIFMA et al. (Prop. 
Trading) (Feb. 2012); Credit Suisse (Seidel); FTN; RBC; NYSE 
Euronext; MFA. These comments are addressed in Part IV.A.3.c.4.c., 
infra.
    \979\ See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC. See 
also FTN (stating that the principal requirement for such hedges 
should be that they reduce the risk of market making).
    \980\ See NYSE Euronext (stating that the best hedge sometimes 
involves a variety of complex and dynamic transactions over the time 
in which an asset is held, which may fall outside the parameters of 
the exemption); MFA; JPMC.
    \981\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit 
Suisse (Seidel); NYSE Euronext; MFA; Japanese Bankers Ass'n.; RBC.
    \982\ RBC.
---------------------------------------------------------------------------

    In addition, some commenters expressed concern that certain 
requirements in the proposed hedging exemption may result in a 
reduction in market-making activities under certain circumstances.\983\ 
For example, one commenter expressed concern that the proposed hedging 
exemption would require a banking entity to identify and tag hedging 
transactions when hedges in a particular asset class take place 
alongside a trading desk's customer flow trading and inventory 
management in that same asset class.\984\ Further, a few commenters 
represented that the proposed reasonable correlation requirement in the 
hedging exemption could impact market making by discouraging market 
makers from entering into customer transactions that do not have a 
direct hedge \985\ or making it more difficult for market makers to 
cost-effectively hedge the fixed income securities they hold in 
inventory, including hedging such inventory positions on a portfolio 
basis.\986\
---------------------------------------------------------------------------

    \983\ See BoA; SIFMA (Asset Mgmt.) (Feb. 2012).
    \984\ See Goldman (Prop. Trading).
    \985\ See BoA.
    \986\ See SIFMA (Asset Mgmt.) (Feb. 2012).
---------------------------------------------------------------------------

    One commenter, however, stated that the proposed approach is 
effective.\987\ Another commenter indicated that it is confusing to 
include hedging within the market-making exemption and suggested that a 
market maker be required to rely on the hedging exemption under Sec.  
----.5 of the proposed rule for its hedging activity.\988\
---------------------------------------------------------------------------

    \987\ See Alfred Brock.
    \988\ See Occupy.
---------------------------------------------------------------------------

    As noted above in the discussion of comments on the proposed source 
of revenue requirement, a number of commenters expressed concern that 
the proposed rule assumed that there are effective, or perfect, hedges 
for all market making-related positions.\989\ Another commenter stated 
that market makers should be required to hedge whenever an inventory 
imbalance arises, and the absence of a hedge in such circumstances may 
evidence prohibited proprietary trading.\990\
---------------------------------------------------------------------------

    \989\ See infra notes 1068 to 1070 and accompanying text.
    \990\ See Public Citizen.
---------------------------------------------------------------------------

c. Treatment of Market Making-Related Hedging in the Final Rule
    Unlike the proposed rule, the final rule does not require that 
market making-related hedging activities separately comply with the 
requirements found in the risk-mitigating hedging exemption if 
conducted or directed by the same trading desk conducting the market-
making activity. Instead, the Agencies are including requirements for 
market making-related hedging activities within the market-making 
exemption in response to comments.\991\ As discussed above, a trading 
desk's compliance program must include written policies and procedures, 
internal controls, independent testing and analysis identifying and 
addressing the products, instruments, exposures, techniques, and 
strategies a trading desk may use to manage the risks of its market 
making-related activities, as well as the actions the trading desk will 
take to demonstrably reduce or otherwise significant mitigate the risks 
of its financial exposure consistent with its required limits.\992\ The 
Agencies believe this approach addresses commenters' concerns that 
limitations on hedging market making-related positions may cause a 
reduction in liquidity, wider spreads, or increased risk and trading 
costs for market makers because it allows banking entities to determine 
how best to manage the risks of trading desks' market making-related 
activities through reasonable policies and procedures, internal 
controls, independent testing, and analysis, rather than requiring 
compliance with the specific requirements of the hedging 
exemption.\993\ Further, this approach addresses commenters' concerns 
about the impact of certain requirements of the hedging exemption on 
market making-related activities.\994\
---------------------------------------------------------------------------

    \991\ See, e.g., Japanese Bankers Ass'n.; SIFMA et al. (Prop. 
Trading) (Feb. 2012); Credit Suisse (Seidel); FTN; RBC; NYSE 
Euronext; MFA.
    \992\ See final rule Sec.  ----.4(b)(2)(iii)(B); supra Part 
IV.A.3.c.3.c.
    \993\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit 
Suisse (Seidel); NYSE Euronext; MFA; Japanese Bankers Ass'n.; RBC.
    \994\ See BoA; SIFMA (Asset Mgmt.) (Feb. 2012); Goldman (Prop. 
Trading).
---------------------------------------------------------------------------

    The Agencies believe it is consistent with the statute's reference 
to ``market making-related'' activities to permit

[[Page 5618]]

market making-related hedging activities under this exemption. In 
addition, the Agencies believe it is appropriate to require a trading 
desk to appropriately manage its risks, consistent with its risk 
management procedures and limits, because management of risk is a key 
factor that distinguishes permitted market making-related activity from 
impermissible proprietary trading. As noted in the proposal, while ``a 
market maker attempts to eliminate some [of the risks arising from] its 
retained principal positions and risks by hedging or otherwise managing 
those risks [ ], a proprietary trader seeks to capitalize on those 
risks, and generally only hedges or manages a portion of those risks 
when doing so would improve the potential profitability of the risk it 
retains.'' \995\
---------------------------------------------------------------------------

    \995\ See Joint Proposal, 76 FR 68,961.
---------------------------------------------------------------------------

    The Agencies recognize that some banking entities may manage the 
risks associated with market making at a different level than the 
individual trading desk.\996\ While this risk management activity is 
not permitted under the market-making exemption, it may be permitted 
under the hedging exemption, provided the requirements of that 
exemption are met. Thus, the Agencies believe banking entities will 
continue to have options available that allow them to efficiently hedge 
the risks arising from their market-making operations. Nevertheless, 
the Agencies understand that this rule will result in additional 
documentation or other potential burdens for market making-related 
hedging activity that is not conducted by the trading desk responsible 
for the market-making positions being hedged.\997\ As discussed in Part 
IV.A.4.d.4., hedging conducted by a different organizational unit than 
the trading desk that is responsible for the underlying positions 
presents an increased risk of evasion, so the Agencies believe it is 
appropriate for such hedging activity to be required to comply with the 
hedging exemption, including the associated documentation requirement.
---------------------------------------------------------------------------

    \996\ See, e.g., letter from JPMC (stating that, to minimize 
risk management costs, firms commonly organize their market-making 
activities so that risks delivered to client-facing desks are 
aggregated and passed by means of internal transactions to a single 
utility desk and suggesting this be recognized as permitted market 
making-related behavior).
    \997\ See final rule Sec.  ----.5(c).
---------------------------------------------------------------------------

5. Compensation Requirement
a. Proposed Compensation Requirement
    Section ----.4(b)(2)(vii) of the proposed market-making exemption 
would have required that the compensation arrangements of persons 
performing market making-related activities at the banking entity be 
designed not to reward proprietary risk-taking.\998\ In the proposal, 
the Agencies noted that activities for which a banking entity has 
established a compensation incentive structure that rewards speculation 
in, and appreciation of, the market value of a financial instrument 
position held in inventory, rather than success in providing effective 
and timely intermediation and liquidity services to customers, would be 
inconsistent with the proposed market-making exemption.
---------------------------------------------------------------------------

    \998\ See proposed rule Sec.  ----.4(b)(2)(vii).
---------------------------------------------------------------------------

    The Agencies stated that under the proposed rule, a banking entity 
relying on the market-making exemption should provide compensation 
incentives that primarily reward customer revenues and effective 
customer service, not proprietary risk-taking. However, the Agencies 
noted that a banking entity relying on the proposed market-making 
exemption would be able to appropriately take into account revenues 
resulting from movements in the price of principal positions to the 
extent that such revenues reflect the effectiveness with which 
personnel have managed principal risk retained.\999\
---------------------------------------------------------------------------

    \999\ See Joint Proposal, 76 FR 68,872; CFTC Proposal, 77 FR 
8358.
---------------------------------------------------------------------------

b. Comments Regarding the Proposed Compensation Requirement
    Several commenters recommended certain revisions to the proposed 
compensation requirement.\1000\ Two commenters stated that the proposed 
requirement is effective,\1001\ while one commenter stated that it 
should be removed from the rule.\1002\ Moreover, in addressing this 
proposed requirement, commenters provided views on: identifiable 
characteristics of compensation arrangements that incentivize 
prohibited proprietary trading,\1003\ methods of monitoring compliance 
with this requirement,\1004\ and potential negative incentives or 
outcomes this requirement could cause.\1005\
---------------------------------------------------------------------------

    \1000\ See Prof. Duffie; SIFMA et al. (Prop. Trading) (Feb. 
2012); John Reed; Credit Suisse (Seidel); JPMC; Morgan Stanley; 
Better Markets (Feb. 2012); Johnson & Prof. Stiglitz; Occupy; AFR et 
al. (Feb. 2012); Public Citizen.
    \1001\ See FTN; Alfred Brock.
    \1002\ See Japanese Bankers Ass'n.
    \1003\ See Occupy.
    \1004\ See Occupy; Goldman (Prop. Trading).
    \1005\ See AllianceBernstein; Prof. Duffie; Investure; STANY; 
Chamber (Dec. 2011).
---------------------------------------------------------------------------

    With respect to suggested modifications to this requirement, a few 
commenters suggested that a market maker's compensation should be 
subject to additional limitations.\1006\ For example, two commenters 
stated that compensation should be restricted to particular sources, 
such as fees, commissions, and spreads.\1007\ One commenter suggested 
that compensation should not be symmetrical between gains and losses 
and, further, that trading gains reflecting an unusually high variance 
in position values should either not be reflected in compensation and 
bonuses or should be less reflected than other gains and losses.\1008\ 
Another commenter recommended that the Agencies remove ``designed'' 
from the rule text and provide greater clarity about how a banking 
entity's compensation regime must be structured.\1009\ Moreover, a 
number of commenters stated that compensation should be vested for a 
period of time, such as until the trader's market making positions have 
been fully unwound and are no longer in the banking entity's 
inventory.\1010\ As one commenter explained, such a requirement would 
discourage traders from carrying inventory and encourage them to get 
out of positions as soon as possible.\1011\ Some commenters also 
recommended that compensation be risk adjusted.\1012\
---------------------------------------------------------------------------

    \1006\ See Better Markets (Feb. 2012); Public Citizen; AFR et 
al. (Feb. 2012); Occupy; John Reed; AFR et al. (Feb. 2012); Johnson 
& Prof. Stiglitz; Prof. Duffie; Sens. Merkley & Levin (Feb. 2012). 
These comments are addressed in note 1027, infra.
    \1007\ See Better Markets (Feb. 2012); Public Citizen.
    \1008\ See AFR et al. (Feb. 2012)
    \1009\ See Occupy.
    \1010\ See John Reed; AFR et al. (Feb. 2012); Johnson & Prof. 
Stiglitz; Prof. Duffie (``A trader's incentives for risk taking can 
be held in check by vesting incentive-based compensation over a 
substantial period of time. Pending compensation can thus be 
forfeited if a trader's negligence causes substantial losses or if 
his or her employer fails.''); Sens. Merkley & Levin (Feb. 2012).
    \1011\ See John Reed.
    \1012\ See Johnson & Prof. Stiglitz; John Reed; Sens. Merkley & 
Levin (Feb. 2012).
---------------------------------------------------------------------------

    A few commenters indicated that the proposed approach may be too 
restrictive.\1013\ Two of these commenters stated that the compensation 
requirement should instead be set forth as guidance in Appendix 
B.\1014\ In addition, two commenters requested that the Agencies 
clarify that compensation arrangements must be designed not to reward 
prohibited proprietary risk-taking. These commenters were concerned the 
proposed approach may restrict a banking entity's ability to provide 
compensation for permitted activities,

[[Page 5619]]

which also involve proprietary trading.\1015\
---------------------------------------------------------------------------

    \1013\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; 
Morgan Stanley.
    \1014\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.
    \1015\ See Morgan Stanley; SIFMA et al. (Prop. Trading) (Feb. 
2012). The Agencies respond to these comments in note 1026 and its 
accompanying text, infra.
---------------------------------------------------------------------------

    Two commenters discussed identifiable characteristics of 
compensation arrangements that clearly incentivize prohibited 
proprietary trading.\1016\ For example, one commenter stated that 
rewarding pure profit and loss, without consideration for the risk that 
was assumed to capture it, is an identifiable characteristic of an 
arrangement that incentivizes proprietary risk-taking.\1017\ For 
purposes of monitoring and ensuring compliance with this requirement, 
one commenter noted that existing Board regulations for systemically 
important banking entities require comprehensive firm-wide policies 
that determine compensation. This commenter stated that those 
regulations, along with appropriately calibrated metrics, should ensure 
that compensation arrangements are not designed to reward prohibited 
proprietary risk-taking.\1018\ For similar purposes, another commenter 
suggested that compensation incentives should be based on a metric that 
meaningfully accounts for the risk underlying profitability.\1019\
---------------------------------------------------------------------------

    \1016\ See Occupy; Alfred Brock.
    \1017\ See Occupy. The Agencies respond to this comment in Part 
IV.A.3.c.5.c., infra.
    \1018\ See Goldman (Prop. Trading).
    \1019\ See Occupy.
---------------------------------------------------------------------------

    Certain commenters expressed concern that the proposed compensation 
requirement could incentivize market makers to act in a way that would 
not be beneficial to customers or market liquidity.\1020\ For example, 
two commenters expressed concern that the requirement could cause 
market makers to widen their spreads or charge higher fees because 
their personal compensation depends on these factors.\1021\ One 
commenter stated that the proposed requirement could dampen traders' 
incentives and discretion and may make market makers less likely to 
accept trades involving significant increases in risk or profit.\1022\ 
Another commenter expressed the view that profitability-based 
compensation arrangements encourage traders to exercise due care 
because such arrangements create incentives to avoid losses.\1023\ 
Finally, one commenter stated that compliance with the proposed 
requirement may be difficult or impossible if the Agencies do not take 
into account the incentive-based compensation rulemaking.\1024\
---------------------------------------------------------------------------

    \1020\ See AllianceBernstein; Investure; Prof. Duffie; STANY. 
This issue is addressed in note 1027, infra.
    \1021\ See AllianceBernstein; Investure.
    \1022\ See Prof. Duffie.
    \1023\ See STANY.
    \1024\ See Chamber (Dec. 2011).
---------------------------------------------------------------------------

c. Final Compensation Requirement
    Similar to the proposed rule, the market-making exemption requires 
that the compensation arrangements of persons performing the banking 
entity's market making-related activities, as described in the 
exemption, are designed not to reward or incentivize prohibited 
proprietary trading.\1025\ The language of the final compensation 
requirement has been modified in response to comments expressing 
concern about the proposed language regarding ``proprietary risk-
taking.'' \1026\ The Agencies note that the Agencies do not intend to 
preclude an employee of a market-making desk from being compensated for 
successful market making, which involves some risk-taking.
---------------------------------------------------------------------------

    \1025\ See final rule Sec.  ----.4(b)(2)(v).
    \1026\ See Morgan Stanley; SIFMA et al. (Prop. Trading) (Feb. 
2012).
---------------------------------------------------------------------------

    The Agencies continue to hold the view that activities for which a 
banking entity has established a compensation incentive structure that 
rewards speculation in, and appreciation of, the market value of a 
position held in inventory, rather than use of that inventory to 
successfully provide effective and timely intermediation and liquidity 
services to customers, are inconsistent with permitted market making-
related activities. Although a banking entity relying on the market-
making exemption may appropriately take into account revenues resulting 
from movements in the price of principal positions to the extent that 
such revenues reflect the effectiveness with which personnel have 
managed retained principal risk, a banking entity relying on the 
market-making exemption should provide compensation incentives that 
primarily reward customer revenues and effective customer service, not 
prohibited proprietary trading.\1027\ For example, a compensation plan 
based purely on net profit and loss with no consideration for inventory 
control or risk undertaken to achieve those profits would not be 
consistent with the market-making exemption.
---------------------------------------------------------------------------

    \1027\ Because the Agencies are not limiting a market maker's 
compensation to specific sources, such as fees, commissions, and 
bid-ask spreads, as recommended by a few commenters, the Agencies do 
not believe the compensation requirement in the final rule will 
incentivize market makers to widen their quoted spreads or charge 
higher fees and commissions, as suggested by certain other 
commenters. See Better Markets (Feb. 2012); Public Citizen; 
AllianceBernstein; Investure. In addition, the Agencies note that an 
approach requiring revenue from fees, commissions, and bid-ask 
spreads to be fully distinguished from revenue from price 
appreciation can raise certain practical difficulties, as discussed 
in Part IV.A.3.c.7. The Agencies also are not requiring compensation 
to be vested for a period of time, as recommended by some commenters 
to reduce traders' incentives for undue risk-taking. The Agencies 
believe the final rule includes sufficient controls around risk-
taking activity without a compensation vesting requirement. See John 
Reed; AFR et al. (Feb. 2012); Johnson & Prof. Stiglitz; Prof. 
Duffie; Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------

6. Registration Requirement
a. Proposed Registration Requirement
    Under Sec.  ----.4(b)(2)(iv) of the proposed rule, a banking entity 
relying on the market-making exemption with respect to trading in 
securities or certain derivatives would be required to be appropriately 
registered as a securities dealer, swap dealer, or security-based swap 
dealer, or exempt from registration or excluded from regulation as such 
type of dealer, under applicable securities or commodities laws. 
Further, if the banking entity was engaged in the business of a 
securities dealer, swap dealer, or security-based swap dealer outside 
the United States in a manner for which no U.S. registration is 
required, the banking entity would be required to be subject to 
substantive regulation of its dealing business in the jurisdiction in 
which the business is located.\1028\
---------------------------------------------------------------------------

    \1028\ See proposed rule Sec.  ----.4(b)(2)(iv); Joint Proposal, 
76 FR 68,872; CFTC Proposal, 77 FR 8357-8358.
---------------------------------------------------------------------------

b. Comments on the Proposed Registration Requirement
    A few commenters stated that the proposed dealer registration 
requirement is effective.\1029\ However, a number of commenters opposed 
the proposed dealer registration requirement in whole or in part.\1030\ 
Commenters' primary concern with the requirement appeared to be its 
application to market making-related activities outside of the United 
States for which no U.S. registration is required.\1031\ For example, 
several commenters stated that many non-U.S. markets do not provide 
substantive regulation of dealers for all asset classes.\1032\ In 
addition, two

[[Page 5620]]

commenters stated that booking entities may be able to rely on intra-
group exemptions under local law rather than carrying dealer 
registrations, or a banking entity may execute customer trades through 
an international dealer but book the position in a non-dealer entity 
for capital adequacy and risk management purposes.\1033\ Several of 
these commenters requested, at a minimum, that the dealer registration 
requirement not apply to dealers in non-U.S. jurisdictions.\1034\
---------------------------------------------------------------------------

    \1029\ See Occupy; Alfred Brock.
    \1030\ See SIFMA et al. (Prop. Trading) (Feb. 2012) (stating 
that if the requirement is not removed from the rule, then it should 
only be an indicative factor of market making); Morgan Stanley; 
Goldman (Prop. Trading); ISDA (Feb. 2012).
    \1031\ See Goldman (Prop. Trading); Morgan Stanley; RBC; SIFMA 
et al. (Prop. Trading) (Feb. 2012); ISDA (Feb. 2012); JPMC. This 
issue is addressed in note 1044 and its accompanying text, infra.
    \1032\ See Goldman (Prop. Trading); RBC; SIFMA et al. (Prop. 
Trading) (Feb. 2012).
    \1033\ See JPMC; Goldman (Prop. Trading).
    \1034\ See Goldman (Prop. Trading); RBC; SIFMA et al. (Prop. 
Trading) (Feb. 2012). See also Morgan Stanley (requesting the 
addition of the phrase ``to the extent it is legally required to be 
subject to such regulation'' to the non-U.S. dealer provisions).
---------------------------------------------------------------------------

    In addition, with respect to the provisions that would generally 
require a banking entity to be a form of SEC- or CFTC-registered dealer 
for market-making activities in securities or derivatives in the United 
States, a few commenters stated that these provisions should be removed 
from the rule.\1035\ These commenters represented that removing these 
provisions would be appropriate for several reasons. For example, one 
commenter stated that dealer registration does not help distinguish 
between market making and speculative trading.\1036\ Another commenter 
indicated that effective market making often requires a banking entity 
to trade on several exchange and platforms in a variety of markets, 
including through legal entities other than SEC- or CFTC-registered 
dealer entities.\1037\ One commenter expressed general concern that the 
proposed requirement may result in the market-making exemption being 
unavailable for market making in exchange-traded futures and options 
because those markets do not have a corollary to dealer registration 
requirements in securities, swaps, and security-based swaps 
markets.\1038\
---------------------------------------------------------------------------

    \1035\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman 
(Prop. Trading); Morgan Stanley; ISDA (Feb. 2012). Rather than 
remove the requirement entirely, one commenter recommended that the 
Agencies move the dealer registration requirement to proposed 
Appendix B, which would allow the Agencies to take into account the 
facts and circumstances of a particular trading activity. See JPMC.
    \1036\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1037\ See Goldman (Prop. Trading).
    \1038\ See CME Group.
---------------------------------------------------------------------------

    Some commenters expressed particular concern about the provisions 
that would generally require registration as a swap dealer or a 
security-based swap dealer.\1039\ For example, one commenter expressed 
concern that these provisions may require banking regulators to 
redundantly enforce CFTC and SEC registration requirements. Moreover, 
according to this commenter, the proposed definitions of ``swap 
dealer'' and ``security-based swap dealer'' do not focus on the market 
making core of the swap dealing business.\1040\ Another commenter 
stated that incorporating the proposed definitions of ``swap dealer'' 
and ``security-based swap dealer'' is contrary to the Administrative 
Procedure Act.\1041\
---------------------------------------------------------------------------

    \1039\ See ISDA (Feb. 2012); SIFMA et al. (Prop. Trading) (Feb. 
2012).
    \1040\ See ISDA (Feb. 2012).
    \1041\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------

c. Final Registration Requirement
    The final requirement of the market-making exemption provides that 
the banking entity must be licensed or registered to engage in market 
making-related activity in accordance with applicable law.\1042\ The 
Agencies have considered comments regarding the dealer registration 
requirement in the proposed rule.\1043\ In response to comments, the 
Agencies have narrowed the scope of the proposed requirement's 
application to banking entities engaged in market making-related 
activity in foreign jurisdictions.\1044\ Rather than requiring these 
banking entities to be subject to substantive regulation of their 
dealing business in the relevant foreign jurisdiction, the final rule 
only require a banking entity to be a registered dealer in a foreign 
jurisdiction to the extent required by applicable foreign law. The 
Agencies have also simplified the language of the proposed requirement, 
although the Agencies have not modified the scope of the requirement 
with respect to U.S. dealer registration requirements.
---------------------------------------------------------------------------

    \1042\ See final rule Sec.  ----.4(b)(2)(vi).
    \1043\ See supra Part IV.A.3.c.5.b. One commenter expressed 
concern that the instruments listed in Sec.  ----.4(b)(2)(iv) of the 
proposed rule could be interpreted as limiting the availability of 
the market-making exemption to other instruments, such as exchange-
traded futures and options. In response to this comment, the 
Agencies note that the reference to particular instruments in Sec.  
----.4(b)(2)(iv) was intended to reflect that trading in certain 
types of instruments gives rise to dealer registration requirements. 
This provision was not intended to limit the availability of the 
market-making exemption to certain types of financial instruments. 
See CME Group.
    \1044\ See Goldman (Prop. Trading); RBC; SIFMA et al. (Prop. 
Trading) (Feb. 2012); Morgan Stanley.
---------------------------------------------------------------------------

    This provision is not intended to expand the scope of licensing or 
registration requirements under relevant U.S. or foreign law that are 
applicable to a banking entity engaged in market-making activities. 
Instead, this provision recognizes that compliance with applicable law 
is an essential indicator that a banking entity is engaged in market-
making activities.\1045\ For example, a U.S. banking entity would be 
expected to be an SEC-registered dealer to rely on the market-making 
exemption for trading in securities--other than exempted securities, 
security-based swaps, commercial paper, bankers acceptances, or 
commercial bills--unless the banking entity is exempt from registration 
or excluded from regulation as a dealer.\1046\ Similarly, a U.S. 
banking entity is expected to be a CFTC-registered swap dealer or SEC-
registered security-based swap dealer to rely on the market-making 
exemption for trading in swaps or security-based swaps, 
respectively,\1047\ unless the banking entity is exempt from 
registration or excluded from regulation as a swap dealer or security-
based swap dealer.\1048\ In response to comments on whether this 
provision should generally require registration as a swap dealer or 
security-based swap dealer to make a market in swaps or security-based 
swaps,\1049\ the Agencies continue to

[[Page 5621]]

believe that this requirement is appropriate. In general, a person that 
is engaged in making a market in swaps or security-based swaps or other 
activity causing oneself to be commonly known in the trade as a market 
maker in swaps or security-based swaps is required to be a registered 
swap dealer or registered security-based swap dealer, unless exempt 
from registration or excluded from regulation as such.\1050\ As noted 
above, compliance with applicable law is an essential indicator that a 
banking entity is engaged in market-making activities.
---------------------------------------------------------------------------

    \1045\ In response to commenters who stated that the dealer 
registration requirement should be removed from the rule because, 
among other things, registration as a dealer does not distinguish 
between permitted market making and impermissible proprietary 
trading, the Agencies recognize that acting as a registered dealer 
does not ensure that a banking entity is engaged in permitted market 
making-related activity. See SIFMA et al. (Prop. Trading) (Feb. 
2012); Goldman (Prop. Trading); Morgan Stanley; ISDA (Feb. 2012). 
However, this requirement recognizes that registration as a dealer 
is an indicator of market making-related activities in the 
circumstances in which a person is legally obligated to be a 
registered dealer to act as a market maker.
    \1046\ A banking entity relying on the market-making exemption 
for transactions in security-based swaps would generally be required 
to be a registered security-based swap dealer and would not be 
required to be a registered securities dealer. However, a banking 
entity may be required to be a registered securities dealer if it 
engages in market-making transactions involving security-based swaps 
with persons that are not eligible contract participants. The 
definition of ``dealer'' in section 3(a)(5) of the Exchange Act 
generally includes ``any person engaged in the business of buying 
and selling securities (not including security-based swaps, other 
than security-based swaps with or for persons that are not eligible 
contract participants), for such person's own account.'' 15 U.S.C. 
78c(a)(5).
    To the extent, if any, that a banking entity relies on the 
market-making exemption for its trading in municipal securities or 
government securities, rather than the exemption in Sec.  ----.6(a) 
of the final rule, this provision may require the banking entity to 
be registered or licensed as a municipal securities dealer or 
government securities dealer.
    \1047\ As noted above, under certain circumstances, a banking 
entity acting as market maker in security-based swaps may be 
required to be a registered securities dealer. See supra note 1046.
    \1048\ For example, a banking entity meeting the conditions of 
the de minimis exception in SEC Rule 3a71-2 under the Exchange Act 
would not need to be a registered security-based swap dealer to act 
as a market maker in security-based swaps. See 17 CFR 240.3a71-2.
    \1049\ See ISDA (Feb. 2012); SIFMA et al. (Prop. Trading) (Feb. 
2012).
    \1050\ See 7 U.S.C. 1a(49)(A); 15 U.S.C. 78c(a)(71)(A).
---------------------------------------------------------------------------

    As noted above, the Agencies have determined that, rather than 
require a banking entity engaged in the business of a securities 
dealer, swap dealer, or security-based swap dealer outside the United 
States to be subject to substantive regulation of its dealing business 
in the foreign jurisdiction in which the business is located, a banking 
entity's dealing activity outside the U.S. should only be subject to 
licensing or registration requirements under applicable foreign law 
(provided no U.S. registration or licensing requirements apply to the 
banking entity's activities). As a result, this requirement will not 
impact a banking entity's ability to engage in permitted market making-
related activities in a foreign jurisdiction that does not provide for 
substantive regulation of dealers.\1051\
---------------------------------------------------------------------------

    \1051\ See Goldman (Prop. Trading); RBC; SIFMA et al. (Prop. 
Trading) (Feb. 2012); Morgan Stanley. This is consistent with one 
commenter's suggestion that the Agencies add ``to the extent it is 
legally required to be subject to such regulation'' to the non-U.S. 
dealer provisions. See Morgan Stanley.
---------------------------------------------------------------------------

7. Source of Revenue Analysis
a. Proposed Source of Revenue Requirement
    To qualify for the market-making exemption, the proposed rule 
required that the market making-related activities of the trading desk 
or other organizational unit be designed to generate revenues primarily 
from fees, commissions, bid/ask spreads or other income not 
attributable to appreciation in the value of financial instrument 
positions it holds in trading accounts or the hedging of such 
positions.\1052\ This proposed requirement was intended to ensure that 
activities conducted in reliance on the market-making exemption 
demonstrate patterns of revenue generation and profitability consistent 
with, and related to, the intermediation and liquidity services a 
market maker provides to its customers, rather than changes in the 
market value of the positions or risks held in inventory.\1053\
---------------------------------------------------------------------------

    \1052\ See proposed rule Sec.  ----.4(b)(2)(v).
    \1053\ See Joint Proposal, 76 FR 68,872; CFTC Proposal, 77 FR 
8358.
---------------------------------------------------------------------------

b. Comments Regarding the Proposed Source of Revenue Requirement
    As discussed in more detail below, many commenters expressed 
concern about the proposed source of revenue requirement. These 
commenters raised a number of concerns including, among others, the 
proposed requirement's potential impact on a market maker's inventory 
or on costs to customers, the difficulty of differentiating revenues 
from spreads and revenues from price appreciation in certain markets, 
and the need for market makers to be compensated for providing 
intermediation services.\1054\ Several of these commenters requested 
that the proposed source of revenue requirement be removed from the 
rule or modified in certain ways. Some commenters, however, expressed 
support for the proposed requirement or requested that the Agencies 
place greater restrictions on a banking entity's permissible sources of 
revenue under the market-making exemption.\1055\
---------------------------------------------------------------------------

    \1054\ These concerns are addressed in Part IV.A.3.c.7.c., 
infra.
    \1055\ See infra note 1103 (responding to these comments).
---------------------------------------------------------------------------

i. Potential Restrictions on Inventory, Increased Costs for Customers, 
and Other Changes to Market-Making Services
    Many commenters stated that the proposed source of revenue 
requirement may limit a market maker's ability to hold sufficient 
inventory to facilitate customer demand.\1056\ Several of these 
commenters expressed particular concern about applying this requirement 
to less liquid markets or to facilitating large customer positions, 
where a market maker is more likely to hold inventory for a longer 
period of time and has increased risk of potential price appreciation 
(or depreciation).\1057\ Further, another commenter questioned how the 
proposed requirement would apply when unforeseen market pressure or 
disappearance of customer demand results in a market maker holding a 
particular position in inventory for longer than expected.\1058\ In 
response to this proposed requirement, a few commenters stated that it 
is important for market makers to be able to hold a certain amount of 
inventory to: Provide liquidity (particularly in the face of order 
imbalances and market volatility),\1059\ facilitate large trades, and 
hedge positions acquired in the course of market making.\1060\
---------------------------------------------------------------------------

    \1056\ See, e.g., NYSE Euronext; SIFMA et al. (Prop. Trading) 
(Feb. 2012); Morgan Stanley; Goldman (Prop. Trading); BoA; Citigroup 
(Feb. 2012); STANY; BlackRock; SIFMA (Asset Mgmt.) (Feb. 2012); ACLI 
(Feb. 2012); T. Rowe Price; PUC Texas; SSgA (Feb. 2012); ICI (Feb. 
2012) Invesco; MetLife; MFA.
    \1057\ See, e.g., Morgan Stanley; BoA; BlackRock; T. Rowe Price; 
Goldman (Prop. Trading); NYSE Euronext (suggesting that principal 
trading by market makers in large sizes is essential in some 
securities, such as an AP's trading in ETFs); Prof. Duffie; SSgA 
(Feb. 2012); CIEBA; SIFMA et al. (Prop. Trading) (Feb. 2012); MFA. 
To explain its concern, one commenter stated that bid-ask spreads 
are useful to capture the concept of market-making revenues when a 
market maker is intermediating on a close to real-time basis between 
balanced customer buying and selling interest for the same 
instrument, but such close-in-time intermediation does not occur in 
many large or illiquid assets, where demand gaps may be present for 
days, weeks, or months. See Morgan Stanley.
    \1058\ See Capital Group.
    \1059\ See NYSE Euronext; CIEBA (stating that if the rule 
discourages market makers from holding inventory, there will be 
reduced liquidity for investors and issuers).
    \1060\ See NYSE Euronext. For a more in-depth discussion of 
comments regarding the benefits of permitting market makers to hold 
and manage inventory, See Part IV.A.3.c.2.b.vi., infra.
---------------------------------------------------------------------------

    Several commenters expressed concern that the proposed source of 
revenue requirement may incentivize a market maker to widen its quoted 
spreads or otherwise impose higher fees to the detriment of its 
customers.\1061\ For example, some commenters stated that the proposed 
requirement could result in a market maker having to sell a position in 
its inventory within an artificially prescribed period of time and, as 
a result, the market maker would pay less to initially acquire the 
position from a customer.\1062\ Other commenters represented that the 
proposed source of revenue requirement would compel market makers to 
hedge their exposure to price movements, which would likely increase 
the cost of intermediation.\1063\
---------------------------------------------------------------------------

    \1061\ See, e.g., Wellington; CIEBA; MetLife; ACLI (Feb. 2012); 
SSgA (Feb. 2012); PUC Texas; ICI (Feb. 2012) BoA.
    \1062\ See MetLife; ACLI (Feb. 2012); ICI (Feb. 2012) SSgA (Feb. 
2012).
    \1063\ See SSgA (Feb. 2012); PUC Texas.
---------------------------------------------------------------------------

    Some commenters stated that the proposed source of revenue 
requirement may make a banking entity less willing to make markets in 
instruments that it may not be able to resell immediately or in the 
short term.\1064\ One commenter indicated that this concern may be 
heightened in times of market stress.\1065\ Further, a few commenters 
expressed the view that the proposed requirement would cause banking 
entities to exit the

[[Page 5622]]

market-making business due to restrictions on their ability to make a 
profit from market-making activities.\1066\ Moreover, in one 
commenter's opinion, the proposed requirement would effectively compel 
market makers to trade on an agency basis.\1067\
---------------------------------------------------------------------------

    \1064\ See ICI (Feb. 2012) SSgA (Feb. 2012); SIFMA (Asset Mgmt.) 
(Feb. 2012); BoA.
    \1065\ See CIEBA (arguing that banking entities may be reluctant 
to provide liquidity when markets are declining and there are more 
sellers than buyers because it would be necessary to hold positions 
in inventory to avoid losses).
    \1066\ See Credit Suisse (Seidel) (arguing that banking entities 
are likely to cease being market makers if they are: (i) Unable to 
take into account the likely direction of a financial instrument, or 
(ii) forced to take losses if a financial instrument moves against 
them, but cannot take gains if the instrument's price moves in their 
favor); STANY (contending that banking entities cannot afford to 
maintain unprofitable or marginally profitable operations in highly 
competitive markets, so this requirement would cause banking 
entities to eliminate a majority of their market-making functions).
    \1067\ See IR&M (arguing that domestic corporate and securitized 
credit markets are too large and heterogeneous to be served 
appropriately by a primarily agency-based trading model).
---------------------------------------------------------------------------

ii. Certain Price Appreciation-Related Profits Are an Inevitable or 
Important Component of Market Making
    A number of commenters indicated that market makers will inevitably 
make some profit from price appreciation of certain inventory positions 
because changes in market values cannot be precisely predicted or 
hedged.\1068\ In particular, several commenters emphasized that matched 
or perfect hedges are generally unavailable for most types of 
positions.\1069\ According to one commenter, a provision that 
effectively requires a market-making business to hedge all of its 
principal positions would discourage essential market-making activity. 
The commenter explained that effective hedges may be unavailable in 
less liquid markets and hedging can be costly, especially in relation 
to the relative risk of a trade and hedge effectiveness.\1070\ A few 
commenters further indicated that making some profit from price 
appreciation is a natural part of market making or is necessary to 
compensate a market maker for its willingness to take a position, and 
its associated risk (e.g., the risk of market changes or decreased 
value), from a customer.\1071\
---------------------------------------------------------------------------

    \1068\ See Wellington; Credit Suisse (Seidel); Morgan Stanley; 
PUC Texas (contending that it is impossible to predict the behavior 
of even the most highly correlated hedge in comparison to the 
underlying position); CIEBA; SSgA (Feb. 2012); AllianceBernstein; 
Investure; Invesco.
    \1069\ See Morgan Stanley; Credit Suisse (Seidel); SSgA (Feb. 
2012); PUC Texas; Wellington; AllianceBernstein; Investure.
    \1070\ See Wellington. Moreover, one commenter stated that, as a 
general matter, market makers need to be compensated for bearing 
risk related to providing immediacy to a customer. This commenter 
stated that ``[t]he greater the inventory risk faced by the market 
maker, the higher the expected return (compensation) that the market 
maker needs,'' to compensate the market maker for bearing the risk 
and reward its specialization skills in that market (e.g., its 
knowledge about market conditions and early indicators that may 
imply future price movements in a particular direction). This 
commenter did not, however, discuss the source of revenue 
requirement in the proposed rule. See Thakor Study.
    \1071\ See Capital Group; Prof. Duffie; Investure; SIFMA et al. 
(Prop. Trading) (Feb. 2012); STANY; SIFMA (Asset Mgmt.) (Feb. 2012); 
RBC; PNC.
---------------------------------------------------------------------------

iii. Concerns Regarding the Workability of the Proposed Standard in 
Certain Markets or Asset Classes
    Some commenters represented that it would be difficult or 
burdensome to identify revenue attributable to the bid-ask spread 
versus revenue arising from price appreciation, either as a general 
matter or for specific markets.\1072\ For example, one commenter 
expressed the opinion that the difference between the bid-ask spread 
and price appreciation is ``metaphysical'' in some sense,\1073\ while 
another stated that it is almost impossible to objectively identify a 
bid-ask spread or to capture profit and loss solely from a bid-ask 
spread in most markets.\1074\ Other commenters represented that it is 
particularly difficult to make this distinction when trades occur 
infrequently or where prices are not transparent, such as in the fixed-
income market where no spread is published.\1075\
---------------------------------------------------------------------------

    \1072\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); 
Goldman (Prop. Trading); BoA; Citigroup (Feb. 2012); Japanese 
Bankers Ass'n.; Sumitomo Trust; Morgan Stanley; Barclays; RBC; 
Capital Group.
    \1073\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1074\ See Citigroup (Feb. 2012). See also Barclays (arguing 
that a bid-ask spread cannot be defined on a consistent basis with 
respect to many instruments).
    \1075\ See Goldman (Prop. Trading); BoA; Morgan Stanley 
(``Observable, actionable, bid/ask spreads exist in only a small 
subset of institutional products and markets. Indicative bid/ask 
spreads may be observable for certain products, but this pricing 
would typically be specific to small size standard lot trades and 
would not represent a spread applicable to larger and/or more 
illiquid trades. End-of-day valuations for assets are calculated, 
but they are not an effective proxy for real-time bid/ask spreads 
because of intra-day price movements.''); RBC; Capital Group 
(arguing that bid-ask spreads in fixed-income markets are not always 
quantifiable or well defined and can fluctuate widely within a 
trading day because of small or odd lot trades, price discovery 
activity, a lack of availability to cover shorts, or external 
factors not directly related to the security being traded).
---------------------------------------------------------------------------

    Many commenters expressed particular concern about the proposed 
requirement's application to specific markets, including: The fixed-
income markets; \1076\ the markets for commodities, derivatives, 
securitized products, and emerging market securities; \1077\ equity and 
physical commodity derivatives markets; \1078\ and customized swaps 
used by customers of banking entities for hedging purposes.\1079\ 
Another commenter expressed general concern about extremely volatile 
markets, where market makers often see large upward or downward price 
swings over time.\1080\
---------------------------------------------------------------------------

    \1076\ See Capital Group; CIEBA; SIFMA et al. (Prop. Trading) 
(Feb. 2012); SSgA (Feb. 2012). These commenters stated that the 
requirement may be problematic for the fixed-income markets because, 
for example, market makers must hold inventory in these markets for 
a longer period of time than in more liquid markets. See id.
    \1077\ See SIFMA et al. (Prop. Trading) (Feb. 2012) (stating 
that these markets are characterized by even less liquidity and less 
frequent trading than the U.S. corporate bond market). This 
commenter also stated that in markets where trades are large and 
less frequent, such as the market for customized securitized 
products, appreciation in price of one position may be a predominate 
contributor to the overall profit and loss of the trading unit. See 
id.
    \1078\ See BoA. According to this commenter, the distinction 
between capturing a spread and price appreciation is fundamentally 
flawed in some markets, like equity derivatives, because the market 
does not trade based on movements of a particular security or 
underlying instrument. This commenter indicated that expected 
returns are instead based on the bid-ask spread the market maker 
charges for implied volatility as reflected in options premiums and 
hedging of the positions. See id.
    \1079\ See CIEBA (stating that because it would be difficult for 
a market maker to enter promptly into an offsetting swap, the market 
maker would not be able to generate income from the spread).
    \1080\ See SIFMA et al. (Prop. Trading) (Feb. 2012). This 
commenter questioned whether proposed Appendix B's reference to 
``unexpected market disruptions'' as an explanatory fact and 
circumstance was intended to permit such market making. See id.
---------------------------------------------------------------------------

    Two commenters emphasized that the revenues a market maker 
generates from hedging the positions it holds in inventory are 
equivalent to spreads in many markets. These commenters explained that, 
under these circumstances, a market maker generates revenue from the 
difference between the customer price for the position and the banking 
entity's price for the hedge. The commenters noted that proposed 
Appendix B expressly recognizes this in the case of derivatives and 
recommended that Appendix B's guidance on this point apply equally to 
certain non-derivative positions.\1081\
---------------------------------------------------------------------------

    \1081\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman 
(Prop. Trading). In its discussion of ``customer revenues,'' 
Appendix B states: ``In the case of a derivative contract, these 
revenues reflect the difference between the cost of entering into 
the derivative contract and the cost of hedging incremental, 
residual risks arising from the contract.'' Joint Proposal, 76 FR 
68,960; CFTC Proposal, 77 FR 8440. See also RBC (requesting 
clarification on how the proposed standard would apply if a market 
maker took an offsetting position in a different instrument (e.g., a 
different bond) and inquiring whether, if the trader took the 
offsetting position, its revenue gain is attributable to price 
appreciation of the two offsetting positions or from the bid-ask 
spread in the respective bonds).
---------------------------------------------------------------------------

    A few commenters questioned how this requirement would work in the 
context of block trading or otherwise facilitating large trades, where 
a market maker may charge a premium or discount for taking on a large 
position

[[Page 5623]]

to provide ``immediacy'' to its customer.\1082\ One commenter further 
explained that explicitly quoted bid-ask spreads are only valid for 
indicated trade sizes that are modest enough to have negligible market 
impact, and such spreads cannot be used for purposes of a significantly 
larger trade.\1083\
---------------------------------------------------------------------------

    \1082\ See Prof. Duffie; NYSE Euronext; Capital Group; RBC; 
Goldman (Prop. Trading). See also Thakor Study (discussing market 
makers' role of providing ``immediacy'' in general).
    \1083\ See CIEBA.
---------------------------------------------------------------------------

iv. Suggested Modifications to the Proposed Requirement
    To address some or all of the concerns discussed above, many 
commenters recommended that the source of revenue requirement be 
modified \1084\ or removed from the rule entirely.\1085\ With respect 
to suggested changes, some commenters stated that the Agencies should 
modify the rule text,\1086\ use a metrics-based approach to focus on 
customer revenues,\1087\ or replace the proposed requirement with 
guidance.\1088\ Some commenters requested that the Agencies modify the 
focus of the requirement so that, for example, dealers' market-making 
activities in illiquid securities can function as close to normal as 
possible \1089\ or market makers can take short-term positions that may 
ultimately result in a profit or loss.\1090\ As discussed below, some 
commenters stated that the Agencies should modify the proposed 
requirement to place greater restrictions on market maker revenue.
---------------------------------------------------------------------------

    \1084\ See, e.g., JPMC; Barclays; Goldman (Prop. Trading); BoA; 
CFA Inst.; ICI (Feb. 2012) Flynn & Fusselman.
    \1085\ See, e.g., CIEBA; SIFMA et al. (Prop. Trading) (Feb. 
2012); Morgan Stanley; Goldman (Prop. Trading); Capital Group; RBC. 
In addition to the concerns discussed above, one commenter stated 
that the proposed requirement may set limits on the values of 
certain metrics, and it would be inappropriate to prejudge the 
appropriate results of such metrics at this time. See SIFMA et al. 
(Prop. Trading) (Feb. 2012).
    \1086\ See, e.g., Barclays. This commenter provided alternative 
rule text stating that ``market making-related activity is conducted 
by each trading unit such that its activities are reasonably 
designed to generate revenues primarily from fees, commissions, bid-
ask spreads, or other income attributable to satisfying reasonably 
expected customer demand.'' See id.
    \1087\ See Goldman (Prop. Trading) (suggesting that the Agencies 
use a metrics-based approach to focus on customer revenues, as 
measured by Spread Profit and Loss (when it is feasible to 
calculate) or other metrics, especially because a proprietary 
trading desk would not be expected to earn any revenues this way). 
This commenter also indicated that the ``primarily'' standard in the 
proposed rule is problematic and can be read to mean ``more than 
50%,'' which is different from Appendix B's acknowledgment that the 
proportion of customer revenues relative to total revenues will vary 
by asset class. See id.
    \1088\ See BoA (recommending that the guidance state that the 
Agencies would consider the design and mix of such revenues as an 
indicator of potentially prohibited proprietary trading, but only 
for those markets for which revenues are quantifiable based on 
publicly available data, such as segments of certain highly liquid 
equity markets).
    \1089\ See CFA Inst.
    \1090\ See ICI (Feb. 2012).
---------------------------------------------------------------------------

v. General Support for the Proposed Requirement or for Placing Greater 
Restrictions on a Market Maker's Sources of Revenue
    Some commenters expressed support for the proposed source of 
revenue requirement or stated that the requirement should be more 
restrictive.\1091\ For example, one of these commenters stated that a 
real market maker's trading book should be fully hedged, so it should 
not generate profits in excess of fees and commissions except in times 
of rare and extraordinary market conditions.\1092\ According to another 
commenter, the final rule should make it clear that banking entities 
seeking to rely on the market-making exemption may not generally seek 
to profit from price movements in their inventories, although their 
activities may give rise to modest and relatively stable profits 
arising from their limited inventory.\1093\ One commenter recommended 
that the proposed requirement be interpreted to limit market making in 
illiquid positions because a banking entity cannot have the required 
revenue motivation when it enters into a position for which there is no 
readily discernible exit price.\1094\
---------------------------------------------------------------------------

    \1091\ See Sens. Merkley & Levin (Feb. 2012); Better Markets 
(Feb. 2012); FTN; Public Citizen; Occupy; Alfred Brock.
    \1092\ See Better Markets (Feb. 2012). See also Public Citizen 
(arguing that the imperfection of a hedge should signal potential 
disqualification of the underlying position from the market-making 
exemption).
    \1093\ See Sens. Merkley & Levin (Feb. 2012). This commenter 
further suggested that the rule identify certain red flags and 
metrics that could be used to monitor this requirement, such as: (i) 
Failure to obtain relatively low ratios of revenue-to-risk, low 
volatility, and relatively high turnover; (ii) significant revenues 
from price appreciation relative to the value of securities being 
traded; (iii) volatile revenues from price appreciation; or (iv) 
revenue from price appreciation growing out of proportion to the 
risk undertaken with the security. See id.
    \1094\ See AFR et al. (Feb. 2012).
---------------------------------------------------------------------------

    Further, some commenters suggested that the Agencies remove the 
word ``primarily'' from the provision to limit banking entities to 
specified sources of revenue.\1095\ In addition, one of these 
commenters requested that the Agencies restrict a market maker's 
revenue to fees and commissions and remove the allowance for revenue 
from bid-ask spreads because generating bid-ask revenues relies 
exclusively on changes in market values of positions held in 
inventory.\1096\ For enforcement purposes, a few commenters suggested 
that the Agencies require banking entities to disgorge any profit 
obtained from price appreciation.\1097\
---------------------------------------------------------------------------

    \1095\ See Occupy; Better Markets (Feb. 2012). See supra note 
1103 (addressing these comments).
    \1096\ See Occupy.
    \1097\ See Occupy; Public Citizen.
---------------------------------------------------------------------------

c. Final Rule's Approach to Assessing Revenues
    Unlike the proposed rule, the final rule does not include a 
requirement that a trading desk's market making-related activity be 
designed to generate revenue primarily from fees, commissions, bid-ask 
spreads, or other income not attributable to appreciation in the value 
of a financial instrument or hedging.\1098\ The revenue requirement was 
one of the most commented upon aspects of the market-making exemption 
in the proposal.\1099\
---------------------------------------------------------------------------

    \1098\ See proposed rule Sec.  ----.4(b)(2)(v).
    \1099\ See infra Part IV.A.3.c.7.b.
---------------------------------------------------------------------------

    The Agencies believe that an analysis of patterns of revenue 
generation and profitability can help inform a judgment regarding 
whether trading activity is consistent with the intermediation and 
liquidity services that a market maker provides to its customers in the 
context of the liquidity, maturity, and depth of the relevant market, 
as opposed to prohibited proprietary trading activities. To facilitate 
this type of analysis, the Agencies have included a metrics data 
reporting requirement that is refined from the proposed metric 
regarding profits and losses. The Comprehensive Profit and Loss 
Attribution metric collects information regarding the daily fluctuation 
in the value of a trading desk's positions to various sources, along 
with its volatility, including: (i) Profit and loss attributable to 
current positions that were also held by the banking entity as of the 
end of the prior day (``existing positions); (ii) profit and loss 
attributable to new positions resulting from the current day's trading 
activity (``new positions''); and (iii) residual profit and loss that 
cannot be specifically attributed to existing positions or new 
positions.\1100\
---------------------------------------------------------------------------

    \1100\ See Appendix A of the final rule (describing the 
Comprehensive Profit and Loss Attribution metric). This approach is 
generally consistent with one commenter's suggested metrics-based 
approach to focus on customer-related revenues. See Goldman (Prop. 
Trading); See also Sens. Merkley & Levin (Feb. 2012) (suggesting the 
use of metrics to monitor a firm's source of revenue); proposed 
Appendix A.
---------------------------------------------------------------------------

    This quantitative measurement has certain conceptual similarities 
to the proposed source of revenue requirement in Sec.  ----.4(b)(2)(v) 
of the proposed rule

[[Page 5624]]

and certain of the proposed quantitative measurements.\1101\ However, 
in response to comments on those provisions, the Agencies have 
determined to modify the focus from particular revenue sources (e.g., 
fees, commissions, bid-ask spreads, and price appreciation) to when the 
trading desk generates revenue from its positions. The Agencies 
recognize that when the trading desk is engaged in market making-
related activities, the day one profit and loss component of the 
Comprehensive Profit and Loss Attribution metric may reflect customer-
generated revenues, like fees, commissions, and spreads (including 
embedded premiums or discounts), as well as that day's changes in 
market value. Thereafter, profit and loss associated with the position 
carried in the trading desk's book may reflect changes in market price 
until the position is sold or unwound. The Agencies also recognize that 
the metric contains a residual component for profit and loss that 
cannot be specifically attributed to existing positions or new 
positions.
---------------------------------------------------------------------------

    \1101\ See supra Part IV.A.3.c.7. and infra Part IV.C.3.
---------------------------------------------------------------------------

    The Agencies believe that evaluation of the Comprehensive Profit 
and Loss Attribution metric could provide valuable information 
regarding patterns of revenue generation by market-making trading desks 
involved in market-making activities that may warrant further review of 
the desk's activities, while eliminating the requirement from the 
proposal that the trading desk demonstrate that its primary source of 
revenue, under all circumstances, is fees, commissions and bid/ask 
spreads. This modified focus will reduce the burden associated with the 
proposed source of revenue requirement and better account for the 
varying depth and liquidity of markets.\1102\ In addition, the Agencies 
believe these modifications appropriately address commenters' concerns 
about the proposed source of revenue requirement and reduce the 
potential for negative market impacts of the proposed requirement cited 
by commenters, such as incentives to widen spreads or disincentives to 
engage in market making in less liquid markets.\1103\
---------------------------------------------------------------------------

    \1102\ The Agencies understand that some commenters interpreted 
the proposed requirement as requiring that both the bid-ask spread 
for a financial instrument and the revenue a market maker acquired 
from such bid-ask spread through a customer trade be identifiable on 
a close-to-real-time basis and readily distinguishable from any 
additional revenue gained from price appreciation (both on the day 
of the transaction and for the rest of the holding period). See, 
e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop. 
Trading); BoA; Citigroup (Feb. 2012); Japanese Bankers Ass'n.; 
Sumitomo Trust; Morgan Stanley; Barclays; RBC; Capital Group. We 
recognize that such a requirement would be unduly burdensome. In 
fact, the proposal noted that bid-ask spreads or similar spreads may 
not be widely disseminated on a consistent basis or otherwise 
reasonably ascertainable in certain asset classes for purposes of 
the proposed Spread Profit and Loss metric in Appendix A of the 
proposal. See Joint Proposal, 76 FR 68,958-68,959; CFTC Proposal, 77 
FR 8438. Moreover, the burden associated with the proposed 
requirement should be further reduced because we are not adopting a 
stand-alone requirement regarding a trading desk's source of 
revenue. Instead, when and how a trading desk generates profit and 
loss from its trading activities is a factor that must be considered 
for purposes of the near term customer demand requirement. It is not 
a dispositive factor for determining compliance with the exemption.
    Further, some commenters expressed concern that the proposed 
requirement suggested market makers were not permitted to profit 
from price appreciation, but rather only from observable spreads or 
explicit fees or commissions. See, e.g., Wellington, Credit Suisse 
(Seidel); Morgan Stanley; PUC Texas; CIEBA; SSgA (Feb. 2012); 
AllianceBernstein; Investure; Invesco. The Agencies confirm that the 
intent of the market-making exemption is not to preclude a trading 
desk from generating any revenue from price appreciation. Because 
this approach clarifies that a trading desk's source of revenue is 
not limited to its quoted spread, the Agencies believe this 
quantitative measurement will address commenters concerns that the 
proposed source of revenue requirement could create incentives for 
market makers to widen their spreads, result in higher transaction 
costs, require market makers to hedge any exposure to price 
movements, or discourage a trading desk from making a market in 
instruments that it may not be able to sell immediately. See 
Wellington; CIEBA; MetLife; ACLI (Feb. 2012); SSgA (Feb. 2012); PUC 
Texas; ICI (Feb. 2012) BoA; SIFMA (Asset Mgmt.) (Feb. 2012). The 
modifications to this provision are designed to better reflect when, 
on average and across many transactions, profits are gained rather 
than how they are gained, similar to the way some firms measure 
their profit and loss today. See, e.g., Goldman (Prop. Trading).
    \1103\ See, e.g., Wellington; CIEBA; MetLife; ACLI (Feb. 2012); 
SSgA (Feb. 2012); PUC Texas; ICI (Feb. 2012) BoA. The Agencies are 
not adopting an approach that limits a market maker to specified 
revenue sources (e.g., fees, commissions, and spreads), as suggested 
by some commenters, due to the considerations discussed above. See 
Occupy; Better Markets (Feb. 2012). In response to the proposed 
source of revenue requirement, some commenters noted that a market 
maker may charge a premium or discount for taking on a large 
position from a customer. See Prof. Duffie; NYSE Euronext; Capital 
Group; RBC; Goldman (Prop. Trading).
---------------------------------------------------------------------------

    The Agencies recognize that this analysis is only informative over 
time, and should not be determinative of an analysis of whether the 
amount, types, and risks of the financial instruments in the trading 
desk's market-maker inventory are designed not to exceed the reasonably 
expected near term demands of clients, customers, or counterparties. 
The Agencies believe this quantitative measurement provides appropriate 
flexibility to obtain information on market-maker revenues, which is 
designed to address commenters' concerns about the proposal's source of 
revenue requirement (e.g., the burdens associated with differentiating 
spread revenue from price appreciation revenue) while also helping 
assess patterns of revenue generation that may be informative over time 
about whether a market maker's activities are designed to facilitate 
and provide customer intermediation.
8. Appendix B of the Proposed Rule
a. Proposed Appendix B Requirement
    The proposed market-making exemption would have required that the 
market making-related activities of the trading desk or other 
organizational unit of the banking entity be consistent with the 
commentary in proposed Appendix B.\1104\ In this proposed Appendix, the 
Agencies provided overviews of permitted market making-related activity 
and prohibited proprietary trading activity.\1105\
---------------------------------------------------------------------------

    \1104\ See proposed rule Sec.  ----.4(b)(2)(vi).
    \1105\ See Joint Proposal, 76 FR 68,873, 68,960-68,961; CFTC 
Proposal, 77 FR 8358, 8439-8440.
---------------------------------------------------------------------------

    The proposed Appendix also set forth various factors that the 
Agencies proposed to use to help distinguish prohibited proprietary 
trading from permitted market making-related activity. More 
specifically, proposed Appendix B set forth six factors that, absent 
explanatory facts and circumstances, would cause particular trading 
activity to be considered prohibited proprietary trading activity and 
not permitted market making-related activity. The proposed factors 
focused on: (i) Retaining risk in excess of the size and type required 
to provide intermediation services to customers (``risk management 
factor''); (ii) primarily generating revenues from price movements of 
retained principal positions and risks, rather than customer revenues 
(``source of revenues factor''); (iii) generating only very small or 
very large amounts of revenue per unit of risk, not demonstrating 
consistent profitability, or demonstrating high earnings volatility 
(``revenues relative to risk factor''); (iv) not trading through a 
trading system that interacts with orders of others or primarily with 
customers of the banking entity's market-making desk to provide 
liquidity services, or retaining principal positions in excess of 
reasonably expected near term customer demands (``customer-facing 
activity factor''); (v) routinely paying rather than earning fees, 
commissions, or spreads (``payment of fees, commissions, and spreads 
factor''); and (vi) providing compensation incentives to employees that 
primarily reward proprietary risk-

[[Page 5625]]

taking (``compensation incentives factor'').\1106\
---------------------------------------------------------------------------

    \1106\ See Joint Proposal, 76 FR 68,873, 68,961-68,963; CFTC 
Proposal, 77 FR 8358, 8440-8442.
---------------------------------------------------------------------------

b. Comments on Proposed Appendix B
    Commenters expressed differing views about the accuracy of the 
commentary in proposed Appendix B and the appropriateness of including 
such commentary in the rule. For example, some commenters stated that 
the description of market making-related activity in the proposed 
appendix is accurate \1107\ or appropriately accounts for differences 
among asset classes.\1108\ Other commenters indicated that the appendix 
is too strict or narrow.\1109\ Some commenters recommended that the 
Agencies revise proposed Appendix B's approach by, for example, placing 
greater focus on what market making is rather than what it is 
not,\1110\ providing presumptions of activity that will be treated as 
permitted market making-related activity,\1111\ re-formulating the 
appendix as nonbinding guidance,\1112\ or moving certain requirements 
of the proposed exemption to the appendix.\1113\ One commenter 
suggested the Agencies remove Appendix B from the rule and instead use 
the conformance period to analyze and develop a body of supervisory 
guidance that appropriately characterizes the nature of market making-
related activity.\1114\
---------------------------------------------------------------------------

    \1107\ See MetLife; ACLI (Feb. 2012).
    \1108\ See Alfred Brock. But See, e.g., Occupy (stating that the 
proposed commentary only accounts for the most liquid and 
transparent markets and fails to accurately describe market making 
in most illiquid or OTC markets).
    \1109\ See Morgan Stanley; IIF; Sumitomo Trust; ISDA (Apr. 
2012); BDA (Feb. 2012) (Oct. 2012) (stating that proposed Appendix B 
places too great of a focus on derivatives trading and does not 
reflect how principal trading operations in equity and fixed income 
markets are structured). One of these commenters requested that the 
appendix be modified to account for certain activities conducted in 
connection with market making in swaps. This commenter indicated 
that a swap dealer may not regularly enjoy a dominant flow of 
customer revenues and may consistently need to make revenue from its 
book management. In addition, the commenter stated that the appendix 
should recognize that making a two-way market may be a dominant 
theme, but there are certain to be frequent occasions when, as a 
matter of market or internal circumstances, a market maker is 
unavailable to trade. See ISDA (Apr. 2012).
    \1110\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1111\ See Sens. Merkley & Levin (Feb. 2012). This commenter 
stated that, for example, Appendix B could deem market making 
involving widely-traded stocks and bonds issued by well-established 
corporations, government securities, or highly liquid asset-backed 
securities as the type of plain vanilla, low risk capital activities 
that are presumptively permitted, provided the activity is within 
certain, specified parameters for inventory levels, revenue-to-risk 
metrics, volatility, and hedging. See id.
    \1112\ See Morgan Stanley; Flynn & Fusselman.
    \1113\ See JPMC. In support of such an approach, the commenter 
argued that sometimes proposed Sec.  ----.4(b) and Appendix B 
addressed the same topic and, when this occurs, it is unclear 
whether compliance with Appendix B constitutes compliance with Sec.  
----.4(b) or if additional compliance steps are required. See id.
    \1114\ See Morgan Stanley.
---------------------------------------------------------------------------

    A few commenters expressed concern about the appendix's facts-and-
circumstances-based approach to distinguishing between prohibited 
proprietary trading and permitted market making-related activity and 
stated that such an approach will make it more difficult or burdensome 
for banking entities to comply with the proposed rule \1115\ or will 
generate regulatory uncertainty.\1116\ As discussed below, other 
commenters opposed proposed Appendix B because of its level of 
granularity \1117\ or due to perceived restrictions on interdealer 
trading or generating revenue from retained principal positions or 
risks in the proposed appendix.\1118\ A number of commenters expressed 
concern about the complexity or prescriptiveness of the six proposed 
factors for distinguishing permitted market making-related activity 
from prohibited proprietary trading.\1119\
---------------------------------------------------------------------------

    \1115\ See NYSE Euronext; Morgan Stanley.
    \1116\ See IAA.
    \1117\ See Wellington; Goldman (Prop. Trading); SIFMA (Asset 
Mgmt.) (Feb. 2012).
    \1118\ See Morgan Stanley; Chamber (Feb. 2012); Goldman (Prop. 
Trading).
    \1119\ See Japanese Bankers Ass'n.; Credit Suisse (Seidel); 
Chamber (Feb. 2012); ICFR; Morgan Stanley; Goldman (Prop. Trading); 
Occupy; Oliver Wyman (Feb. 2012); Oliver Wyman (Dec. 2011); Public 
Citizen; NYSE Euronext. But See Alfred Brock (stating that the 
proposed factors are effective).
---------------------------------------------------------------------------

    With respect to the level of granularity of proposed Appendix B, a 
number of commenters expressed concern that the reference to a ``single 
significant transaction'' indicated that the Agencies will review 
compliance with the proposed market-making exemption on a trade-by-
trade basis and stated that assessing compliance at the level of 
individual transactions would be unworkable.\1120\ One of these 
commenters further stated that assessing compliance at this level of 
granularity would reduce a market maker's willingness to execute a 
customer sell order as principal due to concern that the market maker 
may not be able to immediately resell such position. The commenter 
noted that this chilling effect would be heightened in declining 
markets.\1121\
---------------------------------------------------------------------------

    \1120\ See Wellington; Goldman (Prop. Trading); SIFMA (Asset 
Mgmt.) (Feb. 2012). In particular, proposed Appendix B provided that 
``The particular types of trading activity described in this 
appendix may involve the aggregate trading activities of a single 
trading unit, a significant number or series of transactions 
occurring at one or more trading units, or a single significant 
transaction, among other potential scenarios.'' Joint Proposal, 76 
FR 68,961; CFTC Proposal, 77 FR 8441. The Agencies address 
commenters' trade-by-trade concerns in Part IV.A.3.c.1.c.ii., infra.
    \1121\ See Goldman (Prop. Trading).
---------------------------------------------------------------------------

    A few commenters interpreted certain statements in proposed 
Appendix B as limiting interdealer trading and expressed concerns 
regarding potential limitations on this activity.\1122\ These 
commenters emphasized that market makers may need to trade with non-
customers to: (i) Provide liquidity to other dealers and, indirectly, 
their customers, or to otherwise allow customers to access a larger 
pool of liquidity; \1123\ (ii) conduct price discovery to inform the 
prices a market maker can offer to customers; \1124\ (iii) unwind or 
sell positions acquired from customers; \1125\ (iv) establish or 
acquire positions to meet reasonably expected near term customer 
demand; \1126\ (v) hedge; \1127\ and (vi) sell a financial instrument 
when there are more buyers than sellers for the instrument at that 
time.\1128\ Further, one of these commenters expressed the view that 
the proposed appendix's statements are inconsistent with the statutory 
market-making exemption's reference to ``counterparties.'' \1129\
---------------------------------------------------------------------------

    \1122\ See Morgan Stanley; Goldman (Prop. Trading); Chamber 
(Feb. 2012). Specifically, commenters cited statements in proposed 
Appendix B indicating that market makers ``typically only engage in 
transactions with non-customers to the extent that these 
transactions directly facilitate or support customer transactions.'' 
On this issue, the appendix further stated that ``a market maker 
generally only transacts with non-customers to the extent necessary 
to hedge or otherwise manage the risks of its market making-related 
activities, including managing its risk with respect to movements of 
the price of retained principal positions and risks, to acquire 
positions in amounts consistent with reasonably expected near term 
demand of its customers, or to sell positions acquired from its 
customers.'' The appendix recognized, however, that the 
``appropriate proportion of a market maker's transactions that are 
with customers versus non-customers varies depending on the type of 
positions involved and the extent to which the positions are 
typically hedged in non-customer transactions.'' Joint Proposal, 76 
FR 68,961; CFTC Proposal, 77 FR 8440. Commenters' concerns regarding 
interdealer trading are addressed in Part IV.A.3.c.2.c.i., infra.
    \1123\ See Morgan Stanley; Goldman (Prop. Trading).
    \1124\ See Morgan Stanley; Goldman (Prop. Trading); Chamber 
(Feb. 2012).
    \1125\ See Morgan Stanley; Chamber (Feb. 2012) (stating that 
market makers in the corporate bond, interest rate derivative, and 
natural gas derivative markets frequently trade with other dealers 
to work down a concentrated position originating with a customer 
trade).
    \1126\ See Morgan Stanley; Chamber (Feb. 2012).
    \1127\ See Goldman (Prop. Trading).
    \1128\ See Chamber (Feb. 2012).
    \1129\ See Goldman (Prop. Trading).

---------------------------------------------------------------------------

[[Page 5626]]

    In addition, a few commenters expressed concern about statements in 
proposed Appendix B about a market maker's source of revenue.\1130\ 
According to one commenter, the statement that profit and loss 
generated by inventory appreciation or depreciation must be 
``incidental'' to customer revenues is inconsistent with market making-
related activity in less liquid assets and larger transactions because 
market makers often must retain principal positions for longer periods 
of time in such circumstances and are unable to perfectly hedge these 
positions.\1131\ As discussed above with respect to the source of 
revenue requirement in Sec.  ----.4(b)(v) of the proposed rule, a few 
commenters requested that Appendix B's discussion of ``customer 
revenues'' be modified to state that revenues from hedging will be 
considered to be customer revenues in certain contexts beyond 
derivatives contracts.\1132\
---------------------------------------------------------------------------

    \1130\ See Morgan Stanley; SIFMA et al. (Prop. Trading) (Feb. 
2012); Goldman (Prop. Trading). On this issue, Appendix B stated 
that certain types of ``customer revenues'' provide the primary 
source of a market maker's profitability and, while a market maker 
also incurs losses or generates profits as price movements occur in 
its retained principal positions and risks, ``such losses or profits 
are incidental to customer revenues and significantly limited by the 
banking entity's hedging activities.'' Joint Proposal, 76 FR 68,960; 
CFTC Proposal, 77 FR 8440. The Agencies address commenters' concerns 
about proposed requirements regarding a market maker's source of 
revenue in Part IV.A.3.c.7.c., infra.
    \1131\ See Morgan Stanley.
    \1132\ See supra note 1081 and accompanying text.
---------------------------------------------------------------------------

    A number of commenters discussed the six proposed factors in 
Appendix B that, absent explanatory facts and circumstances, would have 
caused a particular trading activity to be considered prohibited 
proprietary trading activity and not permitted market making-related 
activity.\1133\ With respect to the proposed factors, one commenter 
indicated that they are appropriate,\1134\ while another commenter 
stated that they are complex and their effectiveness is 
uncertain.\1135\ Another commenter expressed the view that ``[w]hile 
each of the selected factors provides evidence of `proprietary 
trading,' warrants regulatory attention, and justifies a shift in the 
burden of proof, some require subjective judgments, are subject to 
gaming or data manipulation, and invite excessive reliance on 
circumstantial evidence and lawyers' opinions.'' \1136\
---------------------------------------------------------------------------

    \1133\ See supra note 1106 and accompanying text.
    \1134\ See Alfred Brock.
    \1135\ See Japanese Bankers Ass'n.
    \1136\ Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------

    In response to the proposed risk management factor,\1137\ one 
commenter expressed concern that it could prevent a market maker from 
warehousing positions in anticipation of predictable but unrealized 
customer demands and, further, could penalize a market maker that 
misestimated expected demand. This commenter expressed the view that 
such an outcome would be contrary to the statute and would harm market 
liquidity.\1138\ Another commenter requested that this presumption be 
removed because in less liquid markets, such as markets for corporate 
bonds, equity derivatives, securitized products, emerging markets, 
foreign exchange forwards, and fund-linked products, a market maker 
needs to act as principal to facilitate client requests and, as a 
result, will be exposed to risk.\1139\
---------------------------------------------------------------------------

    \1137\ The proposed appendix stated that the Agencies would use 
certain quantitative measurements required in proposed Appendix A to 
help assess the extent to which a trading unit's risks are 
potentially being retained in excess amounts, including VaR, Stress 
VaR, VaR Exceedance, and Risk Factor Sensitivities. See Joint 
Proposal, 76 FR 68,961-68,962; CFTC Proposal, 77 FR 8441. One 
commenter questioned whether, assuming such metrics are effective 
and the activity does not exceed the banking entity's expressed risk 
appetite, it is necessary to place greater restrictions on risk-
taking, based on the Agencies' judgment of the level of risk 
necessary for bona fide market making. See ICFR.
    \1138\ See Chamber (Feb. 2012).
    \1139\ See Credit Suisse (Seidel).
---------------------------------------------------------------------------

    Two commenters expressed concern about the proposed source of 
revenue factor.\1140\ One commenter stated that this factor does not 
accurately reflect how market making occurs in a majority of markets 
and asset classes.\1141\ The other commenter expressed concern that 
this factor shifted the emphasis of Sec.  ----.4(b)(v) of the proposed 
rule, which required that market making-related activities be 
``designed'' to generate revenue primarily from certain sources, to the 
actual outcome of activities.\1142\
---------------------------------------------------------------------------

    \1140\ See Goldman (Prop. Trading); Morgan Stanley.
    \1141\ See Morgan Stanley.
    \1142\ See Goldman (Prop. Trading). This commenter suggested 
that the Agencies remove any negative presumptions based on revenues 
and instead use revenue metrics, such as Spread Profit and Loss 
(when it is feasible to calculate) or other metrics for purposes of 
monitoring a banking entity's trading activity. See id.
---------------------------------------------------------------------------

    With respect to the proposed revenues relative to risk factor, one 
commenter supported this aspect of the proposal.\1143\ Some commenters, 
however, expressed concern about using these factors to differentiate 
permitted market making-related activity from prohibited proprietary 
trading.\1144\ These commenters stated that volatile risk-taking and 
revenue can be a natural result of principal market-making 
activity.\1145\ One commenter noted that customer flows are often 
``lumpy'' due to, for example, a market maker's facilitation of large 
trades.\1146\
---------------------------------------------------------------------------

    \1143\ See Occupy (stating that these factors are important and 
will provide invaluable information about the nature of the banking 
entity's trading activity).
    \1144\ See Morgan Stanley; Credit Suisse (Seidel); Oliver Wyman 
(Feb. 2012); Oliver Wyman (Dec. 2011).
    \1145\ See Morgan Stanley; Credit Suisse (Seidel); Oliver Wyman 
(Feb. 2012); Oliver Wyman (Dec. 2011). For example, one commenter 
stated that because markets and trading volumes are volatile, 
consistent profitability and low earnings volatility are outside a 
market maker's control. In support of this statement, the commenter 
indicated that: (i) customer trading activity varies significantly 
with market conditions, which results in volatility in a market 
maker's earnings and profitability; and (ii) a market maker will 
experience volatility associated with changes in the value of its 
inventory positions, and principal risk is a necessary feature of 
market making. See Morgan Stanley.
    \1146\ See Oliver Wyman (Feb. 2012); Oliver Wyman (Dec. 2011).
---------------------------------------------------------------------------

    A few commenters indicated that the analysis in the proposed 
customer-facing activity factor may not accurately reflect how market 
making occurs in certain markets and asset classes due to potential 
limitations on interdealer trading.\1147\ According to another 
commenter, however, a banking entity's non-customer facing trades 
should be required to be matched with existing customer 
counterparties.\1148\ With respect to the near term customer demand 
component of this factor, one commenter expressed concern that it goes 
farther than the statute's activity-based ``design'' test by analyzing 
whether a trading unit's inventory has exceeded reasonably expected 
near term customer demand at any particular point in time.\1149\
---------------------------------------------------------------------------

    \1147\ See Morgan Stanley; Goldman (Prop. Trading).
    \1148\ See Public Citizen.
    \1149\ See Oliver Wyman (Feb. 2012).
---------------------------------------------------------------------------

    Some commenters expressed concern about the payment of fees, 
commissions, and spreads factor.\1150\ One commenter appeared to 
support this proposed factor.\1151\ According to one commenter, this 
factor fails to recognize that market makers routinely pay a variety of 
fees in connection with their market making-related activity, 
including, for example, fees to access liquidity on another market to 
satisfy customer demand, transaction fees as a matter of course, and 
fees in connection with hedging transactions. This commenter also 
indicated that, because spreads in current, rapidly-moving markets are 
volatile, short-term measurements of profit compared to spread revenue 
is problematic, particularly for less liquid

[[Page 5627]]

stocks.\1152\ Another commenter stated that this factor reflects a bias 
toward agency trading and principal market making in highly liquid, 
exchange-traded markets and does not reflect the nature of principal 
market making in most markets.\1153\ One commenter recommended that the 
rule require that a trader who pays a fee be prepared to document the 
chain of custody to show that the instrument is shortly re-sold to an 
interested customer.\1154\
---------------------------------------------------------------------------

    \1150\ See NYSE Euronext; Morgan Stanley.
    \1151\ See Public Citizen.
    \1152\ See NYSE Euronext.
    \1153\ See Morgan Stanley.
    \1154\ See Public Citizen.
---------------------------------------------------------------------------

    Regarding the proposed compensation incentives factor, one 
commenter requested that the Agencies make clear that explanatory facts 
and circumstances cannot justify a trading unit providing compensation 
incentives that primarily reward proprietary risk-taking to employees 
engaged in market making. In addition, the commenter recommended that 
the Agencies delete the word ``primarily'' from this factor.\1155\
---------------------------------------------------------------------------

    \1155\ See Occupy. This commenter also stated that the 
commentary in Appendix B stating that a banking entity may give some 
consideration of profitable hedging activities in determining 
compensation would provide inappropriate incentives. See id.
---------------------------------------------------------------------------

c. Determination To Not Adopt Proposed Appendix B
    To improve clarity, the final rule establishes particular criteria 
for the exemption and does not incorporate the commentary in proposed 
Appendix B regarding the identification of permitted market making-
related activities. This SUPPLEMENTARY INFORMATION provides guidance on 
the standards for compliance with the market-making exemption.
9. Use of Quantitative Measurements
    Consistent with the FSOC study and the proposal, the Agencies 
continue to believe that quantitative measurements can be useful to 
banking entities and the Agencies to help assess the profile of a 
trading desk's trading activity and to help identify trading activity 
that may warrant a more in-depth review.\1156\ The Agencies will not 
use quantitative measurements as a dispositive tool for differentiating 
between permitted market making-related activities and prohibited 
proprietary trading. Like the framework the Agencies have developed for 
the market-making exemption, the Agencies recognize that there may be 
differences in the quantitative measurements across markets and asset 
classes.
---------------------------------------------------------------------------

    \1156\ See infra Part IV.C.3.; final rule Appendix A.
---------------------------------------------------------------------------

4. Section ----.5: Permitted Risk-Mitigating Hedging Activities
    Section ----.5 of the proposed rule implemented section 13(d)(1)(C) 
of the BHC Act, which provides an exemption from the prohibition on 
proprietary trading for certain risk-mitigating hedging 
activities.\1157\ Section 13(d)(1)(C) provides an exemption for risk-
mitigating hedging activities in connection with and related to 
individual or aggregated positions, contracts, or other holdings of a 
banking entity that are designed to reduce the specific risks to the 
banking entity in connection with and related to such positions, 
contracts, or other holdings (the ``hedging exemption''). Section --
--.5 of the final rule implements the hedging exemption with a number 
of modifications from the proposed rule to respond to commenters' 
concerns as described more fully below.
---------------------------------------------------------------------------

    \1157\ See 12 U.S.C. 1851(d)(1)(C); proposed rule Sec.  ----.5.
---------------------------------------------------------------------------

a. Summary of Proposal's Approach to Implementing the Hedging Exemption
    The proposed rule would have required seven criteria to be met in 
order for a banking entity's activity to qualify for the hedging 
exemption. First, Sec. Sec.  ----.5(b)(1) and ----.5(b)(2)(i) of the 
proposed rule generally required that the banking entity establish an 
internal compliance program that is designed to ensure the banking 
entity's compliance with the requirements of the hedging limitations, 
including reasonably designed written policies and procedures, internal 
controls, and independent testing, and that a transaction for which the 
banking entity is relying on the hedging exemption be made in 
accordance with the compliance program established under Sec.  --
--.5(b)(1). Next, Sec.  ----.5(b)(2)(ii) of the proposed rule required 
that the transaction hedge or otherwise mitigate one or more specific 
risks, including market risk, counterparty or other credit risk, 
currency or foreign exchange risk, interest rate risk, basis risk, or 
similar risks, arising in connection with and related to individual or 
aggregated positions, contracts, or other holdings of the banking 
entity. Moreover, Sec.  ----.5(b)(2)(iii) of the proposed rule required 
that the transaction be reasonably correlated, based upon the facts and 
circumstances of the underlying and hedging positions and the risks and 
liquidity of those positions, to the risk or risks the transaction is 
intended to hedge or otherwise mitigate. Furthermore, Sec.  --
--.5(b)(2)(iv) of the proposed rule required that the hedging 
transaction not give rise, at the inception of the hedge, to 
significant exposures that are not themselves hedged in a 
contemporaneous transaction. Section ----.5(b)(2)(v) of the proposed 
rule required that any hedge position established in reliance on the 
hedging exemption be subject to continuing review, monitoring and 
management. Finally, Sec.  ----.5(b)(2)(vi) of the proposed rule 
required that the compensation arrangements of persons performing the 
risk-mitigating hedging activities be designed not to reward 
proprietary risk-taking. Additionally, Sec.  ----.5(c) of the proposed 
rule required the banking entity to document certain hedging 
transactions at the time the hedge is established.
b. Manner of Evaluating Compliance With the Hedging Exemption
    A number of commenters expressed concern that the final rule 
required application of the hedging exemption on a trade-by-trade 
basis.\1158\ One commenter argued that the text of the proposed rule 
seemed to require a trade-by-trade analysis because each ``purchase or 
sale'' or ``hedge'' was subject to the requirements.\1159\ The final 
rule modifies the proposal by generally replacing references to a 
``purchase or sale'' in the Sec.  ----.5(b) requirements with ``risk-
mitigating hedging activity.'' The Agencies believe this approach is 
consistent with the statute, which refers to ``risk-mitigating hedging 
activity.'' \1160\
---------------------------------------------------------------------------

    \1158\ See Ass'n. of Institutional Investors (Feb. 2012); See 
also Barclays; ICI (Feb. 2012); Investure; MetLife; RBC; SIFMA et 
al. (Prop. Trading) (Feb. 2012); SIFMA (Asset Mgmt.) (Feb. 2012); 
Morgan Stanley; Fixed Income Forum/Credit Roundtable; Fidelity; FTN.
    \1159\ See Barclays.
    \1160\ See 12 U.S.C. 1851(d)(1)(C) (stating that ``risk-
mitigating hedging activities'' are permitted under certain 
circumstances).
---------------------------------------------------------------------------

    Section 13(d)(1)(C) of the BHC Act specifically authorizes risk-
mitigating hedging activities in connection with and related to 
``individual or aggregated positions, contracts or other holdings.'' 
\1161\ Thus, the statute does not require that exempt hedging be 
conducted on a trade-by-trade basis, and permits hedging of aggregated 
positions. The Agencies recognized this in the proposed rule, and the 
final rule continues to permit hedging activities in connection with 
and related to individual or aggregated positions.
---------------------------------------------------------------------------

    \1161\ See 12 U.S.C. 1851(d)(1)(C).
---------------------------------------------------------------------------

    The statute also requires that, to be exempt under section 
13(d)(1)(C), hedging activities be risk-mitigating. The final rule 
incorporates this statutory requirement. As explained in more detail 
below, the final rule requires that, in order to qualify for the 
exemption for

[[Page 5628]]

risk-mitigating hedging activities: The banking entity implement, 
maintain, and enforce an internal compliance program, including 
policies and procedures that govern and control these hedging 
activities; the hedging activity be designed to reduce or otherwise 
significantly mitigate and demonstrably reduces or otherwise 
significantly mitigates specific, identifiable risks; the hedging 
activity not give rise to significant new risks that are left unhedged; 
the hedging activity be subject to continuing review, monitoring and 
management to address risk that might develop over time; and the 
compensation arrangements for persons performing risk-mitigating 
hedging activities be designed not to reward or incentivize prohibited 
proprietary trading. These requirements are designed to focus the 
exemption on hedging activities that are designed to reduce risk and 
that also demonstrably reduce risk, in accordance with the requirement 
under section 13(d)(1)(C) that hedging activities be risk-mitigating to 
be exempt. Additionally, the final rule imposes a documentation 
requirement on certain types of hedges.
    Consistent with the other exemptions from the ban on proprietary 
trading for market-making and underwriting, the Agencies intend to 
evaluate whether an activity complies with the hedging exemption under 
the final rule based on the totality of circumstances involving the 
products, techniques, and strategies used by a banking entity as part 
of its hedging activity.\1162\
---------------------------------------------------------------------------

    \1162\ See Part IV.A.4.b., infra.
---------------------------------------------------------------------------

c. Comments on the Proposed Rule and Approach to Implementing the 
Hedging Exemption
    Commenters expressed a variety of views on the proposal's hedging 
exemption. A few commenters offered specific suggestions described more 
fully below regarding how, in their view, the hedging exemption should 
be strengthened to ensure proper oversight of hedging activities.\1163\ 
These commenters expressed concern that the proposal's exemption was 
too broad and argued that all proprietary trading could be designated 
as a hedge under the proposal and thereby evade the prohibition of 
section 13.\1164\
---------------------------------------------------------------------------

    \1163\ See, e.g., AFR et al. (Feb. 2012); AFR (June 2013); 
Better Markets (Feb. 2012); Sens. Merkley & Levin (Feb. 2012).
    \1164\ See, e.g., Occupy.
---------------------------------------------------------------------------

    By contrast, a number of other commenters argued that the proposal 
imposed burdensome requirements that were not required by statute, 
would limit the ability of banking entities to hedge in a prudent and 
cost-effective manner, and would reduce market liquidity.\1165\ These 
commenters argued that implementation of the requirements of the 
proposal would decrease safety and soundness of banking entities and 
the financial system by reducing cost-effective risk management 
options. Some commenters emphasized that the ability of banking 
entities to hedge their positions and manage risks taken in connection 
with their permissible activities is a critical element of liquid and 
efficient markets, and that the cumulative impact of the proposal would 
inhibit this risk-mitigation by raising transaction costs and 
suppressing essential and beneficial hedging activities.\1166\
---------------------------------------------------------------------------

    \1165\ See, e.g., Australian Bankers' Ass'n (Feb. 2012); BoA; 
Barclays; Credit Suisse (Seidel); Goldman (Prop. Trading); HSBC; ICI 
(Feb. 2012); Japanese Bankers Ass'n.; JPMC; Morgan Stanley; Chamber 
(Feb. 2012); Wells Fargo (Prop. Trading); Rep. Bachus et al.; RBC; 
SIFMA et al. (Prop. Trading) (Feb. 2012); See also Stephen Roach.
    \1166\ See Credit Suisse (Seidel); ICI (Feb. 2012); Wells Fargo 
(Prop. Trading); See also Banco de M[eacute]xico; SIFMA et al. 
(Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); BoA.
---------------------------------------------------------------------------

    A number of commenters expressed concern that the proposal's 
hedging exemption did not permit the full breadth of transactions in 
which banking entities engage to hedge or mitigate risks, such as 
portfolio hedging,\1167\ dynamic hedging,\1168\ anticipatory 
hedging,\1169\ or scenario hedging.\1170\ Some commenters stated that 
restrictions on a banking entity's ability to hedge may have a chilling 
effect on its willingness to engage in other permitted activities, such 
as market making.\1171\ In addition, many of these commenters stated 
that, if a banking entity is limited in its ability to hedge its 
market-making inventory, it may be less willing or able to assume risk 
on behalf of customers or provide financial products to customers that 
are used for hedging purposes. As a result, according to these 
commenters, it will be more difficult for customers to hedge their 
risks and customers may be forced to retain risk.\1172\
---------------------------------------------------------------------------

    \1167\ See MetLife; SIFMA et al. (Prop. Trading) (Feb. 2012); 
Morgan Stanley; Barclays; Goldman (Prop. Trading); BoA; ABA; HSBC; 
Fixed Income Forum/Credit Roundtable; ICI (Feb. 2012); ISDA (Feb. 
2012).
    \1168\ See Goldman (Prop. Trading); BoA.
    \1169\ See Barclays; State Street (Feb. 2012); SIFMA et al. 
(Prop. Trading) (Feb. 2012); Japanese Bankers Ass'n.; Credit Suisse 
(Seidel); BoA; PNC et al.; ISDA (Feb. 2012).
    \1170\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; 
Goldman (Prop. Trading); BoA; Comm. on Capital Markets Regulation. 
Each of these types of activities is discussed further below. See 
infra Part IV.A.4.d.2.
    \1171\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit 
Suisse (Seidel); Barclays; Goldman (Prop. Trading); BoA.
    \1172\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman 
(Prop. Trading); Credit Suisse (Seidel).
---------------------------------------------------------------------------

    Another commenter contended that the proposal represented an 
inappropriate ``one-size-fits-all'' approach to hedging that did not 
properly take into account the way banking entities and especially 
market intermediaries operate, particularly in less-liquid 
markets.\1173\ Two commenters requested that the Agencies clarify that 
a banking entity may use its discretion to choose any hedging strategy 
that meets the requirements of the proposed exemption and, in 
particular, that a banking entity is not obligated to choose the ``best 
hedge'' and may use the cheapest instrument available.\1174\ One 
commenter suggested uncertainty about the permissibility of a situation 
where gains on a hedge position exceed losses on the underlying 
position. The commenter suggested that uncertainty may lead banking 
entities to not use the most cost-effective hedge, which would make 
hedging less efficient and raise costs for banking entities and 
customers.\1175\ However, another commenter expressed concern about 
banking entities relying on the cheapest satisfactory hedge. The 
commenter explained that such hedges lead to more complicated risk 
profiles and require banking entities to engage in additional 
transactions to hedge the exposures resulting from the imperfect, 
cheapest hedge.\1176\
---------------------------------------------------------------------------

    \1173\ See Barclays.
    \1174\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit 
Suisse (Seidel).
    \1175\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1176\ See Occupy.
---------------------------------------------------------------------------

    A few commenters suggested the hedging exemption be modified in 
favor of a simpler requirement that banking entities adopt risk limits 
and policies and procedures commensurate with qualitative guidance 
issued by the Agencies.\1177\ Many of these commenters also expressed 
concerns that the proposed rule's hedging exemption would not allow so-
called asset-liability management (``ALM'') activities.\1178\ Some 
commenters proposed that the risk-mitigating hedging exemption 
reference a set of relevant descriptive factors rather than

[[Page 5629]]

specific prescriptive requirements.\1179\ Other alternative frameworks 
suggested by commenters include: (i) Reformulating the proposed 
requirements as supervisory guidance; \1180\ (ii) establishing a safe 
harbor,\1181\ presumption of compliance,\1182\ or bright line test; 
\1183\ or (iii) a principles-based approach that would require a 
banking entity to document its risk-mitigating hedging strategies for 
submission to its regulator.\1184\
---------------------------------------------------------------------------

    \1177\ See BoA; Barclays; CH/ABASA; Credit Suisse (Seidel); 
HSBC; ICI (Feb. 2012); ISDA (Apr. 2012); JPMC; Morgan Stanley; PNC; 
SIFMA et al. (Prop. Trading) (Feb. 2012); See also Stephen Roach.
    \1178\ A detailed discussion of ALM activities is provided in 
Part IV.A.1.d.2 of this SUPPLEMENTARY INFORMATION relating to the 
definition of trading account. As explained in that part, the final 
rule does not allow use of the hedging exemption for ALM activities 
that are outside of the hedging activities specifically permitted by 
the final rule.
    \1179\ See BoA; JPMC; Morgan Stanley.
    \1180\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; PNC 
et al.; ICI.
    \1181\ See Prof. Richardson; ABA (Keating).
    \1182\ See Barclays; BoA; ISDA (Feb. 2012).
    \1183\ See Johnson & Prof. Stiglitz.
    \1184\ See HSBC.
---------------------------------------------------------------------------

d. Final Rule
    The final rule provides a multi-faceted approach to implementing 
the hedging exemption that seeks to ensure that hedging activity is 
designed to be risk-reducing in nature and not designed to mask 
prohibited proprietary trading.\1185\ The final rule includes a number 
of modifications in response to comments.
---------------------------------------------------------------------------

    \1185\ See final rule Sec.  ----.5.
---------------------------------------------------------------------------

    This multi-faceted approach is intended to permit hedging 
activities that are risk-mitigating and to limit potential abuse of the 
hedging exemption while not unduly constraining the important risk-
management function that is served by a banking entity's hedging 
activities. This approach is also intended to ensure that any banking 
entity relying on the hedging exemption has in place appropriate 
internal control processes to support its compliance with the terms of 
the exemption. While commenters proposed a number of alternative 
frameworks for the hedging exemption, the Agencies believe the final 
rule's multi-faceted approach most effectively balances commenter 
concerns with statutory purpose. In response to commenter requests to 
reformulate the proposed rule as supervisory guidance,\1186\ including 
the suggestion that the Agencies simply require banking entities to 
adopt risk limits and policies and procedures commensurate with 
qualitative Agency guidance,\1187\ the Agencies believe that such an 
approach would provide less clarity than the adopted approach. Although 
a purely guidance-based approach could provide greater flexibility, it 
would also provide less specificity, which could make it difficult for 
banking entity personnel and the Agencies to determine whether an 
activity complies with the rule and could lead to an increased risk of 
evasion of the statutory requirements. Further, while a bright-line or 
safe harbor approach to the hedging exemption would generally provide a 
high degree of certainty about whether an activity qualifies for the 
exemption, it would also provide less flexibility to recognize the 
differences in hedging activity across markets and asset classes.\1188\ 
In addition, the use of any bright-line approach would more likely be 
subject to gaming and avoidance as new products and types of trading 
activities are developed than other approaches to implementing the 
hedging exemption. Similarly, the Agencies decline to establish a 
presumption of compliance because, in light of the constant innovation 
of trading activities and the differences in hedging activity across 
markets and asset classes, establishing appropriate parameters for a 
presumption of compliance with the hedging exemption would potentially 
be less capable of recognizing these legitimate differences than our 
current approach.\1189\ Moreover, the Agencies decline to follow a 
principles-based approach requiring a banking entity to document its 
hedging strategies for submission to its regulator.\1190\ The Agencies 
believe that evaluating each banking entity's trading activity based on 
an individualized set of documented hedging strategies could be 
unnecessarily burdensome and result in unintended competitive impacts 
since banking entities would not be subject to one uniform rule. The 
Agencies believe the multi-faceted approach adopted in the final rule 
establishes a consistent framework applicable to all banking entities 
that will reduce the potential for such adverse impacts.
---------------------------------------------------------------------------

    \1186\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; PNC 
et al.; ICI (Feb. 2012); BoA; Morgan Stanley.
    \1187\ See BoA; Barclays; CH/ABASA; Credit Suisse (Seidel); 
HSBC; ICI (Feb. 2012); ISDA (Apr. 2012); JPMC; Morgan Stanley; PNC; 
SIFMA et al. (Prop. Trading) (Feb. 2012); See also Stephen Roach.
    \1188\ Some commenters requested that the Agencies establish a 
safe harbor. See Prof. Richardson; ABA (Keating). One commenter 
requested that the Agencies adopt a bright-line test. See Johnson & 
Prof. Stiglitz.
    \1189\ A few commenters requested that the Agencies establish a 
presumption of compliance. See Barclays; BoA; ISDA (Feb. 2012).
    \1190\ One commenter suggested this principles-based approach. 
See HSBC.
---------------------------------------------------------------------------

    Further, the Agencies believe the scope of the final hedging 
exemption is appropriate because it permits risk-mitigating hedging 
activities, as mandated by section 13 of the BHC Act,\1191\ while 
requiring a robust compliance program and other internal controls to 
help ensure that only genuine risk-mitigating hedges can be used in 
reliance on the exemption.\1192\ In response to concerns that the 
proposed hedging exemption would reduce legitimate hedging activity and 
thus impact market liquidity and the banking entity's willingness to 
engage in permissible customer-related activity,\1193\ the Agencies 
note that the requirements of the final hedging exemption are designed 
to permit banking entities to properly mitigate specific risk 
exposures, consistent with the statute. In addition, hedging related to 
market-making activity conducted by a market-making desk is subject to 
the requirements of the market-making exemption, which are designed to 
permit banking entities to continue providing valuable intermediation 
and liquidity services, including related risk-management 
activity.\1194\ Thus, the final hedging exemption will not negatively 
impact the safety and soundness of banking entities or the financial 
system or have a chilling effect on a banking entity's willingness to 
engage in other permitted activities, such as market making.\1195\
---------------------------------------------------------------------------

    \1191\ Section 13(d)(1)(C) of the BHC Act permits ``risk-
mitigating hedging activities in connection with and related to 
individual or aggregated positions, contracts, or other holdings of 
a banking entity that are designed to reduce the specific risks to 
the banking entity in connection with and related to such positions, 
contracts, or other holdings.'' 12 U.S.C. 1851(d)(1)(C).
    \1192\ Some commenters were concerned that the proposed hedging 
exemption was too broad and that all proprietary trading could be 
designated as a hedge. See, e.g., Occupy.
    \1193\ See, e.g., Australian Bankers Ass'n. (Feb. 2012).; BoA; 
Barclays; Credit Suisse (Seidel); Goldman (Prop. Trading); HSBC; 
Japanese Bankers Ass'n.; JPMC; Morgan Stanley; Chamber (Feb. 2012); 
Wells Fargo (Prop. Trading); Rep. Bachus et al.; RBC; SIFMA et al. 
(Prop. Trading) (Feb. 2012).
    \1194\ See supra Part IV.A.3.c.4.
    \1195\ Some commenters believed that restrictions on hedging 
would have a chilling effect on banking entities' willingness to 
engage in market making, and may result in customers experiencing 
difficulty in hedging their risks or force customers to retain risk. 
See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit Suisse 
(Seidel); Barclays; Goldman (Prop. Trading); BoA; IHS.
---------------------------------------------------------------------------

    These limits and requirements are designed to prevent the type of 
activity conducted by banking entities in the past that involved taking 
large positions using novel strategies to attempt to profit from 
potential effects of general economic or market developments and 
thereby potentially offset the general effects of those events on the 
revenues or profits of the banking entity. The documentation 
requirements in the final rule support these limits by identifying 
activity that occurs in reliance on the risk-mitigating hedging 
exemption at an organizational level or desk that is not responsible 
for establishing the risk or positions being hedged.

[[Page 5630]]

1. Compliance Program Requirement
    The first criterion of the proposed hedging exemption required a 
banking entity to establish an internal compliance program designed to 
ensure the banking entity's compliance with the requirements of the 
hedging exemption and conduct its hedging activities in compliance with 
that program. While the compliance program under the proposal was 
expected to be appropriate for the size, scope, and complexity of each 
banking entity's activities and structure, the proposal would have 
required each banking entity with significant trading activities to 
implement robust, detailed hedging policies and procedures and related 
internal controls and independent testing designed to prevent 
prohibited proprietary trading in the context of permitted hedging 
activity.\1196\ These enhanced programs for banking entities with large 
trading activity were expected to include written hedging policies at 
the trading unit level and clearly articulated trader mandates for each 
trader designed to ensure that hedging strategies mitigated risk and 
were not for the purpose of engaging in prohibited proprietary trading.
---------------------------------------------------------------------------

    \1196\ These aspects of the compliance program requirement are 
described in further detail in Part IV.C. of this SUPPLEMENTARY 
INFORMATION.
---------------------------------------------------------------------------

    Commenters, including industry groups, generally expressed support 
for requiring policies and procedures to monitor the safety and 
soundness, as well as appropriateness, of hedging activity.\1197\ Some 
of these commenters advocated that the final rule presume that a 
banking entity is in compliance with the hedging exemption if the 
banking entity's hedging activity is done in accordance with the 
written policies and procedures required under its compliance 
program.\1198\ One commenter represented that the proposed compliance 
framework was burdensome and complex.\1199\
---------------------------------------------------------------------------

    \1197\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1198\ See BoA; Barclays; HSBC; JPMC; Morgan Stanley; See also 
Goldman (Prop. Trading); RBC; Barclays; ICI (Feb. 2012); ISDA (Apr. 
2012); PNC; SIFMA et al. (Prop. Trading) (Feb. 2012). See the 
discussion of why the Agencies decline to take a presumption of 
compliance approach above.
    \1199\ See Barclays.
---------------------------------------------------------------------------

    Other commenters expressed concerns that the hedging exemption 
would be too limiting and burdensome for community and regional 
banks.\1200\ Some commenters argued that foreign banking entities 
should not be subject to the requirements of the hedging exemption for 
transactions that do not introduce risk into the U.S. financial 
system.\1201\ Other commenters stated that coordinated hedging through 
and by affiliates should qualify as permitted risk-mitigating hedging 
activity.\1202\
---------------------------------------------------------------------------

    \1200\ See ICBA; M&T Bank.
    \1201\ See, e.g., Bank of Canada; Allen & Overy (on behalf of 
Canadian Banks). Additionally, foreign banking entities engaged in 
hedging activity may be able to rely on the exemption for trading 
activity conducted by foreign banking entities in lieu of the 
hedging exemption, provided they meet the requirements of the 
exemption for trading by foreign banking entities under Sec.  --
--.6(e) of the final rule. See infra Part IV.A.8.
    \1202\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.
---------------------------------------------------------------------------

    Some commenters urged the Agencies to adopt detailed limitations on 
hedging activities. For example, one commenter urged that all hedging 
trades be labeled as such at the inception of the trade and detailed 
information regarding the trader, manager, and supervisor authorizing 
the trade be kept and reviewed.\1203\ Another commenter suggested that 
the hedging exemption contain a requirement that the banking entity 
employee who approves a hedge affirmatively certify that the hedge 
conforms to the requirements of the rule and has not been put in place 
for the direct or indirect purpose or effect of generating speculative 
profits.\1204\ A few commenters requested limitations on instruments 
that can be used for hedging purposes.\1205\
---------------------------------------------------------------------------

    \1203\ See Sens. Merkley & Levin (Feb. 2012).
    \1204\ See Better Markets (Feb. 2012).
    \1205\ See Sens. Merkley & Levin (Feb. 2012); Occupy; Andrea 
Psoras.
---------------------------------------------------------------------------

    The final rule retains the proposal's requirement that a banking 
entity establish an internal compliance program that is designed to 
ensure the banking entity limits its hedging activities to hedging that 
is risk-mitigating.\1206\ The final rule largely retains the proposal's 
approach to the compliance program requirement, except to the extent 
that, as requested by some commenters,\1207\ the final rule modifies 
the proposal to provide additional detail regarding the elements that 
must be included in a compliance program. Similar to the proposal, the 
final rule contemplates that the scope and detail of a compliance 
program will reflect the size, activities, and complexity of banking 
entities in order to ensure that banking entities engaged in more 
active trading have enhanced compliance programs without imposing undue 
burden on smaller organizations and entities that engage in little or 
no trading activity.\1208\ The final rule also requires, like the 
proposal, that the banking entity implement, maintain, and enforce the 
program.\1209\
---------------------------------------------------------------------------

    \1206\ See final rule Sec.  ----.5(b)(1). The final rule retains 
the proposal's requirement that the compliance program include, 
among other things, written hedging policies.
    \1207\ See, e.g., BoA; ICI (Feb. 2012); ISDA (Feb. 2012); JPMC; 
Morgan Stanley; PNC; SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1208\ See final rule Sec.  ----.20(a) (stating that ``[t]he 
terms, scope and detail of [the] compliance program shall be 
appropriate for the types, size, scope and complexity of activities 
and business structure of the banking entity''). The Agencies 
believe this helps address some commenters' concern that the hedging 
exemption would be too limiting and burdensome for community and 
regional banks. See ICBA; M&T Bank.
    \1209\ Many of these policies and procedures were contained as 
part of the proposed rule's compliance program requirements under 
Appendix C. They have been moved, and in some cases modified, in 
order to more clearly demonstrate how they are incorporated into the 
requirements of the hedging exemption.
---------------------------------------------------------------------------

    In response to commenter concerns about ensuring the appropriate 
level of senior management involvement in establishing these 
policies,\1210\ the final rule requires that the written policies and 
procedures be developed and implemented by a banking entity at the 
appropriate level of organization and expressly address the banking 
entity's requirements for escalation procedures, supervision, and 
governance related to hedging activities.\1211\
---------------------------------------------------------------------------

    \1210\ See Better Markets (Feb. 2012). The final rule does not 
require affirmative certification of each hedge, as suggested by 
this commenter, because the Agencies believe it would unnecessarily 
slow legitimate transactions. The Agencies believe the final rule's 
required management framework and escalation procedures achieve the 
same objective as the commenter's suggested approach, while imposing 
fewer burdens on legitimate risk-mitigating hedging activity.
    \1211\ See final rule Sec. Sec.  ----.20(b), ----.5(b). This 
approach builds on the proposal's requirement that senior management 
and intermediate managers be accountable for the effective 
implementation of the compliance program.
---------------------------------------------------------------------------

    Like the proposal, the final rule specifies that a banking entity's 
compliance regime must include reasonably designed written policies and 
procedures regarding the positions, techniques and strategies that may 
be used for hedging, including documentation indicating what positions, 
contracts or other holdings a trading desk may use in its risk-
mitigating hedging activities.\1212\ The

[[Page 5631]]

focus on policies and procedures governing risk identification and 
mitigation, analysis and testing of position limits and hedging 
strategies, and internal controls and ongoing monitoring is expected to 
limit use of the hedging exception to risk-mitigating hedging. The 
final rule adds to the proposed compliance program approach by 
requiring that the banking entity's written policies and procedures 
include position and aging limits with respect to such positions, 
contracts, or other holdings.\1213\ The final rule, similar to the 
proposed rule, also requires that the compliance program contain 
internal controls and ongoing monitoring, management, and authorization 
procedures, including relevant escalation procedures.\1214\ Further, 
the final rule retains the proposed requirement that the compliance 
program provide for the conduct of analysis and independent testing 
designed to ensure that the positions, techniques, and strategies that 
may be used for hedging may reasonably be expected to demonstrably 
reduce or otherwise significantly mitigate the specific, identifiable 
risks being hedged.\1215\
---------------------------------------------------------------------------

    \1212\ This approach is generally consistent with some 
commenters' suggested approach of limiting the instruments that can 
be used for hedging purposes; although the final rules provide 
banking entities with discretion to determine the types of 
positions, contracts, or other holdings that will mitigate specific 
risks of individual or aggregated holdings and thus may be used for 
risk-mitigating hedging activity. See Sens. Merkley & Levin (Feb. 
2012); Occupy; Andrea Psoras. In response to one commenter's request 
that the final rule require all hedges to be labeled at inception 
and certain detailed information be documented for each hedge, the 
Agencies note that the final rules continue to require detailed 
documentation for hedging activity that presents a heightened risk 
of evasion. See Sens. Merkley & Levin (Feb. 2012); final rule Sec.  
----.5(c); infra Part IV.A.4.d.4. The Agencies believe a 
documentation requirement targeted at these scenarios balances the 
need to prevent evasion of the general prohibition on proprietary 
trading with the concern that documentation requirements can slow or 
impede legitimate risk-mitigating activity in the normal course.
    \1213\ See final rule Sec.  ----.5(b)(1)(i). Some commenters 
expressed support for the use of risk limits in determining whether 
trading activity qualifies for the hedging exemption. See, e.g., 
Barclays; Credit Suisse (Seidel); ICI (Feb. 2012); Morgan Stanley.
    \1214\ See final rule Sec.  ----.5(b)(1)(ii).
    \1215\ See final rule Sec.  ----.5(b)(1)(iii). The final rule's 
requirement to demonstrably reduce or otherwise significantly 
mitigate is discussed in greater detail below.
---------------------------------------------------------------------------

    The final rule also adds that correlation analysis be undertaken as 
part of the analysis of the hedging positions, techniques, and 
strategies that may be used. This provision effectively changes the 
requirement in the proposed rule that the hedge must maintain 
correlation into a requirement that correlation be analyzed as part of 
the compliance program before a hedging activity is undertaken. This 
provision incorporates the concept in the proposed rule that a hedge 
should be correlated (negatively, when sign is considered) to the risk 
being hedged. However, the Agencies recognize that some effective 
hedging activities, such as deep out-of-the-money puts and calls, may 
not be exhibit a strong linear correlation to the risks being hedged 
and also that correlation over a period of time between two financial 
positions does not necessarily mean one position will in fact reduce or 
mitigate a risk of the other. Rather, the Agencies expect the banking 
entity to undertake a correlation analysis that will, in many but not 
all instances, provide a strong indication of whether a potential 
hedging position, strategy, or technique will or will not demonstrably 
reduce the risk it is designed to reduce. It is important to recognize 
that the rule does not require the banking entity to prove correlation 
mathematically or by other specific methods. Rather, the nature and 
extent of the correlation analysis undertaken would be dependent on the 
facts and circumstances of the hedge and the underlying risks targeted. 
If correlation cannot be demonstrated, then the Agencies would expect 
that such analysis would explain why not and also how the proposed 
hedging position, technique, or strategy is designed to reduce or 
significantly mitigate risk and how that reduction or mitigation can be 
demonstrated without correlation.
    Moreover, the final rule requires hedging activity conducted in 
reliance on the hedging exemption be subject to continuing review, 
monitoring, and management that is consistent with the banking entity's 
written hedging policies and procedures and is designed to reduce or 
otherwise significantly mitigate, and demonstrably reduces or otherwise 
significantly mitigates, the specific, identifiable risks that develop 
over time from hedging activity and underlying positions.\1216\ This 
ongoing review should consider market developments, changes in 
positions or the configuration of aggregated positions, changes in 
counterparty risk, and other facts and circumstances related to the 
risks associated with the underlying and hedging positions, contracts, 
or other holdings.
---------------------------------------------------------------------------

    \1216\ The proposal also contained a continuing review, 
monitoring, and management requirement. See proposed rule Sec.  --
--.5(b)(2)(v). The final rule modifies the proposed requirement, 
however, by removing the ``reasonable correlation'' requirement and 
instead requiring that the hedge demonstrably reduce or otherwise 
significantly mitigate specific identifiable risks. Correlation 
analysis is, however, a necessary component of the analysis element 
in the compliance program requirement of the hedging exemption in 
the final rule. See final rule Sec.  ----.5(b). This change is 
discussed below.
---------------------------------------------------------------------------

    The Agencies believe that requiring banking entities to develop and 
follow detailed compliance policies and procedures related to risk-
mitigating hedging activity will help both banking entities and 
examiners understand the risks to which banking entities are exposed 
and how these risks are managed in a safe and sound manner. With this 
increased understanding, banking entities and examiners will be better 
able to evaluate whether banking entities are engaged in legitimate, 
risk-reducing hedging activity, rather than impermissible proprietary 
trading. While the Agencies recognize there are certain costs 
associated with this compliance program requirement,\1217\ we believe 
this provision is necessary to ensure compliance with the statute and 
the final rule. As discussed in Part IV.C.1., the Agencies have 
modified the proposed compliance program structure to reduce burdens on 
small banking entities.\1218\
---------------------------------------------------------------------------

    \1217\ See Barclays.
    \1218\ See infra Part IV.C.1. Some commenters expressed concern 
that the compliance program requirement would place undue burden on 
regional or community banks. See ICBA; M&T Bank.
---------------------------------------------------------------------------

    The Agencies note that hedging may occur across affiliates under 
the hedging exemption.\1219\ To ensure that hedging across trading 
desks or hedging done at a level of the organization outside of the 
trading desk does not result in prohibited proprietary trading, the 
final rule imposes enhanced documentation requirements on these 
activities, which are discussed more fully below. The Agencies also 
note that nothing in the final rule limits or restricts the ability of 
the appropriate supervisory agency of a banking entity to place limits 
on interaffiliate hedging in a manner consistent with their safety and 
soundness authority to the extent the agency has such authority.\1220\ 
Additionally, nothing in the final rule limits or modifies the 
applicability of CFTC regulations with respect to the clearing of 
interaffiliate swaps.\1221\
---------------------------------------------------------------------------

    \1219\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.
    \1220\ In addition, section 608 of the Dodd-Frank Act added 
credit exposure arising from securities borrowing and lending or a 
derivative transaction with an affiliate to the list of covered 
transactions subject to the restrictions of section 23A of the FR 
Act, in each case to the extent that such transaction causes a bank 
to have credit exposure to the affiliate. See 12 U.S.C. 371c(b)(7) 
and (8). As a consequence, interaffiliate hedging activity within a 
banking entity may be subject to limitation or restriction under 
section 23A of the FR Act.
    \1221\ See 17 CFR 50.52.
---------------------------------------------------------------------------

2. Hedging of Specific Risks and Demonstrable Reduction of Risk
    Section ----.5(b)(2)(ii) of the proposed rule required that a 
qualifying transaction hedge or otherwise mitigate one or more specific 
risks, including market risk, counterparty or other credit risk, 
currency or foreign exchange risk, interest rate risk, basis risk, or 
similar risks, arising in connection with and related to individual or 
aggregated positions, contracts, or other holdings of a banking 
entity.\1222\ This criterion

[[Page 5632]]

implemented the essential element of the hedging exemption that the 
transaction be risk-mitigating.
---------------------------------------------------------------------------

    \1222\ See proposed rule Sec.  ----.5(b)(2)(ii); See also Joint 
Proposal, 76 FR 68,875.
---------------------------------------------------------------------------

    Some commenters expressed support for this provision, particularly 
the requirement that a banking entity be able to tie a hedge to a 
specific risk.\1223\ One of these commenters stated that a demonstrated 
reduction in risk should be a key indicator of whether a hedge is in 
fact permitted.\1224\ However, some commenters argued that the list of 
risks eligible to be hedged under the proposed rule, which included 
risks arising from aggregated positions, could justify transactions 
that should be viewed as prohibited proprietary trading.\1225\ Another 
commenter contended that the term ``basis risk'' was undefined and 
could heighten the potential that this exemption would be used to evade 
the prohibition on proprietary trading.\1226\
---------------------------------------------------------------------------

    \1223\ See AFR (June 2013); Sens. Merkley & Levin (Feb. 2012); 
Public Citizen; Johnson & Prof. Stiglitz.
    \1224\ See Sens. Merkley & Levin (Feb. 2012).
    \1225\ See Public Citizen; See also Occupy.
    \1226\ See Occupy.
---------------------------------------------------------------------------

    Other commenters argued that requiring a banking entity to specify 
the particular risk being hedged discourages effective hedging and 
increases the risk at banking entities. These commenters contended that 
hedging activities must address constantly changing positions and 
market conditions.\1227\ Another commenter argued that this requirement 
could render a banking entity's hedges impermissible if those hedges do 
not succeed in fully hedging or mitigating an identified risk as 
determined by a post hoc analysis and could prevent banking entities 
from entering into hedging transactions in anticipation of risks that 
the banking entity expects will arise (or increase).\1228\ Certain 
commenters requested that the hedging exemption provide a safe harbor 
for positions that satisfy FASB ASC Topic 815 (formerly FAS 133) 
hedging accounting standards, which provides that an entity recognize 
derivative instruments, including certain derivative instruments 
embedded in other contracts, as assets or liabilities in the statement 
of financial position and measure them at fair value.\1229\ Another 
commenter suggested that scenario hedges could be identifiable and 
subject to review by the Agencies using VaR, Stress VaR, and VaR 
Exceedance, as well as revenue metrics.\1230\
---------------------------------------------------------------------------

    \1227\ See, e.g., Japanese Bankers Ass'n.
    \1228\ See Barclays.
    \1229\ See ABA (Keating); Wells Fargo (Prop. Trading). Although 
certain accounting standards, such as FASB ASC Topic 815 hedge 
accounting standards, address circumstances in which a transaction 
may be considered a hedge of another transaction, the final rule 
does not refer to or expressly rely on these accounting standards 
because such standards: (i) Are designed for financial statement 
purposes, not to identify proprietary trading; and (ii) change often 
and are likely to change in the future without consideration of the 
potential impact on section 13 of the BHC Act.
    \1230\ See JPMC.
---------------------------------------------------------------------------

    The Agencies have considered these comments carefully in light of 
the statute. Section 13(d)(1)(C) of the BHC Act provides an exemption 
from the prohibition on proprietary trading only for hedging activity 
that is ``designed to reduce the specific risks to the banking entity 
in connection with and related to'' individual or aggregated positions, 
contracts, or other holdings of the banking entity.\1231\ Thus, while 
the statute permits hedging of individual or aggregated positions (as 
discussed more fully below), the statute requires that, to be exempt 
from the prohibition on proprietary trading, hedging transactions be 
designed to reduce specific risks.\1232\ Moreover, it requires that 
these specific risks be in connection with or related to the individual 
or aggregated positions, contracts, or other holdings of the banking 
entity.
---------------------------------------------------------------------------

    \1231\ 12 U.S.C. 1851(d)(1)(C).
    \1232\ Some commenters expressed support for the requirement 
that a banking entity tie a hedge to a specific risk. See AFR (June 
2012); Sens. Merkley & Levin (Feb. 2012); Public Citizen; Johnson & 
Prof. Stiglitz.
---------------------------------------------------------------------------

    The final rule implements these requirements. To ensure that exempt 
hedging activities are designed to reduce specific risks, the final 
rule requires that the hedging activity at inception of the hedging 
activity, including, without limitation, any adjustments to the hedging 
activity, be designed to reduce or otherwise significantly mitigate and 
demonstrably reduces or otherwise significantly mitigates one or more 
specific, identifiable risks, including market risk, counterparty or 
other credit risk, currency or foreign exchange risk, interest rate 
risk, commodity price risk, basis risk, or similar risks, arising in 
connection with and related to identified individual or aggregated 
positions, contracts, or other holdings of the banking entity, based 
upon the facts and circumstances of the individual or aggregated 
underlying and hedging positions, contracts, or other holdings of the 
banking entity and the risks and liquidity thereof.\1233\ Hedging 
activities and limits should be based on analysis conducted by the 
banking entity of the appropriateness of hedging instruments, 
strategies, techniques, and limits. As discussed above, this analysis 
must include analysis of correlation between the hedge and the specific 
identifiable risk or risks that the hedge is designed to reduce or 
significantly mitigate.\1234\
---------------------------------------------------------------------------

    \1233\ See final rule Sec.  ----.5(b)(2)(ii).
    \1234\ See final rule Sec.  ----.5(b)(1)(iii).
---------------------------------------------------------------------------

    This language retains the focus of the statute and the proposed 
rule on reducing or mitigating specific and identified risks.\1235\ As 
discussed more fully above, banking entities are required to describe 
in their compliance policies and procedures the types of strategies, 
techniques, and positions that may be used for hedging.
---------------------------------------------------------------------------

    \1235\ Some commenters represented that the proposed list of 
risks eligible to be hedged could justify transactions that should 
be considered proprietary trading. See Public Citizen; Occupy. One 
commenter was concerned about the proposed inclusion of ``basis 
risk'' in this list. See Occupy. As noted in the proposal, the 
Agencies believe the inclusion of a list of eligible risks, 
including basis risk, helps implement the essential element of the 
statutory hedging exemption--i.e., that the transaction is risk-
reducing in connection with a specific risk. See Joint Proposal, 76 
FR 68,875. See also 12 U.S.C. 1851(d)(1)(C). Further, the Agencies 
believe the other requirements of the final hedging exemption, 
including requirements regarding internal controls and a compliance 
program, help to ensure that only legitimate hedging activity 
qualifies for the exemption.
---------------------------------------------------------------------------

    The final rule does not prescribe the hedging strategy that a 
banking entity must employ. While one commenter urged that the final 
rule require each banking entity to adopt the ``best hedge'' for every 
transaction,\1236\ the Agencies believe that the complexity of 
positions, market conditions at the time of a transaction, availability 
of hedging transactions, costs of hedging, and other circumstances at 
the time of the transaction make a requirement that a banking entity 
always adopt the ``best hedge'' impractical, unworkable, and 
subjective.
---------------------------------------------------------------------------

    \1236\ See, e.g., Occupy.
---------------------------------------------------------------------------

    Nonetheless, the statute requires that, to be exempt under section 
13(d)(1)(C), hedging activity must be risk-mitigating. To ensure that 
only risk-mitigating hedging is permitted under this exemption, the 
final rule requires that in its written policies and procedures the 
banking entity identify the instruments and positions that may be used 
in hedging, the techniques and strategies the banking entity deems 
appropriate for its hedging activities, as well as position limits and 
aging limits on hedging positions. These written policies and 
procedures also must specify the escalation and approval procedures 
that apply if a trader seeks to conduct hedging activities beyond the 
limits, position types, strategies, or techniques authorized for the 
trader's activities.\1237\
---------------------------------------------------------------------------

    \1237\ A banking entity must satisfy the enhanced documentation 
requirements of Sec.  ----.5(c) if it engages in hedging activity 
utilizing positions, contracts, or holdings that were not identified 
in its written policies and procedures.

---------------------------------------------------------------------------

[[Page 5633]]

    As noted above, commenters were concerned that risks associated 
with permitted activities and holdings change over time, making a 
determination regarding the effectiveness of hedging activities in 
reducing risk dependent on the time when risk is measured. To address 
this, the final rule requires that the exempt hedging activity be 
designed to reduce or otherwise significantly mitigate, and 
demonstrably reduces or otherwise significantly mitigates, risk at the 
inception of the hedge. As explained more fully below, because risks 
and the effectiveness of a hedging strategy may change over time, the 
final rule also requires the banking entity to implement a program to 
review, monitor, and manage its hedging activity over the period of 
time the hedging activity occurs in a manner designed to reduce or 
significantly mitigate and demonstrably reduce or otherwise 
significantly mitigate new or changing risks that may develop over time 
from both the banking entity's hedging activities and the underlying 
positions. Many commenters expressed concern that the proposed ongoing 
review, monitoring, and management requirement would limit a banking 
entity's ability to engage in aggregated position hedging.\1238\ One 
commenter stated that because aggregated position hedging may result in 
modification of hedging exposures across a variety of underlying risks, 
even as the overall risk profile of a banking entity is reduced, it 
would become impossible to subsequently review, monitor, and manage 
individual hedging transactions for compliance.\1239\ The Agencies note 
that the final rule, like the statute, requires that the hedging 
activity relate to individual or aggregated positions, contracts or 
other holdings being hedged, and accordingly, the review, monitoring 
and management requirement would not limit the extent of permitted 
hedging provided for in section 13(d)(1)(C) as implied by some 
commenters. Further, the final rule recognizes that the determination 
of whether hedging activity demonstrably reduces or otherwise 
significantly mitigates risks that may develop over time should be 
``based upon the facts and circumstances of the underlying and hedging 
positions, contracts and other holdings of the banking entity and the 
risks and liquidity thereof.'' \1240\
---------------------------------------------------------------------------

    \1238\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Barclays; 
ICI (Feb. 2012); Morgan Stanley.
    \1239\ See Barclays.
    \1240\ Final rule Sec.  ----.5(b)(2)(iv)(B). The Agencies 
believe this provision addresses some commenters' concern that the 
ongoing review, monitoring, and management requirement would limit 
hedging of aggregated positions, and that such ongoing review of 
individual hedge transactions with a variety of underlying risks 
would be impossible. See SIFMA (Prop. Trading) (Feb. 2012); 
Barclays; ICI (Feb. 2012); Morgan Stanley.
---------------------------------------------------------------------------

    A number of other commenters argued that a legitimate risk-reducing 
hedge may introduce new risks at inception.\1241\ A few commenters 
contended that a requirement that no new risks be associated with a 
hedge would be inconsistent with prudent risk management and greatly 
reduce the ability of banking entities to reduce overall risk through 
hedging.\1242\ A few commenters stated that the proposed requirement 
does not recognize that it is not always possible to hedge a new risk 
exposure arising from a hedge in a cost-effective manner.\1243\ With 
respect to the timing of the initial hedge and any additional 
transactions necessary to reduce significant exposures arising from it, 
one of these commenters represented that requiring contemporaneous 
hedges is impracticable, would raise transaction costs, and would make 
hedging uneconomic.\1244\ Another commenter stated that this 
requirement could have a chilling effect on risk managers' willingness 
to engage in otherwise permitted hedging activity.\1245\
---------------------------------------------------------------------------

    \1241\ See ABA (Keating); BoA; Barclays; Credit Suisse (Seidel); 
Goldman (Prop. Trading); SIFMA et al. (Prop. Trading) (Feb. 2012); 
See also AFR et al. (Feb. 2012).
    \1242\ See Credit Suisse (Seidel); Goldman (Prop. Trading); 
SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1243\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Barclays.
    \1244\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1245\ See BoA.
---------------------------------------------------------------------------

    Other commenters stated that a position that does not fully offset 
the risk of an underlying position is not in fact a hedge.\1246\ These 
commenters believed that the introduction of new risks at inception of 
a transaction indicated that the transaction was impermissible 
proprietary trading and not a hedge.\1247\
---------------------------------------------------------------------------

    \1246\ See Sens. Merkley & Levin (Feb. 2012); Public Citizen; 
AFR (Nov. 2012).
    \1247\ See Better Markets (Feb. 2012); AFR et al. (Feb. 2012).
---------------------------------------------------------------------------

    The Agencies recognize that prudent risk-reducing hedging 
activities by banking entities are important to the efficiency of the 
financial system.\1248\ The Agencies further recognize that hedges are 
generally imperfect; consequently, hedging activities can introduce new 
and sometimes significant risks, such as credit risk, basis risk, or 
new market risk, especially when hedging illiquid positions.\1249\ 
However, the Agencies also recognize that hedging activities present an 
opportunity to engage in impermissible proprietary trading designed to 
profit from exposure to these types of risks.
---------------------------------------------------------------------------

    \1248\ See FSOC study (stating that ``[p]rudent risk management 
is at the core of both institution-specific safety and soundness, as 
well as macroprudential and financial stability'').
    \1249\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------

    To address these competing concerns, the final rule substantially 
retains the proposed requirement that, at the inception of the hedging 
activity, the risk-reducing hedging activity does not give rise to 
significant new or additional risk that is not itself contemporaneously 
hedged. This approach is designed to allow banking entities to continue 
to engage in prudent risk-mitigating activities while ensuring that the 
hedging exemption is not used to engage in prohibited proprietary 
trading by taking on prohibited short-term exposures under the guise of 
hedging.\1250\ As noted in the proposal, however, the Agencies 
recognize that exposure to new risks may result from legitimate hedging 
transactions; \1251\ this provision only prohibits the introduction of 
additional significant exposures through the hedging transaction unless 
those additional exposures are contemporaneously hedged.
---------------------------------------------------------------------------

    \1250\ Some commenters stated that it is not always possible to 
hedge a new risk exposure arising from a hedge in a cost-effective 
manner, and requiring contemporaneous hedges would raise transaction 
costs and the potential for hedges to become uneconomical. See SIFMA 
et al. (Prop. Trading) (Feb. 2012); Barclays. As noted in the 
proposal, the Agencies believe that requiring a contemporaneous 
hedge of any significant new risk that arises at the inception of a 
hedge is appropriate because a transaction that creates significant 
new risk exposure that is not itself hedged at the same time would 
appear to be indicative of prohibited proprietary trading. See Joint 
Proposal, 76 FR 68,876. Thus, the Agencies believe this requirement 
is necessary to prevent evasion of the general prohibition on 
proprietary trading. In response to commenters' concerns about 
transaction costs and uneconomical hedging, the Agencies note that 
this provision only requires additional hedging of ``significant'' 
new or additional risk and does not apply to any risk exposure 
arising from a hedge.
    \1251\ See Joint Proposal, 76 FR 68,876.
---------------------------------------------------------------------------

    As noted above, the final rule recognizes that whether hedging 
activity will demonstrably reduce risk must be based upon the facts and 
circumstances of the individual or aggregated underlying and hedging 
positions, contracts, or other holdings of the banking entity and the 
risks and liquidity thereof.\1252\ The Agencies believe this approach 
balances commenters' request that the Agencies clarify that a banking 
entity may use its discretion to choose any hedging strategy that meets 
the requirements of

[[Page 5634]]

the proposed exemption \1253\ with concerns that allowing banking 
entities to rely on the cheapest satisfactory hedge will lead to 
additional hedging transactions.\1254\ The Agencies expect that hedging 
strategies and techniques, as well as assessments of risk, will vary 
across positions, markets, activities and banking entities, and that a 
``one-size-fits-all'' approach would not accommodate all types of 
appropriate hedging activity.\1255\
---------------------------------------------------------------------------

    \1252\ See final rule Sec.  ----.5(b)(2)(ii).
    \1253\ See SIFMA (Prop. Trading) (Feb. 2012); Credit Suisse 
(Seidel); Barclays; Goldman (Prop. Trading); BoA.
    \1254\ See Occupy.
    \1255\ See Barclays.
---------------------------------------------------------------------------

    By its terms, section 13(d)(1)(C) of the BHC Act permits a banking 
entity to engage in risk-mitigating hedging activity ``in connection 
with and related to individual or aggregated positions . . . .'' \1256\ 
The preamble to the proposed rule made clear that, consistent with the 
statutory reference to mitigating risks of individual or aggregated 
positions, this criterion permits hedging of risks associated with 
aggregated positions.\1257\ This approach is consistent with prudent 
risk-management and safe and sound banking practice.\1258\
---------------------------------------------------------------------------

    \1256\ 12 U.S.C. 1851(d)(1)(C).
    \1257\ See Joint Proposal, 76 FR 68,875.
    \1258\ See, e.g., Australian Bankers' Ass'n. (Feb. 2012); BoA; 
Barclays; Credit Suisse (Seidel); Goldman (Prop. Trading); HSBC; ICI 
(Feb. 2012); Japanese Bankers Ass'n.; JPMC; Morgan Stanley; Wells 
Fargo (Prop. Trading); Rep. Bachus et al.; RBC; SIFMA (Prop. 
Trading) (Feb. 2012).
---------------------------------------------------------------------------

    The proposed rule explained that, to be exempt under this 
provision, hedging activities must reduce risk with respect to 
``positions, contracts, or other holdings of the banking entity.'' The 
proposal also required that a banking entity relying on the exemption 
be prepared to identify the specific position or risks associated with 
aggregated positions being hedged and demonstrate that the hedging 
transaction was risk-reducing in the aggregate, as measured by 
appropriate risk management tools.
    Some commenters were of the view that the hedging exemption applied 
to aggregated positions or portfolio hedging and was consistent with 
prudent risk-management practices. These commenters argued that 
permitting a banking entity to hedge aggregate positions and risks 
arising from a portfolio of assets would be more efficient from both a 
procedural and business standpoint.\1259\
---------------------------------------------------------------------------

    \1259\ See, e.g. ABA (Keating); Ass'n. of Institutional 
Investors (Sept. 2012); BoA; See also Barclays (expressing concern 
that the proposed rule could result in regulatory review of 
individual hedging trades for compliance on a post hoc basis); HSBC; 
ISDA (Apr. 2012); ICI (Feb. 2012); PNC; MetLife; RBC; SIFMA (Prop. 
Trading) (Feb. 2012).
---------------------------------------------------------------------------

    By contrast, other commenters argued that portfolio-based hedging 
could be used to mask prohibited proprietary trading.\1260\ One 
commenter contended that the statute provides no basis for portfolio 
hedging, and another commenter similarly suggested that portfolio 
hedging should be prohibited.\1261\ Another commenter suggested 
adopting limits that would prevent the use of the hedging exemption to 
conduct proprietary activity at one desk as a theoretical ``hedge for 
proprietary trading at another desk.'' \1262\ Among the limits 
suggested by these commenters were a requirement that a banking entity 
have a well-defined compliance program, the formation of central ``risk 
management'' groups to perform and monitor hedges of aggregated 
positions, and a requirement that the banking entity demonstrate the 
capacity to measure aggregate risk across the institution with 
precision using proven models.\1263\ A few commenters suggested that 
the presence of portfolio hedging should be viewed as an indicator of 
imperfections in hedging at the desk level and be a flag used by 
examiners to identify and review the integrity of specific 
hedges.\1264\
---------------------------------------------------------------------------

    \1260\ See, e.g., AFR et al. (Feb. 2012); Sens. Merkley & Levin 
(Feb. 2012); Occupy; Public Citizen; Johnson & Prof. Stiglitz.
    \1261\ See Sens. Merkley & Levin (Feb. 2012) (commenting that 
the use of the term ``aggregate'' positions was intended to note 
that firms do not have to hedge on a trade-by-trade basis but could 
not hedge on a portfolio basis); Johnson & Prof. Stiglitz.
    \1262\ See AFR et al. (Feb. 2012) (citing 156 Cong. Rec. S5898 
(daily ed. July 15, 2010) (statement of Sen. Merkley)).
    \1263\ See, e.g., Occupy; Public Citizen.
    \1264\ See Public Citizen; Occupy; AFR et al. (Feb. 2012).
---------------------------------------------------------------------------

    The final rule, like the proposed rule, implements the statutory 
language providing for risk-mitigating hedging activities related to 
individual or aggregated positions. For example, activity permitted 
under the hedging exemption would include the hedging of one or more 
specific risks arising from identified positions, contracts, or other 
holdings, such as the hedging of the aggregate risk of identified 
positions of one or more trading desks. Further, the final rule 
requires that these hedging activities be risk-reducing with respect to 
the identified positions, contracts, or other holdings being hedged and 
that the risk reduction be demonstrable. Specifically, the final rule 
requires, among other things: That the banking entity has a robust 
compliance program reasonably designed to ensure compliance with the 
exemption; that each hedge is subject to continuing review, monitoring 
and management designed to demonstrably reduce or otherwise 
significantly mitigate the specific, identifiable risks that develop 
over time related to the hedging activity and the underlying positions, 
contracts, or other holdings of the banking entity; and that the 
banking entity meet a documentation requirement for hedges not 
established by the trading desk responsible for the underlying position 
or for hedges effected through a financial instrument, technique or 
strategy that is not specifically identified in the trading desk's 
written policies and procedures. The Agencies believe this approach 
addresses concerns that a banking entity could use the hedging 
exemption to conduct proprietary activity at one desk as a theoretical 
hedge for proprietary trading at another desk in a manner consistent 
with the statute.\1265\ Further, the Agencies believe the adopted 
exemption allows banking entities to engage in hedging of aggregated 
positions \1266\ while helping to ensure that such hedging activities 
are truly risk-mitigating.\1267\
---------------------------------------------------------------------------

    \1265\ See AFR et al. (Feb. 2012) (citing 156 Cong. Rec. S5898 
(daily ed. July 15, 2010) (statement of Sen. Merkley)).
    \1266\ See MetLife; SIFMA et al. (Prop. Trading) (Feb. 2012); 
Morgan Stanley; Barclays; Goldman (Prop. Trading); BoA; ABA 
(Keating); HSBC; Fixed Income Forum/Credit Roundtable; ICI (Feb. 
2012); ISDA (Feb. 2012).
    \1267\ The Agencies believe certain limits suggested by 
commenters, such as the formation of central ``risk management'' 
groups to monitor hedges of aggregated positions, are unnecessary 
given the aforementioned limits in the final rule. See Occupy; 
Public Citizen.
---------------------------------------------------------------------------

    As noted above, several commenters questioned whether the hedging 
exemption should apply to ``portfolio'' hedging and whether portfolio 
hedging may create the potential for abuse of the hedging exemption. 
The term ``portfolio hedging'' is not used in the statute. The language 
of section 13(d)(1)(C) of the BHC Act permits a banking entity to 
engage in risk-mitigating hedging activity ``in connection with and 
related to individual or aggregated positions . . . .'' \1268\ After 
consideration of the comments regarding portfolio hedging, and in light 
of the statutory language, the Agencies are of the view that the 
statutory language is clear on its face that a banking entity may 
engage in risk-mitigating hedging in connection with aggregated 
positions of the banking entity. The permitted hedging activity, when 
involving more than one position, contract, or other holding, must be 
in

[[Page 5635]]

connection with or related to aggregated positions of the banking 
entity.
---------------------------------------------------------------------------

    \1268\ See 12 U.S.C. 1851(d)(1)(C).
---------------------------------------------------------------------------

    Moreover, hedging of aggregated positions under this exemption must 
be related to identifiable risks related to specific positions, 
contracts, or other holdings of the banking entity. Hedging activity 
must mitigate one or more specific risks arising from an identified 
position or aggregation of positions. The risks in this context are not 
intended to be more generalized risks that a trading desk or 
combination of desks, or the banking entity as a whole, believe exists 
based on non-position-specific modeling or other considerations. For 
example, the hedging activity cannot be 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.\1269\ Rather, the hedging exemption permits the 
banking entity to engage in trading activity designed to reduce or 
otherwise mitigate specific, identifiable risks related to identified 
individual or aggregated positions that the banking entity it otherwise 
lawfully permitted to have.
---------------------------------------------------------------------------

    \1269\ The Agencies believe that it would be inconsistent with 
Congressional intent to permit some or all of these activities under 
the hedging exemption, regardless of whether certain metrics could 
be useful for monitoring such activity. See JPMC.
---------------------------------------------------------------------------

    When undertaking a hedge to mitigate the risk of an aggregation of 
positions, the banking entity must be able to specifically identify the 
risk factors arising from this set of positions. In identifying the 
aggregate set of positions that is being hedged for purposes of Sec.  
----.5(b)(2)(ii) and, where applicable, Sec.  ----.5(c)(2)(i), the 
banking entity needs to identify the positions being hedged with 
sufficient specificity so that at any point in time, the specific 
financial instrument positions or components of financial instrument 
positions held by the banking entity that comprise the set of positions 
being hedged can be clearly identified.
    The proposal would have permitted a series of hedging transactions 
designed to rebalance hedging position(s) based on changes resulting 
from permissible activities or from a change in the price or other 
characteristic of the individual or aggregated positions, contracts, or 
other holdings being hedged.\1270\ The Agencies recognized that, in 
such dynamic hedging, material changes in risk may require a 
corresponding modification to the banking entity's current hedge 
positions.\1271\
---------------------------------------------------------------------------

    \1270\ See proposed rule Sec.  ----.5(b)(2)(ii) (requiring that 
the hedging transaction ``hedges or otherwise mitigates one or more 
specific risks . . . arising in connection with and related to 
individual or aggregated positions, contracts, or other holdings of 
[the] banking entity''). The proposal noted that this requirement 
would include, for example, dynamic hedging. See Joint Proposal, 76 
FR 68,875.
    \1271\ The proposal noted that this corresponding modification 
to the hedge should also be reasonably correlated to the material 
changes in risk that are intended to be hedged or otherwise 
mitigated, as required by Sec.  ----.5(b)(2)(iii) of the proposed 
rule.
---------------------------------------------------------------------------

    Some commenters questioned the risk-mitigating nature of a hedge 
if, at inception, that hedge contained component risks that must be 
dynamically managed throughout the life of the hedge. These commenters 
stated that hedges that do not continuously match the risk of 
underlying positions are not in fact risk-mitigating hedges in the 
first place.\1272\
---------------------------------------------------------------------------

    \1272\ See AFR et al. (Feb. 2012); Public Citizen; See also 
Better Markets (Feb. 2012), Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------

    On the other hand, other commenters argued that banking entities 
must be permitted to engage in dynamic hedging activity, such as in 
response to market conditions which are unforeseeable or out of the 
control of the banking entity,\1273\ and expressed concern that the 
limitations of the proposed rule, especially the requirement that 
hedging transactions ``maintain a reasonable level of correlation,'' 
might impede truly risk-reducing hedging activity.\1274\
---------------------------------------------------------------------------

    \1273\ See Japanese Bankers Ass'n.
    \1274\ See, e.g., BoA; Barclays; ISDA (Apr. 2012); PNC; PNC et 
al.; SIFMA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------

    A number of commenters asserted that there could be confusion over 
the meaning of ``reasonable correlation,'' which was used in the 
proposal as part of explaining what type of activity would qualify for 
the hedging exemption. Some commenters urged requiring that there be a 
``high'' or ``strong'' correlation between the hedge and the risk of 
the underlying asset.\1275\
---------------------------------------------------------------------------

    \1275\ See, e.g., Occupy; Public Citizen; AFR et. al. (Feb. 
2012); AFR (June 2013); Better Markets (Feb. 2012); Sens. Merkley & 
Levin (Feb. 2012).
---------------------------------------------------------------------------

    Other commenters indicated that uncertainty about the meaning of 
reasonable correlation could limit valid risk-mitigating hedging 
activities because the level of correlation between a hedge and the 
risk of the position or aggregated positions being hedged changes over 
time as a result of changes in market factors and conditions.\1276\ 
Some commenters represented that the proposed provision would cause 
certain administrative burdens \1277\ or may result in a reduction in 
market-making activities in certain asset classes.\1278\ A few 
commenters expressed concern that the reasonable correlation 
requirement could render a banking entity's hedges impermissible if 
they do not succeed in being reasonably correlated to the relevant risk 
or risks based on an after-the-fact analysis that incorporates market 
developments that could not have been foreseen at the time the hedge 
was placed. These commenters tended to favor a different approach or a 
type of safe harbor based on an initial determination of 
correlation.\1279\ Some commenters argued the focus of the hedging 
exemption should be on risk reduction and not on reasonable 
correlation.\1280\ One commenter suggested that risk management metrics 
such as VaR and risk factor sensitivities could be the focus for 
permitted hedging instead of requirements like reasonable correlation 
under the proposal.\1281\
---------------------------------------------------------------------------

    \1276\ See BoA; Barclays; Comm. on Capital Markets Regulation; 
Credit Suisse (Seidel); FTN; Goldman (Prop. Trading); ICI (Feb. 
2012); Japanese Bankers Ass'n.; JPMC; Morgan Stanley; SIFMA et al. 
(Prop. Trading) (Feb. 2012); STANY; See also Chamber (Feb. 2012).
    \1277\ See Japanese Bankers Ass'n.; Goldman (Prop. Trading); 
BoA.
    \1278\ See BoA; SIFMA (Asset Mgmt.) (Feb. 2012). As discussed 
above, market-maker hedging at the trading desk level is no longer 
subject to the hedging exemption and is instead subject to the 
requirements of the market-making exemption, which is designed to 
permit banking entities to continue providing legitimate market-
making services, including managing the risk of market-making 
activity. See also supra Part IV.A.3.c.4. of this SUPPLEMENTARY 
INFORMATION.
    \1279\ See Barclays; Goldman (Prop. Trading); Chamber (Feb. 
2012); SIFMA et al. (Prop. Trading) (Feb. 2012); See also FTN; BoA.
    \1280\ See, e.g., FTN; Goldman (Prop. Trading); ISDA (Apr. 
2012); See also Sens. Merkley & Levin (Feb. 2012); Occupy.
    \1281\ See Goldman (Prop. Trading). Consistent with the FSOC 
study and the proposal, the Agencies continue to believe that 
quantitative measurements can be useful to banking entities and the 
Agencies to help assess the profile of a trading desk's trading 
activity and to help identify trading activity that may warrant a 
more in-depth review. See infra Part IV.C.3.; final rule Appendix A. 
The Agencies do not intend to use quantitative measurements as a 
dispositive tool for differentiating between permitted hedging 
activities and prohibited proprietary trading.
---------------------------------------------------------------------------

    In consideration of commenter concerns about the proposed 
reasonable correlation requirement, the final rule modifies the 
proposal in the following key respects. First, the final rule modifies 
the requirement of ``reasonable correlation'' by providing that the 
hedge demonstrably reduce or otherwise significantly mitigate specific 
identifiable risks.\1282\ This change is

[[Page 5636]]

designed to reinforce that hedging activity should be demonstrably risk 
reducing or mitigating rather than simply correlated to risk. This 
change acknowledges that hedges need not simply be correlated to 
underlying positions, and that hedging activities should be consciously 
designed to reduce or mitigate identifiable risks, not simply the 
result of pairing correlated positions, as some commenters 
suggested.\1283\ As discussed above, the Agencies do, however, 
recognize that correlation is often a critical element of demonstrating 
that a hedging activity reduces the risks it is designed to address. 
Accordingly, the final rule requires that banking entities conduct 
correlation analysis as part of the required compliance program in 
order to utilize the hedging exemption.\1284\ The Agencies believe this 
change better allows consideration of the facts and circumstances of 
the particular hedging activity as part of the correlation analysis and 
therefore addresses commenters' concerns that the proposed reasonable 
correlation requirement could cause administrative burdens, impede 
legitimate hedging activity,\1285\ and require an after-the-fact 
analysis.\1286\
---------------------------------------------------------------------------

    \1282\ Some commenters stated that the hedging exemption should 
focus on risk reduction, not reasonable correlation. See, e.g., FTN; 
Goldman (Prop. Trading); ISDA (Apr. 2012); Sens. Merkley & Levin 
(Feb. 2012); Occupy. One of these commenters noted that demonstrated 
risk reduction should be a key requirement. See Sens. Merkley & 
Levin (Feb. 2012).
    \1283\ See FTN; Goldman (Prop. Trading); ISDA (Apr. 2012); See 
also Sens. Merkley & Levin (Feb. 2012); Occupy.
    \1284\ See final rule Sec.  ----.5(b)(1)(iii).
    \1285\ Some commenters expressed concern that the proposed 
``reasonable correlation'' requirement might impede truly risk-
reducing activity. See, e.g., BoA; Barclays; Comm. on Capital 
Markets Regulation; Credit Suisse (Seidel); FTN; Goldman (Prop. 
Trading); ICI (Feb. 2012); ISDA (Apr. 2012); Japanese Bankers 
Ass'n.; JPMC; Morgan Stanley; PNC; PNC et al.; SIFMA et al. (Prop. 
Trading) (Feb. 2012); STANY. Some of these commenters stated that 
the proposed requirement would cause administrative burdens. See 
Japanese Bankers Ass'n.; Goldman (Prop. Trading); BoA.
    \1286\ See Barclays; Goldman (Prop. Trading); Chamber (Feb. 
2012); SIFMA et al. (Prop. Trading) (Feb. 2012; See also FTN.
---------------------------------------------------------------------------

    Second, the final rule provides that the determination of whether 
an activity or strategy is risk-reducing or mitigating must, in the 
first instance, be made at the inception of the hedging activity. A 
trade that is not risk-reducing at its inception is not viewed as a 
hedge for purposes of the exemption in Sec.  ----.5.\1287\
---------------------------------------------------------------------------

    \1287\ By contrast, the proposed requirement did not specify 
that the hedging activity reduce risk ``at the inception of the 
hedge.'' See proposed rule Sec.  ----.5(b)(2)(ii).
---------------------------------------------------------------------------

    Third, the final rule requires that the banking entity conduct 
analysis and independent testing designed to ensure that the positions, 
techniques, and strategies used for hedging are reasonably designed to 
reduce or otherwise mitigate the risk being hedged. As noted above, 
such analysis and testing must include correlation analysis. Evidence 
of negative correlation may be a strong indicator that a given hedging 
position or strategy is risk-reducing. Moreover, positive correlation, 
in some instances, may be an indicator that a hedging position or 
strategy is not designed to be risk-mitigating. The type of analysis 
and factors considered in the analysis should take account of the facts 
and circumstances, including type of position being hedged, market 
conditions, depth and liquidity of the market for the underlying and 
hedging position, and type of risk being hedged.
    The Agencies recognize that markets and risks are dynamic and that 
the risks from a permissible position or aggregated positions may 
change over time, new risks may emerge in the positions underlying the 
hedge and in the hedging position, new risks may emerge from the 
hedging strategy over time, and hedges may become less effective over 
time in addressing the related risk.\1288\ The final rule, like the 
proposal, continues to allow dynamic hedging. Additionally, the final 
rule requires the banking entity to engage in ongoing review, 
monitoring, and management of its positions and related hedging 
activity to reduce or otherwise significantly mitigate the risks that 
develop over time. This ongoing hedging activity must be designed to 
reduce or otherwise significantly mitigate, and must demonstrably 
reduce or otherwise significantly mitigate, the material changes in 
risk that develop over time from the positions, contracts, or other 
holdings intended to be hedged or otherwise mitigated in the same way, 
as required for the initial hedging activity. Moreover, the banking 
entity is required under the final rule to support its decisions 
regarding appropriate hedging positions, strategies and techniques for 
its ongoing hedging activity in the same manner as for its initial 
hedging activities. In this manner, the final rule permits a banking 
entity to engage in effective management of its risks throughout 
changing market conditions \1289\ while also seeking to prohibit the 
banking entity from taking large proprietary positions through action 
or inaction related to an otherwise permissible hedge.\1290\
---------------------------------------------------------------------------

    \1288\ Some commenters noted that hedging activities must 
address constantly changing positions and market conditions and 
expressed concern about requiring a banking entity to identify the 
particular risk being hedged. See Japanese Bankers Ass'n.; Barclays.
    \1289\ A few commenters expressed concern that the proposed 
``reasonable correlation'' requirement would render hedges 
impermissible if not reasonably correlated to the relevant risk(s) 
based on a post hoc analysis. See, e.g., Barclays; Goldman (Prop. 
Trading); Chamber (Feb. 2012); SIFMA et al. (Prop. Trading) (Feb. 
2012).
    \1290\ Some commenters questioned the risk-mitigating nature of 
a hedge if, at inception, it contained risks that must be 
dynamically managed throughout the life of the hedge. See, e.g., AFR 
et al. (Feb. 2012); Public Citizen.
---------------------------------------------------------------------------

    As explained above, the final rule requires a banking entity 
relying on the hedging exemption to be able to demonstrate that the 
banking entity is exposed to the specific risks being hedged at the 
inception of the hedge and any adjustments thereto. However, in the 
proposal, the Agencies requested comment on whether the hedging 
exemption should be available in certain cases where hedging activity 
begins before the banking entity becomes exposed to the underlying 
risk. The Agencies proposed that the hedging exemption would be 
available in certain cases where the hedge is established ``slightly'' 
before the banking entity becomes exposed to the underlying risk if 
such anticipatory hedging activity: (i) Was consistent with appropriate 
risk management practices; (ii) otherwise met the terms of the hedging 
exemption; and (iii) did not involve the potential for speculative 
profit. For example, a banking entity that was contractually obligated 
or otherwise highly likely to become exposed to a particular risk could 
engage in hedging that risk in advance of actual exposure.\1291\
---------------------------------------------------------------------------

    \1291\ See Joint Proposal, 76 FR 68,875.
---------------------------------------------------------------------------

    A number of commenters argued that anticipatory hedging is a 
necessary and prudent activity and that the final rule should permit 
anticipatory hedging more broadly than did the proposed rule.\1292\ In 
particular, commenters were concerned that permitting hedging activity 
only if it occurs ``slightly'' before a risk is taken could limit 
hedging activities that are crucial to risk management.\1293\ 
Commenters expressed concern that the proposed approach would, among 
other things, make it difficult for banking entities to accommodate 
customer requests for transactions with specific price or size 
executions \1294\ and limit dynamic hedging activities that are 
important to sound risk management.\1295\ In addition, a number of 
commenters requested that the rule permit banking entities to engage in 
scenario hedging, a form of

[[Page 5637]]

anticipatory hedging that addresses potential exposures to ``tail 
risks.''\1296\
---------------------------------------------------------------------------

    \1292\ See, e.g., Barclays; SIFMA et al. (Prop. Trading); 
Japanese Bankers Ass'n.; Credit Suisse (Seidel); BoA; PNC et al.; 
ISDA (Feb. 2012).
    \1293\ See BoA; Credit Suisse (Seidel); ISDA (Feb. 2012); JPMC; 
Morgan Stanley; PNC et al.; SIFMA et al. (Prop. Trading) (Feb. 
2012).
    \1294\ See Credit Suisse (Seidel); BoA.
    \1295\ See PNC et al.
    \1296\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; 
Goldman (Prop. Trading); BoA; Comm. on Capital Market Regulation. As 
discussed above, hedging activity relying on this exemption cannot 
be 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.
---------------------------------------------------------------------------

    Some commenters expressed concern about the proposed criterion that 
the hedging activity not involve the potential for speculative 
profit.\1297\ These commenters argued that the proper focus of the 
hedging exemption should be on the purpose of the transaction, and 
whether the hedge is correlated to the underlying risks being hedged 
(in other words, whether the hedge is effective in mitigating 
risk).\1298\ By contrast, another commenter urged the Agencies to adopt 
a specific metric to track realized profits on hedging activities as an 
indicator of prohibited arbitrage trading.\1299\
---------------------------------------------------------------------------

    \1297\ See ABA (Keating); CH/ABASA; See also Credit Suisse 
(Seidel); PNC; PNC et al.; SIFMA et al. (Prop. Trading) (Feb. 2012). 
One commenter argued that anticipatory hedging should not be 
permitted because it represents illegal front running. See Occupy. 
The Agencies note that not all anticipatory hedging would constitute 
illegal front running. Any activity that is illegal under another 
provision of law, such as front running under section 10(b) of the 
Exchange Act, remains illegal; and section 13 of the BHC Act and any 
implementing rules thereunder do not represent a grant of authority 
to engage in any such activity. See 15 U.S.C. 78j.
    \1298\ As discussed above, the final hedging exemption replaces 
the ``reasonable correlation'' concept with the requirement that 
hedging activity ``demonstrably reduce or otherwise significantly 
mitigate'' specific, identifiable risks.
    \1299\ See AFR et al. (Feb. 2012); See also Part IV.C.3.d., 
infra.
---------------------------------------------------------------------------

    Like the proposal, the final rule does not prohibit anticipatory 
hedging. However, in response to commenter concerns that the proposal 
would limit a banking entity's ability to respond to customer requests 
and engage in prudent risk management, the final rule does not retain 
the proposed requirement discussed above that an anticipatory hedge be 
established ``slightly'' before the banking entity becomes exposed to 
the underlying risk and meet certain conditions. To address commenter 
concerns with the statutory mandate, several parts of the final rule 
are designed to ensure that all hedging activities, including 
anticipatory hedging activities, are designed to be risk reducing and 
not impermissible proprietary trading activities. For example, the 
final rule retains the proposed requirement that a banking entity have 
reasonably designed policies and procedures indicating the positions, 
techniques and strategies that each trading desk may use for hedging. 
These policies and procedures should specifically address when 
anticipatory hedging is appropriate and what policies and procedures 
apply to anticipatory hedging.
    The final rule also requires that a banking entity relying on the 
hedging exemption be able to demonstrate that the hedging activity is 
designed to reduce or significantly mitigate, and does demonstrably 
reduce or otherwise significantly mitigate, specific, identifiable 
risks in connection with individual or aggregated positions of the 
banking entity.\1300\ Importantly, to use the hedging exemption, the 
final rule requires that the banking entity subject its hedging 
activity to continuing review, monitoring, and management that is 
designed to reduce or significantly mitigate specific, identifiable 
risks, and that demonstrably reduces or otherwise significantly 
mitigates identifiable risks, in connection with individual or 
aggregated positions of the banking entity.\1301\ The final rule also 
requires ongoing recalibration of the hedging activity by the banking 
entity to ensure that the hedging activity satisfies the requirements 
set out in Sec.  ----.5(b)(2) and is not prohibited proprietary 
trading. If an anticipated risk does not materialize within a limited 
time period contemplated when the hedge is entered into, under these 
provisions, the banking entity would be required to extinguish the 
anticipatory hedge or otherwise demonstrably reduce the risk associated 
with that position as soon as reasonably practicable after it is 
determined that the anticipated risk will not materialize. This 
requirement focuses on the purpose of the hedge as a trade designed to 
reduce anticipated risk and not for other purposes. The Agencies will 
(and expect that banking entities also will) monitor the activities of 
banking entities to identify prohibited trading activity that is 
disguised as anticipatory hedging.
---------------------------------------------------------------------------

    \1300\ This requirement modifies proposed rule Sec. Sec.  --
--.5(b)(2)(ii) and (iii). As discussed above, the addition of 
``demonstrably reduces or significantly mitigates'' language 
replaces the proposed ``reasonable correlation'' requirement.
    \1301\ The proposed rule contained a similar provision, except 
that the proposed provision also required that the continuing review 
maintain a reasonable level of correlation between the hedge 
transaction and the risk being hedged. See proposed rule Sec.  --
--.5(b)(2)(v). As discussed above, the proposed ``reasonable 
correlation'' requirement was removed from that provision and 
instead a requirement has been added to the compliance program 
provision that correlation analysis be undertaken when analyzing 
hedging positions, techniques, and strategies before they are 
implemented.
---------------------------------------------------------------------------

    As noted above, one commenter suggested the Agencies adopt a metric 
to monitor the profitability of a banking entity's hedging 
activity.\1302\ We are not adopting such a metric because we do not 
believe it would be useful to monitor the profit and loss associated 
with hedging activity in isolation without considering the profit and 
loss associated with the individual or aggregated positions being 
hedged. For example, the commenter's suggested metric would not appear 
to provide information about whether the gains arising from hedging 
positions offset or mitigate losses from individual or aggregated 
positions being hedged.
---------------------------------------------------------------------------

    \1302\ See AFR et al. (Feb. 2012).
---------------------------------------------------------------------------

3. Compensation
    The proposed rule required that the compensation arrangements of 
persons performing risk-mitigating hedging activities be designed not 
to reward proprietary risk-taking.\1303\ In the proposal, the Agencies 
stated that hedging activities for which a banking entity has 
established a compensation incentive structure that rewards speculation 
in, and appreciation of, the market value of a covered financial 
position, rather than success in reducing risk, are inconsistent with 
permitted risk-mitigating hedging activities.\1304\
---------------------------------------------------------------------------

    \1303\ See proposed rule Sec.  ----.5(b)(2)(vi).
    \1304\ See Joint Proposal, 76 FR 68,868.
---------------------------------------------------------------------------

    Commenters generally supported this requirement and indicated that 
its inclusion was very important and valuable.\1305\ Some commenters 
argued that the final rule should limit compensation based on profits 
derived from hedging transactions, even if those hedging transactions 
were in fact risk-mitigating hedges, and urged that employees be 
compensated instead based on success in risk mitigation at the end of 
the life of the hedge.\1306\ In contrast, other commenters argued that 
the compensation requirement should restrict only compensation 
arrangements that incentivize employees to engage in prohibited 
proprietary risk-taking.\1307\
---------------------------------------------------------------------------

    \1305\ See, e.g., AFR et al. (Feb. 2012); Sens. Merkley & Levin 
(Feb. 2012); Public Citizen.
    \1306\ See AFR et al. (Feb. 2012); AFR (June 2013).
    \1307\ See Morgan Stanley.
---------------------------------------------------------------------------

    After considering comments received on the compensation 
requirements of the proposed hedging exemption, the final rule 
substantially retains the proposed requirement that the compensation 
arrangements of persons performing risk-mitigating hedging activities 
be designed not to reward prohibited proprietary trading. The final

[[Page 5638]]

rule is also modified to make clear that rewarding or incentivizing 
profit making from prohibited proprietary trading is not 
permitted.\1308\
---------------------------------------------------------------------------

    \1308\ One commenter stated that the compensation requirement 
should restrict only compensation arrangements that incentivize 
employees to engage in prohibited proprietary risk-taking, rather 
than apply to hedging activities. See Morgan Stanley.
---------------------------------------------------------------------------

    The Agencies recognize that compensation, especially incentive 
compensation, may be both an important motivator for employees as well 
as a useful indicator of the type of activity that an employee or 
trading desk is engaged in. For instance, an incentive compensation 
plan that rewards an employee engaged in activities under the hedging 
exemption based primarily on whether that employee's positions 
appreciate in value instead of whether such positions reduce or 
mitigate risk would appear to be designed to reward prohibited 
proprietary trading rather than risk-reducing hedging activities.\1309\ 
Similarly, a compensation arrangement that is designed to incentivize 
an employee to exceed the potential losses associated with the risks of 
the underlying position rather than reduce risks of underlying 
positions would appear to reward prohibited proprietary trading rather 
than risk-mitigating hedging activities. The banking entity should 
review its compensation arrangements in light of the guidance and rules 
imposed by the appropriate Federal supervisor for the entity regarding 
compensation.\1310\
---------------------------------------------------------------------------

    \1309\ Thus, the Agencies agree with one commenter who stated 
that compensation for hedging should not be based purely on profits 
derived from hedging. However, the final rule does not require 
compensation vesting, as suggested by this commenter, because the 
Agencies believe the final hedging exemption includes sufficient 
requirements to ensure that only risk-mitigating hedging is 
permitted under the exemption without a compensation vesting 
provision. See AFR et al. (Feb. 2012); AFR (June 2013).
    \1310\ See 12 U.S.C. 5641.
---------------------------------------------------------------------------

4. Documentation Requirement
    Section ----.5(c) of the proposed rule would have imposed a 
documentation requirement on certain types of hedging transactions. 
Specifically, for any transaction that a banking entity conducts in 
reliance on the hedging exemption that involved a hedge established at 
a level of organization different than the level of organization 
establishing or responsible for the positions, contracts, or other 
holdings the risks of which the hedging transaction is designed to 
reduce, the banking entity was required, at a minimum, to document: the 
risk-mitigating purpose of the transaction; the risks of the individual 
or aggregated positions, contracts, or other holdings of a banking 
entity that the transaction is designed to reduce; and the level of 
organization that is establishing the hedge.\1311\ Such documentation 
was required to be established at the time the hedging transaction is 
effected. The Agencies expressed concern in the proposal that hedging 
transactions established at a different level of organization than the 
positions being hedged may present or reflect heightened potential for 
prohibited proprietary trading, either at the trading desk level or at 
the level instituting the hedging transaction. In other words, the 
further removed hedging activities are from the specific positions, 
contracts, or other holdings the banking entity intends to hedge, the 
greater the danger that such activity is not limited to hedging 
specific risks of individual or aggregated positions, contracts, or 
other holdings of the banking entity, as required by the rule.
---------------------------------------------------------------------------

    \1311\ For example, as explained under the proposal, a hedge 
would be established at a different level of organization of the 
banking entity if multiple market-making desks were exposed to 
similar risks and, to hedge such risks, a hedge was established at 
the direction of a supervisor or risk manager responsible for more 
than one desk rather than at each of the market-making desks that 
established the initial positions, contracts, or other holdings. See 
Joint Proposal, 76 FR 68,876 n.161.
---------------------------------------------------------------------------

    Some commenters argued that the final rule should require 
comprehensive documentation for all activity conducted pursuant to the 
hedging exemption, regardless of where it occurs in an 
organization.\1312\ One of these commenters stated that such 
documentation can be easily and quickly produced by traders and noted 
that traders already record execution details of every trade.\1313\ 
Several commenters argued that the rule should impose a requirement 
that banks label all hedges at their inception and provide information 
regarding the specific risk being offset, the expected duration of the 
hedge, how it will be monitored, how it will be wound down, and the 
names of the trader, manager, and supervisor approving the hedge.\1314\
---------------------------------------------------------------------------

    \1312\ See AFR (June 2013); Occupy.
    \1313\ See Occupy.
    \1314\ See Sens. Merkley & Levin (Feb. 2012); Occupy; AFR (June 
2013).
---------------------------------------------------------------------------

    Some commenters requested that the documentation requirement be 
applied at a higher level of organization,\1315\ and some commenters 
noted that policies and procedures alone would be sufficient to address 
hedging activity, wherever conducted within the organization.\1316\ Two 
commenters indicated that making the documentation requirement narrower 
is necessary to avoid impacts or delays in daily trading operations 
that could lead to a banking entity being exposed to greater 
risks.\1317\ A number of commenters stated that any enhanced 
documentation requirement would be burdensome and costly, and would 
impede rapid and effective risk mitigation, whether done at a trading 
desk or elsewhere in the banking entity.\1318\
---------------------------------------------------------------------------

    \1315\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; 
Barclays; See also Japanese Bankers Ass'n.
    \1316\ See JPMC; SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1317\ See JPMC; Barclays.
    \1318\ See Barclays; JPMC; SIFMA et al. (Prop. Trading) (Feb. 
2012); See also Japanese Bankers Ass'n.
---------------------------------------------------------------------------

    At least one commenter also argued that a banking entity should be 
permitted to consolidate some or all of its hedging activity into a 
trading desk that is not responsible for the underlying positions 
without triggering a requirement that all hedges undertaken by a 
trading desk be documented solely because the hedges are not undertaken 
by the trading desk that originated the underlying position.\1319\
---------------------------------------------------------------------------

    \1319\ See JPMC.
---------------------------------------------------------------------------

    The final rule substantially retains the proposed requirement for 
enhanced documentation for hedging activity conducted under the hedging 
exemption if the hedging is not conducted by the specific trading desk 
establishing or responsible for the underlying positions, contracts, or 
other holdings, the risks of which the hedging activity is designed to 
reduce. The final rule clarifies that a banking entity must prepare 
enhanced documentation if a trading desk establishes a hedging position 
and is not the trading desk that established the underlying positions, 
contracts, or other holdings. The final rule also requires enhanced 
documentation for hedges established to hedge aggregated positions 
across two or more desks. This change in the final rule clarifies that 
the level of the organization at which the trading desk exists is 
important for determining whether the trading desk established or is 
responsible for the underlying positions, contracts, or other holdings. 
The final rule recognizes that a trading desk may be responsible for 
hedging aggregated positions of that desk and other desks, business 
units, or affiliates. In that case, the trading desk putting on the 
hedge is at least one step removed from some of the positions being 
hedged. Accordingly, the final rule provides that the documentation 
requirements in Sec.  ----.5 apply if a trading desk is hedging 
aggregated positions that include positions from more than one trading 
desk.

[[Page 5639]]

    The final rule adds to the proposal by requiring enhanced 
documentation for hedges established by the specific trading desk 
establishing or directly responsible for the underlying positions, 
contracts, or other holdings, the risks of which the purchases or sales 
are designed to reduce, if the hedge is effected through a financial 
instrument, technique, or strategy that is not specifically identified 
in the trading desk's written policies and procedures as a product, 
instrument, exposure, technique, or strategy that the trading desk may 
use for hedging.\1320\ The Agencies note that this documentation 
requirement does not apply to hedging activity conducted by a trading 
desk in connection with the market making-related activities of that 
desk or by a trading desk that conducts hedging activities related to 
the other permissible trading activities of that desk so long as the 
hedging activity is conducted in accordance with the compliance program 
for that trading desk.
---------------------------------------------------------------------------

    \1320\ One commenter suggested that the rule require 
documentation when a banking entity needs to engage in new types of 
hedging transactions that are not covered by its hedging policies, 
although this commenter's suggested approach would only apply when a 
hedge is conducted two levels above the level at which the risk 
arose. See SIFMA et al. (Prop. Trading) (Feb. 2012). The Agencies 
agree that documentation is needed when a trading desk is acting 
outside of its hedging policies and procedures. However, the final 
rule does not limit this documentation requirement to circumstances 
when the hedge is conducted two organizational levels above the 
trading desk. Such an approach would be less effective than the 
adopted approach at addressing evasion concerns.
---------------------------------------------------------------------------

    The Agencies continue to believe that, for the reasons stated in 
the proposal, it is appropriate to retain documentation of hedging 
transactions conducted by those other than the traders responsible for 
the underlying position in order to permit evaluation of the activity. 
In order to reduce the burden of the documentation requirement while 
still giving effect to the rule's purpose, the final rule requires 
limited documentation for hedging activity that is subject to a 
documentation requirement, consisting of: (1) The specific, 
identifiable risk(s) of the identified positions, contracts, or other 
holdings that the purchase or sale is designed to reduce; (2) the 
specific risk-mitigating strategy that the purchase or sale is designed 
to fulfill; and (3) the trading desk or other business unit that is 
establishing and responsible for the hedge transaction. As in the 
proposal, this documentation must be established contemporaneously with 
the hedging transaction. Documentation would be contemporaneous if it 
is completed reasonably promptly after a trade is executed. The banking 
entity is required to retain records for no less than 5 years (or such 
longer period as may be required under other law) in a form that allows 
the banking entity to promptly produce such records to the Agency on 
request.\1321\ While the Agencies recognize this documentation 
requirement may result in certain costs, the Agencies believe this 
requirement is necessary to prevent evasion of the statute and final 
rule.
---------------------------------------------------------------------------

    \1321\ See final rule Sec.  ----5(c)(3).
---------------------------------------------------------------------------

5. Section ----.6(a)-(b): Permitted Trading in Certain Government and 
Municipal Obligations
    Section ----.6 of the proposed rule permitted a banking entity to 
engage in trading activities that were authorized by section 13(d)(1) 
of the BHC Act,\1322\ including trading in certain government 
obligations, trading on behalf of customers, trading by insurance 
companies, and trading outside of the United States by certain foreign 
banking entities.\1323\ Section ----.6 of the final rule generally 
incorporates these same statutory exemptions. However, the final rule 
has been modified in some ways in response to comments received on the 
proposal.
---------------------------------------------------------------------------

    \1322\ See proposed rule Sec.  ----.6.
    \1323\ See 12 U.S.C. 1851(d)(1)(A), (C), (F), and (H).
---------------------------------------------------------------------------

a. Permitted Trading in U.S. Government Obligations
    Section 13(d)(1)(A) permits trading in various U.S. government, 
U.S. agency and municipal securities.\1324\ Section ----.6(a) of the 
proposed rule, which implemented section 13(d)(1)(A) of the BHC Act, 
permitted the purchase or sale of a financial instrument that is an 
obligation of the United States or any agency thereof or an obligation, 
participation, or other instrument of or issued by the Government 
National Mortgage Association, the Federal National Mortgage 
Association, the Federal Home Loan Mortgage Corporation, a Federal Home 
Loan Bank, the Federal Agricultural Mortgage Corporation or a Farm 
Credit System institution chartered under and subject to the provisions 
of the Farm Credit Act of 1971 (12 U.S.C. 2001 et seq.).\1325\ The 
proposal did not contain an exemption for trading in derivatives 
referencing exempt U.S. government and agency securities, but requested 
comment on whether the final rule should contain an exemption for 
proprietary trading in options or other derivatives referencing an 
exempt government obligation.\1326\
---------------------------------------------------------------------------

    \1324\ 12 U.S.C. 1851(d)(1)(A).
    \1325\ The Agencies proposed that United States ``agencies'' for 
this purpose would include those agencies described in section 
201.108(b) of the Board's Regulation A. See 12 CFR 201.108(b). The 
Agencies also noted that the terms of the exemption would encompass 
the purchase or sale of enumerated government obligations on a 
forward basis (e.g., in a to-be-announced market). In addition, this 
would include pass-through or participation certificates that are 
issued and guaranteed by a government-sponsored entity (e.g., the 
Federal National Mortgage Association and the Federal Home Loan 
Mortgage Corporation) in connection with its securitization 
activities.
    \1326\ See Joint Proposal, 76 FR 68,878.
---------------------------------------------------------------------------

    Commenters were generally supportive of the manner in which the 
proposal implemented the exemption for permitted trading in U.S. 
government and U.S. agency obligations.\1327\ Many commenters argued 
that the exemption for permissible proprietary trading in government 
obligations should be expanded, however, to include trading in 
derivatives on government obligations.\1328\ These commenters asserted 
that failure to provide an exemption would adversely impact liquidity 
in the underlying government obligations themselves and increase 
borrowing costs to governments.\1329\ Several commenters asserted that 
U.S. government and agency obligations and derivatives on those 
instruments are substitutes and pose the same investment risks and 
opportunities.\1330\ According to some commenters, the significant 
connections between these markets and the interchangeable nature of 
these instruments significantly contribute to price discovery, in 
particular, in the cash market for U.S. Treasury obligations.\1331\ 
Commenters also argued that trading in Treasury futures and options 
improves liquidity in Treasury securities markets by providing an 
outlet to relieve any supply and demand imbalances in spot obligations. 
Many commenters argued that the authority to engage in trading in 
derivatives on U.S. government, agency, and municipal obligations is 
inherent in the statutory exceptions granted by section 13(d)(1)(A) to 
trade in the underlying obligation.\1332\ To the extent there is any 
doubt about the scope of those exemptions, commenters urged the 
Agencies to use the exemptive

[[Page 5640]]

authority under section 13(d)(1)(J) if necessary to permit proprietary 
trading in derivatives on government obligations.\1333\ Two commenters 
opposed providing an exemption for proprietary trading in derivatives 
on exempt government obligations.\1334\
---------------------------------------------------------------------------

    \1327\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); 
Sens. Merkley & Levin (Feb. 2012).
    \1328\ See BoA; CalPERS; Credit Suisse (Seidel); CME Group; 
Fixed Income Forum/Credit Roundtable; FIA; JPMC; Morgan Stanley; 
PNC; SIFMA et al. (Prop. Trading) (Feb. 2012); Wells Fargo (Prop. 
Trading).
    \1329\ See BoA; FIA; HSBC; JPMC; Morgan Stanley; Wells Fargo 
(Prop. Trading).
    \1330\ See Barclays; Credit Suisse (Seidel); Fixed Income Forum/
Credit Roundtable; FIA.
    \1331\ See Barclays; CME Group; Fixed Income Forum/Credit 
Roundtable; See also UBS.
    \1332\ See CME Group; See also Morgan Stanley; PNC; SIFMA et al. 
(Prop. Trading) (Feb. 2012); Wells Fargo (Prop. Trading).
    \1333\ See Barclays; CME Group; JPMC.
    \1334\ See Occupy; Alfred Brock.
---------------------------------------------------------------------------

    The final rule has not been modified to permit a banking entity to 
engage in proprietary trading of derivatives on U.S. government and 
agency obligations.
    The Agencies note that the cash market for exempt government 
obligations is already one of the most liquid markets in the world, and 
the final rule will permit banking entities to participate fully in 
these cash markets. In addition, the final rule permits banking 
entities to make a market in U.S. government securities and in 
derivatives on those securities. Moreover, the final rule allows 
banking entities to continue to use U.S. government obligations and 
derivatives on those obligations in risk-mitigating hedging activities 
permitted by the rule. Further, proprietary trading in derivatives on 
such obligations will continue by entities other than banking entities.
    Proprietary trading of derivatives on U.S. government obligations 
is not necessary to promote and protect the safety and soundness of a 
banking entity or the financial stability of the United States. 
Commenters offered no compelling reasons why derivatives on exempt 
government obligations pose little or no risk to the financial system 
as compared to derivatives on other financial products for which 
proprietary trading is generally prohibited and did not indicate how 
proprietary trading in derivatives of U.S. government and agency 
obligations by banking entities would promote the safety and soundness 
of those entities or the financial stability of the United States. For 
these reasons, the Agencies have not determined to provide an exemption 
for proprietary trading in derivatives on exempt government 
obligations.
    The Agencies believe banking entities will continue to provide 
significant support and liquidity to the U.S. government and agency 
security markets through permitted trading in the cash exempt 
government obligations markets, making markets in government obligation 
derivatives and through derivatives trading for hedging purposes. The 
final rule adopts the same approach as the proposed rule for the 
exemption for permitted trading in U.S. government and U.S. agency 
obligations. In response to commenters, the Agencies are clarifying how 
banking entities would be permitted to use Treasury derivatives on 
Treasury securities when relying on the exemptions for market-making 
related activities and risk-mitigating hedging activities. The Agencies 
agree with commenters that some Treasury derivatives are close economic 
substitutes for Treasury securities and provide many of the same 
economic exposures.\1335\ The Agencies also understand that the markets 
for Treasury securities and Treasury futures are fully integrated, and 
that trading in these derivative instruments is essential to ensuring 
the continued smooth functioning of market-making related activities in 
Treasury securities. Treasury derivatives are frequently used by market 
makers to hedge their market-making related positions across many 
different types of fixed-income securities. Under the final rule, 
market makers will generally be able to continue their practice of 
using Treasury futures to hedge their activities as block positioners 
off exchanges. Additionally, when engaging in permitted market-making 
related or risk-mitigating hedging activities in accordance with the 
requirements in Sec. Sec.  ----.4(b) or ----.(5), the final rule 
permits banking entities to acquire a short or long position in 
Treasury futures through manual trading or automated processes. For 
example, a banking entity would be permitted to use Treasury futures to 
hedge the duration risk (i.e., the measure of a bond's price 
sensitivity to interest rates movements) associated with the banking 
entity's market-making in Treasury securities or other fixed-income 
products, provided that the banking entity complies with the market-
making requirements in Sec.  ----.4(b). In their market making, banking 
entities also frequently trade Treasury futures (and acquire a 
corresponding long or short position) in reasonable anticipation of the 
near-term demands of their clients, customers, and counterparties. For 
example, banking entities may acquire a long or short position in 
Treasury futures to hedge anticipated market risk when they reasonably 
expect clients, customers, or counterparties will seek to establish 
long or short positions in on- or off-the-run Treasury securities. 
Similarly, banking entities could acquire a long or short position in 
the ``Treasury basis'' to hedge the anticipated basis risk associated 
with making markets for clients, customers, or counterparties that are 
reasonably expected to engage in basis trading of the price spread 
between Treasury futures and Treasury securities. A banking entity can 
also use Treasury futures (or other derivatives on exempt government 
obligations) to hedge other risks such as the aggregated interest rate 
risk for specifically identified loans as well as other financial 
instruments such as asset-backed securities, corporate bonds, and 
interest rate swaps. Therefore, depending on the relevant facts and 
circumstances, banking entities would be permitted to acquire a very 
large long or short position in Treasury derivatives provided that they 
comply with the requirements in Sec. Sec.  ----.4(b) or ----.(5). The 
Agencies also understand that banking entities that have been 
designated as ``primary dealers'' by the Federal Reserve Bank of New 
York are required to underwrite issuances of Treasury securities. This 
necessitates the banking entities to frequently establish very large 
short positions in Treasury futures to order to hedge the duration risk 
associated with potentially owning a large volume of Treasury 
securities. As described below,\1336\ the Agencies note that, with 
respect to a banking entity that acts as a primary dealer for Treasury 
securities, the U.S. government will be considered a client, customer, 
or counterparty of the banking entity for purposes of the market-making 
exemption.\1337\ We believe this interpretation appropriately captures 
the unique relationship between a primary dealer and the government. 
Moreover, this interpretation clarifies that a banking entity may rely 
on the market-making exemption for its activities as primary dealer to 
the extent those activities are outside the scope of the underwriting 
exemption.\1338\
---------------------------------------------------------------------------

    \1335\ See infra note 1330.
    \1336\ See infra Part IV.A.3.c.2.c.i.
    \1337\ See supra note 905 (explaining the functions of primary 
dealers).
    \1338\ See supra Part IV.A.3.c.2.b.ix. (discussing commenters' 
concerns regarding primary dealer activity, as well as one 
commenter's request for such an interpretation).
---------------------------------------------------------------------------

    The final rule also includes an exemption for obligations of or 
guaranteed by the United States or an agency of the United States. An 
obligation guaranteed by the U.S. or an agency of the U.S. is, in 
effect, an obligation of the U.S. or that agency.
    The final rule also includes an exemption for an obligation of the 
FDIC, or any entity formed by or on behalf of the FDIC for the purpose 
of facilitating the disposal of assets acquired or held by the FDIC in 
its corporate capacity or as conservator or receiver under the Federal 
Deposit Insurance Act (``FDI Act'') or Title II of the Dodd-Frank

[[Page 5641]]

Act.\1339\ These FDIC receivership and conservatorship operations are 
authorized under the FDI Act and Title II of the Dodd-Frank Act and are 
designed to lower the FDIC's resolution costs. The Agencies believe 
that an exemption for these types of obligations would promote and 
protect the safety and soundness of banking entities and the financial 
stability of the United States because they facilitate the FDIC's 
ability to conduct receivership and conservatorship operations in an 
orderly manner, thereby limiting risks to the financial system 
generally that might otherwise occur if the FDIC was restricted in its 
ability to conduct these operations.
---------------------------------------------------------------------------

    \1339\ See final rule Sec.  ----.6(a)(4).
---------------------------------------------------------------------------

b. Permitted Trading in Foreign Government Obligations
    The proposed rule did not contain an exemption for trading in 
obligations of foreign sovereign entities. As part of the proposal, 
however, the Agencies specifically requested comment on whether 
proprietary trading in the obligations of foreign governments would 
promote and protect the safety and soundness of banking entities and 
the financial stability of the United States under section 13(d)(1)(J) 
of the BHC Act.\1340\
---------------------------------------------------------------------------

    \1340\ See Joint Proposal, 76 FR 68,878.
---------------------------------------------------------------------------

    The treatment of proprietary trading in foreign sovereign 
obligations prompted a significant number of comments. Many commenters, 
including foreign governments, foreign and domestic banking entities, 
and various trade groups, argued that the final rule should permit 
trading in foreign sovereign debt, including obligations issued by 
political subdivisions of foreign governments.\1341\ Representatives 
from foreign governments such as Canada, Germany, Luxembourg, Japan, 
Australia, and Mexico specifically requested an exemption for trading 
in obligations of their governments and argued that an exemption was 
necessary and appropriate to maintain and promote financial stability 
in their markets.\1342\ Some commenters also requested an exemption for 
trading in obligations of multinational central banks, such as 
Eurobonds issued or guaranteed by the European Central Bank.\1343\
---------------------------------------------------------------------------

    \1341\ See, e.g., Allen & Overy (Gov't Obligations); Allen & 
Overy (Canadian Banks); BoA; Australian Bankers Ass'n. (Feb. 2012); 
AFMA; Banco de M[eacute]xico; Bank of Canada; Ass'n of German Banks; 
BAROC; Barclays; BEC (citing the National Institute of Banking and 
Finance); British Bankers' Ass'n.; BaFin/Deutsche Bundesbank; 
Chamber (Feb. 2012); Mexican Banking Comm'n.; French Treasury et 
al.; EFAMA; ECOFIN; EBF; French Banking Fed'n.; FSA (Apr. 2012); 
FIA; Goldman (Prop. Trading); HSBC; Hong Kong Inv. Funds 
Association; IIB/EBF; ICFR; ICSA; IRSG; Japanese Bankers Ass'n.; 
Ass'n. of Banks in Malaysia; OSFI; British Columbia; Qu[eacute]bec; 
Sumitomo Trust; TMA Hong Kong; UBS; Union Asset.
    \1342\ See, e.g., Allen & Overy (Gov't Obligations); Bank of 
Canada; British Columbia; Ontario; IIAC; Quebec; IRSG; IIB/EBF; 
Mitsubishi; Gov't of Japan/Bank of Japan; Australian Bankers Ass'n 
(Feb. 2012); AFMA; Banco de M[eacute]xico; Ass'n. of German Banks; 
ALFI; Embassy of Switzerland.
    \1343\ See Ass'n. of German Banks; Goldman (Prop. Trading); IIB/
EBF; ICFR; FIA; Mitsubishi; Sumitomo Trust; Allen & Overy (Gov't 
Obligations).
---------------------------------------------------------------------------

    Many commenters argued that the same rationale for the statutory 
exemption for proprietary trading in U.S. government obligations 
supported exempting proprietary trading in foreign sovereign debt and 
related obligations.\1344\ Commenters contended that lack of an express 
exemption for trading in foreign sovereign obligations could critically 
impact the functioning of money market operations of foreign central 
banks and limit the ability of foreign sovereign governments to conduct 
monetary policy or finance their operations.\1345\ These commenters 
also contended that an exemption for proprietary trading in foreign 
sovereign debt would promote and protect the safety and soundness and 
the financial stability of the United States by avoiding the possible 
negative effects of a contraction of government bond market 
liquidity.\1346\
---------------------------------------------------------------------------

    \1344\ See Allen & Overy (Gov't. Obligations); Banco de 
M[eacute]xico; Barclays; BaFIN/Deutsche Bundesbank; EFAMA; Union 
Asset; TMA Hong Kong; ICI (Feb. 2012) (arguing that such an 
exemption would be consistent with Congressional intent to limit the 
extra-territorial application of U.S. law).
    \1345\ See Banco de M[eacute]xico; Barclays; BoA; Gov't of 
Japan/Bank of Japan; IIAC; OSFI.
    \1346\ See, e.g., Allen & Overy (Gov't. Obligations); AFMA; 
Banco de M[eacute]xico; Ass'n. of German Banks; Barclays; Mexican 
Banking Comm'n.; EFAMA; EBF; French Banking Fed'n.; Goldman (Prop. 
Trading); HSBC; IIB/EBF; HSBC; ICSA; T. Rowe Price; UBS; Union 
Asset; IRSG; EBF; Mitsubishi (citing Japanese Bankers Ass'n. and 
IIB); Wells Fargo (Prop. Trading); ICI Global.
---------------------------------------------------------------------------

    Commenters also contended that in some foreign markets, local 
regulations or market practice require U.S. banking entities operating 
in those jurisdictions to hold, trade or support government issuance of 
local sovereign securities. They also indicated that these instruments 
are traded in the United States or on U.S. markets.\1347\ In addition, 
a number of commenters contended that U.S. and foreign banking entities 
often perform functions for foreign governments similar to those 
provided in the United States by U.S. primary dealers and alleged that 
restricting these trading activities would have a significant negative 
impact on the ability of foreign governments to implement their 
monetary policy and on liquidity for such securities in many foreign 
markets.\1348\ A few commenters further argued that banking entities 
use foreign sovereign debt, particularly debt of their home country and 
of the country in which they are operating, to manage their risk by 
posting sovereign securities as collateral in foreign jurisdictions, to 
manage international rate and foreign exchange risk (particularly in 
local operations), and for liquidity and asset-liability management 
purposes in different countries.\1349\ Similarly, commenters expressed 
concern that the lack of an exemption for trading in foreign government 
obligations could adversely interact with other banking regulations, 
such as liquidity requirements under the Basel III capital rules that 
encourage financial institutions to hold large concentrations of 
sovereign bonds to match foreign currency denominated 
obligations.\1350\ Commenters also expressed particular concern that 
the limitations and obligations of section 13 of the BHC Act would 
likely be problematic and unduly burdensome if banking entities were 
able to trade in foreign sovereign obligations only under the market 
making or other proposed exemptions from the proprietary trading 
prohibition.\1351\ One commenter expressed the view that lack of an 
exemption for proprietary trading in foreign government obligations 
together with the proposed exemption for trading that occurs solely 
outside the U.S. may cause foreign banks to close their U.S. branches 
to avoid being subject to section 13 of the BHC Act and any final rule 
thereunder.\1352\
---------------------------------------------------------------------------

    \1347\ See Allen & Overy (Gov't. Obligations) (contending that 
``even if not primary dealers, banking entities or their branches or 
agencies acting in certain foreign jurisdictions, such as Singapore 
and India, are still required to hold or transact in local sovereign 
debt under local law''); BoA; Barclays; Citigroup; SIFMA et al. 
(Prop. Trading) (Feb. 2012).
    \1348\ See Allen & Overy (Gov't. Obligations); Australian 
Bankers Ass'n. (Feb. 2012); BoA; Banco de M[eacute]xico; Barclays; 
Citigroup; Goldman (Prop. Trading); IIB/EBF; See also JPMC 
(suggesting that, at a minimum, the Agencies should make clear that 
all of a firm's activities that are necessary or reasonably 
incidental to its acting as a primary dealer in a foreign 
government's debt securities are protected by the market-making-
related permitted activity); SIFMA et al. (Prop. Trading) (Feb. 
2012). As discussed in Parts IV.A.2.c.2.c. and IV.A.2.c.2.b.ix of 
this SUPPLEMENTARY INFORMATION, the Agencies believe primary dealing 
activities would generally qualify under the scope of the market-
making or underwriting exemption.
    \1349\ See Citigroup; SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1350\ See Allen & Overy (Gov't. Obligations); BoA.
    \1351\ See Barclays; IIAC; UBS; Ass'n. of Banks in Malaysia; 
IIB/EBF.
    \1352\ See Comm. on Capital Markets Regulation.

---------------------------------------------------------------------------

[[Page 5642]]

    According to some commenters, providing an exemption only for 
proprietary trading in U.S. government obligations, without a similar 
exemption for foreign government obligations, would be discriminatory 
and inconsistent with longstanding principles of national treatment and 
with U.S. treaty obligations, such as obligations under the World Trade 
Organization framework or bilateral trade agreements.\1353\ In 
addition, several commenters argued that not exempting proprietary 
trading of foreign sovereign debt may encourage foreign regulators to 
enact similar regulations to the detriment of U.S. financial 
institutions operating abroad.\1354\ However, another commenter 
disagreed that the failure to exempt trading in foreign government 
obligations would violate trade agreements or that the proposal 
discriminated in any way against foreign banking entities' ability to 
compete with U.S. banking entities in the U.S.\1355\
---------------------------------------------------------------------------

    \1353\ See Allen & Overy (Gov't. Obligations); Banco de 
M[eacute]xico; IIB/EBF; Ass'n. of Banks in Malaysia.
    \1354\ See Sumitomo Trust; SIFMA et al. (Prop. Trading) (Feb. 
2012); Allen & Overy (Govt. Obligations); BoA; ICI Global; RBC; 
ICFR; ICI (Feb. 2012); Bank of Canada; Cadwalader (on behalf of 
Singapore Banks); Ass'n. of Banks in Malaysia; Cadwalader (on behalf 
of Thai Banks); Chamber (Feb. 2012); BAROC. See also IIB/EBF.
    \1355\ See Sens. Merkley &Levin (Feb. 2012).
---------------------------------------------------------------------------

    Based on these concerns, some commenters suggested that the 
Agencies exempt proprietary trading by foreign banking entities in 
obligations of their home or host country.\1356\ Other commenters 
suggested allowing trading in foreign government obligations that meet 
some condition on quality (e.g., OECD-member country obligations, 
government bonds eligible as collateral for Federal Reserve advances, 
sovereign bonds issued by G-20 countries, or other highly liquid or 
rated instruments).\1357\ One commenter indicated that in their view, 
provided appropriate risk-management procedures are followed, investing 
in non-U.S. government securities is as low risk as investing in U.S. 
government securities despite current price volatility in certain types 
of sovereign debt.\1358\ Some commenters also suggested the final rule 
give deference to home country regulation and permit foreign banking 
entities to engage in proprietary trading in any government obligation 
to the extent that such trading is permitted by the entity's primary 
regulator.\1359\
---------------------------------------------------------------------------

    \1356\ See Cadwalader (on behalf of Thai Banks); IIB/EBF; Ass'n. 
of Banks in Malaysia; UBS; See also BAROC.
    \1357\ See BoA; Cadwalader (on behalf of Singapore Banks); IIB/
EBF; Norinchukin; OSFI; Cadwalader (on behalf of Thai Banks); Ass'n. 
of Banks in Malaysia; UBS; See also BAROC; ICFR; Japanese Bankers 
Ass'n.; JPMC; Qu[eacute]bec.
    \1358\ See, e.g., Allen & Overy (Gov't Obligations).
    \1359\ See Allen & Overy (Gov't. Obligations); HSBC.
---------------------------------------------------------------------------

    By contrast, other commenters argued that proprietary trading in 
foreign sovereign obligations represents a risky activity and that 
there is no effective way to draw the line between safe and unsafe 
foreign debt.\1360\ Two of these commenters pointed to several publicly 
reported instances where proprietary trading in foreign sovereign 
obligations resulted in significant losses to certain firms. These 
commenters argued that restricting proprietary trading in foreign 
sovereign debt would not cause reduced liquidity in government bond 
markets since banking entities would still be permitted to make a 
market in and underwrite foreign government obligations.\1361\ A few 
commenters suggested that, if the final rule exempted proprietary 
trading in foreign sovereign debt, foreign governments should commit to 
pay for any damage to the U.S. financial system related to proprietary 
trading in their obligations pursuant to such exemption.\1362\
---------------------------------------------------------------------------

    \1360\ See Better Markets (Feb. 2012); Occupy; Prof. Johnson; 
Sens. Merkley & Levin (Feb. 2012).
    \1361\ See Prof. Johnson; Better Markets (Feb. 2012).
    \1362\ See Better Markets (Feb. 2012); See also Prof. Johnson.
---------------------------------------------------------------------------

    The Agencies carefully considered all the comments related to 
proprietary trading in foreign sovereign debt in light of the language, 
purpose and standards for exempting activity contained in section 13 of 
the BHC Act. Under section 13(d)(1)(J), the Agencies may grant an 
exemption from the prohibitions of the section for any activity that 
the Agencies determine would promote and protect the safety and 
soundness of the banking entity and the financial stability of the 
United States.
    The Agencies note as an initial matter that section 13 permits 
banking entities--both inside the United States and outside the United 
States--to make markets in and to underwrite all types of securities, 
including all types of foreign sovereign debt. The final rule 
implements the statutory market-making and underwriting exemptions, and 
thus, the key role of banking entities in facilitating trading and 
liquidity in foreign government debt through market-making and 
underwriting is maintained. This includes underwriting and marketmaking 
as a primary dealer in foreign sovereign obligations. Banking entities 
may also hold foreign sovereign debt in their long-term investment 
book. In addition, the final rule does not prevent foreign banking 
entities from engaging in proprietary trading outside of the United 
States in any type of sovereign debt.\1363\ Moreover, the Agencies 
continue to believe that positions, including positions in foreign 
government obligations, acquired or taken for the bona fide purpose of 
liquidity management and in accordance with a documented liquidity 
management plan that is consistent with the relevant Agency's 
supervisory requirements, guidance and expectations regarding liquidity 
management are not covered by the prohibitions in section 13.\1364\ The 
final rule continues to incorporate this view.\1365\
---------------------------------------------------------------------------

    \1363\ See final rule Sec.  ----.6(e).
    \1364\ See Joint Proposal, 76 FR 68,862.
    \1365\ See final rule Sec.  ----.3(d)(3).
---------------------------------------------------------------------------

    The issue raised by commenters, therefore, is the extent to which 
proprietary trading in foreign sovereign obligations by U.S. banking 
entities anywhere in the world and by foreign banking entities in the 
United States is consistent with promoting and protecting the safety 
and soundness of the banking entity and the financial stability of the 
United States. Taking into account the information provided by 
commenters, the Agencies' understanding of market operations, and the 
purpose and language of section 13, the Agencies have determined to 
grant a limited exemption to the prohibition on proprietary trading for 
trading in foreign sovereign obligations under certain circumstances.
    This exemption, which is contained in Sec.  ----.6(b) of the final 
rule, permits the U.S. operations of foreign banking entities to engage 
in proprietary trading in the United States in the foreign sovereign 
debt of the foreign sovereign under whose laws the banking entity--or 
the banking entity that controls it--is organized (hereinafter, the 
``home country''), and any multinational central bank of which the 
foreign sovereign is a member so long as the purchase or sale as 
principal is not made by an insured depository institution.\1366\

[[Page 5643]]

Similar to the exemption for proprietary trading in U.S. government 
obligations, the permitted trading activity in the U.S. by the eligible 
U.S. operations of a foreign banking entity would extend to obligations 
of political subdivisions of the foreign banking entity's home 
country.\1367\
---------------------------------------------------------------------------

    \1366\ See final rule Sec.  ----.6(b). Some commenters requested 
an exemption for trading in obligations of multinational central 
banks. See Ass'n. of German Banks; Goldman (Prop. Trading); IIB/EBF; 
ICFR; FIA; Mitsubishi; Sumitomo Trust; Allen & Overy (Gov't. 
Obligations). In the case of a foreign banking entity that is owned 
or controlled by a second foreign banking entity domiciled in a 
country other than the home country of the first foreign banking 
entity, the final rule would permit the eligible U.S. operations of 
the first foreign banking entity to engage in proprietary trading 
only in the sovereign debt of the first foreign banking entity's 
home country, and would permit the U.S. operations of the second 
foreign banking entity to engage in proprietary trading only in the 
sovereign debt of the home country of the second foreign banking 
entity. As noted earlier, other provisions of the final rule make 
clear that the rule does not restrict the proprietary trading 
outside of the United States of either foreign banking organization 
in debt of any foreign sovereign.
    \1367\ See Part IV.A.5.c., infra. Many commenters requested an 
exemption for trading in foreign sovereign debt, including 
obligations issued by political subdivisions of foreign governments. 
See, e.g., Allen & Overy (Gov't. Obligations); BoA; Australian 
Bankers Ass'n. (Feb. 2012); Banco de M[eacute]xico; Bank of Canada; 
Ass'n. of German Banks; BAROC; Barclays.
---------------------------------------------------------------------------

    Permitting the eligible U.S. operations of a foreign banking entity 
to engage in proprietary trading in the United States in the foreign 
sovereign obligations of the foreign entity's home country allows these 
U.S. operations of foreign banking entities to continue to support the 
smooth functioning of markets in foreign sovereign obligations in the 
same manner as U.S. banking entities are permitted to support the 
smooth functioning of markets in U.S. government and agency 
obligations.\1368\ At the same time, the risk of these trading 
activities is largely determined by the foreign sovereign that charters 
the foreign bank. By not permitting proprietary trading in foreign 
sovereign debt in insured depository institutions (other than in 
accordance with the limitations in other exemptions), the exemption 
limits the direct risks of these activities to insured depository 
institutions in keeping with the statute.\1369\ Thus, the Agencies have 
determined that this limited exemption for proprietary trading in 
foreign sovereign obligations promotes and protects the safety and 
soundness of banking entities and also promotes and protects the 
financial stability of the United States.
---------------------------------------------------------------------------

    \1368\ As part of this exemption, for example, the U.S. 
operations of a European bank would be able to trade in obligations 
issued by the European Central Bank. Many commenters represented 
that the same rationale for exempting trading in U.S. government 
obligations supports exempting trading in foreign sovereign debt. 
See, e.g., Allen & Overy (Gov't. Obligations); Banco de 
M[eacute]xico; Barclays; EFAMA; ICI (Feb. 2012).
    \1369\ The Agencies believe this approach appropriately balances 
commenter concerns that proprietary trading in foreign sovereign 
obligations represents a risky activity and the interest in 
preserving the ability of U.S. operations of foreign banking 
entities to continue to support the smooth functioning of markets in 
foreign sovereign obligations in the same manner as U.S. banking 
entities are permitted to support the smooth functioning of markets 
in U.S. government and agency obligations. See Better Markets (Feb. 
2012); Occupy; Prof. Johnson; Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------

    The Agencies have also determined to permit a foreign bank or 
foreign broker-dealer regulated as a securities dealer and controlled 
by a U.S. banking entity to engage in proprietary trading in the 
obligations of the foreign sovereign under whose laws the foreign 
entity is organized (hereinafter, the ``home country''), including 
obligations of an agency or political subdivision of that foreign 
sovereign.\1370\ This limited exemption is necessary to allow U.S. 
banking organizations to continue to own and acquire foreign banking 
organizations and broker-dealers without requiring those foreign 
banking organizations and broker-dealers to discontinue proprietary 
trading in the sovereign debt of the foreign banking entity's home 
country.\1371\ The Agencies have determined that this limited exemption 
will promote the safety and soundness of banking entities and the 
financial stability of the United States by allowing U.S. banking 
entities to continue to be affiliated with and operate foreign banking 
entities and benefit from international diversification and 
participation in global financial markets.\1372\ However, the Agencies 
intend to monitor activity of banking entities under this exemption to 
ensure that U.S. banking entities are not seeking to evade the 
restrictions of section 13 by using an affiliated foreign bank or 
broker-dealer to engage in proprietary trading in foreign sovereign 
debt on behalf of or for the benefit of other parts of the U.S. banking 
entity.
---------------------------------------------------------------------------

    \1370\ See final rule Sec.  ----.6(c). Many commenters requested 
an exemption for trading in foreign sovereign debt, and some 
commenters suggested exempting proprietary trading by foreign 
banking entities in obligations of their home country. See, e.g., 
Allen & Overy (Gov't. Obligations); BoA; FSA (Apr. 2012); Cadwalader 
(on behalf of Thai Banks); IIB/EBF; Ass'n. of Banks in Malaysia; 
UBS.
    \1371\ Commenters argued that in some foreign markets, U.S. 
banks operating in those jurisdictions are required by local 
regulation or market practice to trade in local sovereign 
securities. See, e.g., Allen & Overy (Gov't. Obligations); AFMA; 
Ass'n. of German Banks; Barclays; EBF; Goldman (Prop. Trading); UBS.
    \1372\ Some commenters represented that the limitations and 
obligations of section 13 would be problematic and unduly burdensome 
on banking entities because they would only be able to trade in 
foreign sovereign obligations under existing exemptions, such as the 
market-making exemption. See Barclays; IIAC; UBS; Ass'n. of Banks in 
Malaysia; IIB/EBF.
---------------------------------------------------------------------------

    Apart from this limited exemption, the Agencies have not extended 
this exemption to proprietary trading in foreign sovereign debt by U.S. 
banking entities for several reasons. First, section 13 was primarily 
concerned with the risks posed to the U.S. financial system by 
proprietary trading activities. This risk is most directly transmitted 
by U.S. banking entities, and while commenters alleged that prohibiting 
U.S. banking entities from engaging in proprietary trading in debt of 
foreign sovereigns would harm liquidity in those markets, the evidence 
provided by commenters did not sufficiently indicate that permitting 
U.S. banking entities to engage in proprietary trading (as opposed to 
market-making or underwriting) in debt of foreign sovereigns 
contributed in any significant degree to the liquidity of markets in 
foreign sovereign instruments.\1373\ Thus, expanding the exemption to 
permit U.S. banking entities to engage in proprietary trading in debt 
of foreign sovereigns would likely increase the risks to these entities 
and the U.S. financial system without a significant concomitant and 
offsetting benefit. As explained above, these U.S. entities are 
permitted by the final rule to continue to engage fully in market-
making in and underwriting of debt of foreign sovereigns anywhere in 
the world. The only restriction placed on these entities is on the 
otherwise impermissible proprietary trading in these instruments for 
the purpose of selling in the near term or otherwise with the intent to 
resell in order to profit from short-term price movements.
---------------------------------------------------------------------------

    \1373\ See, e.g., BoA; Citigroup; Goldman (Prop. Trading); IIB/
EBF; Allen & Overy (Gov't. Obligations); Australian Bankers Ass'n. 
(Feb. 2012).; Banco de M[eacute]xico; Barclays. The Agencies 
recognize some commenters' representation that restricting trading 
in foreign sovereign debt would not necessarily cause reduced 
liquidity in government bond markets because banking entities would 
still be able to make a market in and underwrite foreign government 
obligations. See Prof. Johnson; Better Markets (Feb. 2012).
---------------------------------------------------------------------------

    The Agencies recognize that, depending on the extent to which 
banking entities subject to the rule have contributed to the liquidity 
of trading markets for foreign sovereign debt, the lack of an exemption 
for proprietary trading in foreign sovereign debt could result in 
certain negative impacts on the markets for such debt. In general, the 
Agencies believe these concerns should be mitigated somewhat by the 
refined exemptions for market making, underwriting and permitted 
trading activity of foreign banking entities; however, those exemptions 
do not address certain of the collateral, capital, and other 
operational issues identified by commenters.\1374\ Foreign sovereign

[[Page 5644]]

debt of home and host countries generally serves these purposes. Due to 
the relationships among global financial markets, permitting trading 
that supports these essential functions promotes the financial 
stability and the safety and soundness of banking entities.\1375\ In 
contrast, a broad exemption for proprietary trading in all foreign 
sovereign debt without the limitations contained in the underwriting, 
market making and hedging exemptions could lead to more complicated 
risk profiles and significant unhedged risk exposures that section 13 
of the BHC Act is designed to address. Thus, the Agencies believe use 
of section 13(d)(1)(J) exemptive authority to permit proprietary 
trading in foreign government obligations in certain limited 
circumstances is appropriate.
---------------------------------------------------------------------------

    \1374\ Representatives from foreign governments stated that an 
exemption allowing trading in obligations of their governments is 
necessary to maintain financial stability in their markets. See, 
e.g., Allen & Overy (Gov't. Obligations); Bank of Canada; IRSG; IIB/
EBF; Gov't of Japan/Bank of Japan; Australian Bankers Ass'n. (Feb. 
2012); Banco de M[eacute]xico; Ass'n. of German Banks; ALFI. 
Commenters argued that exempting trading in foreign sovereign debt 
would avoid the possible negative impacts of a contraction of 
government bond market liquidity. See, e.g., BoA; Citigroup; Goldman 
(Feb. 2012); IIB/EBF. Additionally, commenters suggested that 
failing to provide an exemption for this activity would impact money 
market operations of foreign central banks and limit the ability of 
foreign sovereign governments to conduct monetary policy or finance 
their operations. See, e.g., Barclays; BoA; Gov't of Japan/Bank of 
Japan; OSFI. A number of commenters also argued that, since U.S. and 
foreign banking entities often perform functions for foreign 
governments similar to those provided in the U.S. by U.S. primary 
dealers, the lack of an exemption would have a significant, negative 
impact on the ability of foreign governments to implement monetary 
policy and on liquidity in many foreign markets. See, e.g., Allen & 
Overy (Gov't. Obligations); Australian Bankers Ass'n. (Feb. 2012); 
BoA; Banco de M[eacute]xico; Barclays; Citigroup (Feb. 2012); 
Goldman (Prop. Trading); IIB/EBF. Some commenters argued that 
banking entities and their customers use foreign sovereign debt to 
manage their risk by posting collateral in foreign jurisdictions and 
to manage international rate and foreign exchange risk. See 
Citigroup (Feb. 2012); SIFMA et al. (Prop. Trading) (Feb. 2012).
    \1375\ The Agencies generally concur with commenters' concerns 
that because the lack of an exemption could result in negative 
consequences--such as harming liquidity in foreign sovereign debt 
markets, making it more difficult and more costly for foreign 
governments to fund themselves, or subjecting banking entities to 
increased concentration risk--systemic risk could increase or there 
could be spillover effects that would harm global markets, including 
U.S. markets. See IIF; EBF; ICI Global; HSBC; Barclays; ICI (Feb. 
2012); IIB/EBF; Union Asset. Additionally, in consideration of one 
commenter's statements, the Agencies believe that failing to provide 
this exemption may cause foreign banks to close their U.S. branches, 
which could harm U.S. markets. See Comm. on Capital Markets 
Regulation.
---------------------------------------------------------------------------

    The Agencies decline to follow commenters' suggested alternative of 
allowing trading in foreign government obligations if the obligations 
meet a particular condition on quality, such as obligations of OECD 
member countries.\1376\ The Agencies do not believe such an approach 
responds to the statutory purpose of limiting risks posed to the U.S. 
financial system by proprietary trading activities as directly as our 
current approach, which is structured to limit the exposure of banking 
entities, including insured depository institutions, to the risks of 
foreign sovereign debt. Additionally, the Agencies decline to permit 
proprietary trading in any obligation permitted under the laws of the 
foreign banking entity's home country,\1377\ because such an approach 
could result in unintended competitive impacts since banking entities 
would not be subject to one uniform standard inside the United States. 
Further, unlike some commenters, the Agencies do not believe it is 
appropriate to require foreign governments to commit to paying for any 
damage to the U.S. financial system resulting from the foreign 
sovereign debt exemption.\1378\
---------------------------------------------------------------------------

    \1376\ See, e.g., BoA; Cadwalader (on behalf of Singapore 
Banks).; IIB/EBF; OSFI; UBS; BAROC; Japanese Bankers Ass'n.; JPMC.
    \1377\ Some commenters suggested permitting non-U.S. banking 
entities to trade in any government obligation to the extent that 
such trading is permitted by the entity's primary regulator. See 
Allen & Overy (Gov't. Obligations); HSBC.
    \1378\ See Better Markets (Feb. 2012); See also Prof. Johnson.
---------------------------------------------------------------------------

    The proposal also did not contain an exemption for trading in 
derivatives on foreign government obligations. Many commenters who 
recommended providing an exemption for proprietary trading in foreign 
government obligations also requested that the exemption be extended to 
derivatives on foreign government obligations.\1379\ Two of these 
commenters urged that trading in derivatives on foreign sovereign 
obligations should be exempt for the same reason that trading in 
derivatives on U.S. government obligations is exempt because such 
trading supports liquidity and price stability in the market for the 
underlying government obligations.\1380\ One commenter recommended that 
the Agencies use the authority in section 13(d)(1)(J) to grant an 
exemption for proprietary trading in derivatives on foreign government 
obligations.\1381\
---------------------------------------------------------------------------

    \1379\ See Barclays; Credit Suisse (Seidel); IIB/EBF; Japanese 
Bankers Ass'n.; Norinchukin; RBC; Sumitomo Trust; UBS.
    \1380\ See Barclays; FIA.
    \1381\ See Barclays.
---------------------------------------------------------------------------

    The final rule has not been modified in Sec.  ----.6(b) to permit a 
banking entity to engage in proprietary trading in derivatives on 
foreign government obligations. As noted above, the Agencies have 
determined not to permit proprietary trading in derivatives on U.S. 
exempt government obligations under section 13(d) and, for the same 
reasons, have determined not to extend the permitted activities to 
include proprietary trading in derivatives on foreign government 
obligations.
c. Permitted Trading in Municipal Securities
    Section ----.6(a) of the proposed rule implemented an exemption to 
the prohibition against proprietary trading under section 13(d)(1)(A) 
of the BHC Act, which permits trading in certain governmental 
obligations. This exemption permits the purchase or sale of obligations 
issued by any State or any political subdivision thereof (the 
``municipal securities trading exemption''). The proposed rule included 
both general obligation bonds and limited obligation bonds, such as 
revenue bonds, within the scope of this municipal securities trading 
exemption. The proposed rule, however, did not extend to obligations of 
``agencies'' of States or political subdivisions thereof.\1382\
---------------------------------------------------------------------------

    \1382\ See Joint Proposal, 76 FR 68,878 n.165.
---------------------------------------------------------------------------

    Many commenters, including industry participants, trade groups, and 
Federal and state governmental representatives, argued that the 
municipal securities trading exemption should be interpreted to permit 
banking entities to engage in proprietary trading in a broader range of 
municipal securities, including the following: Obligations issued 
directly by States and political subdivisions thereof; obligations 
issued by agencies, constituted authorities, and similar governmental 
entities acting as instrumentalities on behalf of States and political 
subdivisions thereof; and obligations issued by such governmental 
entities that are treated as political subdivisions under various more 
expansive definitions of political subdivisions under Federal and state 
laws.\1383\ These commenters argued that States and municipalities 
often issue obligations through agencies and instrumentalities and that 
these obligations generally have the same level of risk as direct 
obligations of States and political subdivisions.\1384\ Commenters 
asserted that permitting trading in a broader group of municipal 
securities would be consistent with the

[[Page 5645]]

terms and purposes of section 13 and would not adversely affect the 
safety and soundness of banking entities involved in these transactions 
or create additional risk to the financial stability of the United 
States.\1385\
---------------------------------------------------------------------------

    \1383\ See, e.g., ABA (Keating); Ashurst; Ass'n. of 
Institutional Investors (Feb. 2012); BoA; BDA (Feb. 2012); Capital 
Group; Chamber (Feb. 2012); Citigroup (Jan. 2012); CHFA; Eaton 
Vance; Fidelity; Fixed Income Forum/Credit Roundtable; HSBC; MEFA; 
Nuveen Asset Mgmt.; Sens. Merkley & Levin (Feb. 2012); Am. Pub. 
Power et al.; MSRB; Fidelity; State of New York; STANY; SIFMA 
(Municipal Securities) (Feb. 2012); State Street (Feb. 2012); North 
Carolina; T. Rowe Price; Sumitomo Trust; UBS; Washington State 
Treasurer; Wells Fargo (Prop. Trading).
    \1384\ See, e.g., CHFA; Sens. Merkley & Levin (Feb. 2012); Am. 
Pub. Power et al.; North Carolina; Washington State Treasurer; See 
also NABL; Ashurst; BDA (Feb. 2012); Chamber (Feb. 2012); Eaton 
Vance; Fidelity; MEFA; MSRB; Am. Pub. Power et al.; Nuveen Asset 
Mgmt.; PNC; SIFMA (Municipal Securities) (Feb. 2012); UBS.
    \1385\ See Ashurst; Citigroup (Jan. 2012); Eaton Vance; Am. Pub. 
Power et al.; SIFMA (Municipal Securities) (Feb. 2012); North 
Carolina; T. Rowe Price; Wells Fargo (Prop. Trading); See also 
Capital Group (arguing that municipal securities are not generally 
used as a profit making strategy and thus, including all municipal 
securities in the exemption by itself should not adversely affect 
the safety and soundness of banking entities); PNC (arguing that the 
safe and sound nature of trading in State and municipal agency 
obligations was ``a fact recognized by Congress in 1999 when it 
authorized well capitalized national banks to underwrite and deal 
in, without limit, general obligation, limited obligation and 
revenue bonds issued by or on behalf of any State, or any public 
agency or authority of any State or political subdivision of a 
State''); Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------

    Commenters expressed concerns that the proposed rule would result 
in a bifurcation of the municipal securities market that would achieve 
no meaningful benefits to the safety and soundness of banking entities, 
create administrative burdens for determining whether or not a 
municipal security qualifies for the exemption, result in inconsistent 
applications across different States, increase costs, and decrease 
liquidity in the diverse municipal securities market.\1386\ Commenters 
also argued that the market for securities issued by agencies and 
instrumentalities of States and political subdivisions thereof would be 
especially disrupted, and would affect about 40 percent of the 
municipal securities market.\1387\
---------------------------------------------------------------------------

    \1386\ See, e.g., MSRB; City of New York; Am. Pub. Power et al.; 
Wells Fargo; State of New York; Washington State Treasurer; ABA 
(Keating); Capital Group; North Carolina; Eaton Vance; Port 
Authority; Connecticut; Citigroup (Jan. 2012); Ashurst; Nuveen Asset 
Mgmt.; SIFMA (Municipal Securities) (Feb. 2012).
    \1387\ See, e.g., MSRB (stating that, based on data from Thomson 
Reuters, 41.4 percent of the municipal securities issued in FY 2011 
were issued by agencies and authorities).
---------------------------------------------------------------------------

    Commenters recommended that the final rule provide a broad 
exemption to the prohibition on proprietary trading for municipal 
securities, based on the definition of ``municipal securities'' used in 
section 3(a)(29) of the Exchange Act,\1388\ which is understood by 
market participants and by Congress, and has a well-settled meaning and 
an established body of law. \1389\ Other commenters contended that 
adopting the same definition of municipal securities as used in the 
Federal securities laws would reduce regulatory burden, remove 
uncertainty, and lead to consistent treatment of these securities under 
the banking and securities laws.\1390\ According to some commenters, 
the terms ``agency'' and ``political subdivision'' are used differently 
under some State laws, and some State laws identify certain agencies as 
political subdivisions or define political subdivision to include 
agencies.\1391\ Commenters also noted that a number of Federal statutes 
and regulations define the term ``political subdivision'' to include 
municipal agencies and instrumentalities.\1392\ Commenters suggested 
that the Agencies interpret the term ``political subdivision'' in 
section 13 more broadly than in the proposal to include a wider range 
of State and municipal governmental obligations issued by agencies and 
instrumentalities or, alternatively, that the Agencies use the 
exemptive authority in section 13(d)(1)(J) if necessary to permit 
proprietary trading of a broader array of State and municipal 
obligations.\1393\
---------------------------------------------------------------------------

    \1388\ See 15 U.S.C. 78c(a)(29).
    \1389\ See ABA (Keating); Ashurst; BoA; Capital Group; Chamber 
(Feb. 2012); Comm. on Capital Markets Regulation; Citigroup (Jan. 
2012); Eaton Vance; Fidelity; MEFA; MTA-NY; MSRB; Am. Pub. Power et 
al.; NABL; NCSL; State of New York; Nuveen Asset Mgmt.; Port 
Authority; PNC; SIFMA (Municipal Securities) (Feb. 2012); North 
Carolina; T. Rowe Price; UBS; Washington State Treasurer; Wells 
Fargo (Prop. Trading).
    \1390\ See Ashurst; Citigroup (Jan. 2012) (noting that the 
National Bank Act explicitly lists State agencies and authorities as 
examples of political subdivisions); MSRB.
    \1391\ See, e.g., Citigroup (Jan. 2012).
    \1392\ See, e.g., MSRB; Citigroup (Jan. 2012). In addition to 
the Federal securities laws, the National Bank Act explicitly 
includes agencies and authorities as examples of political 
subdivisions. See 12 U.S.C. 24(seventh) (permitting investments in 
securities ``issued by or on behalf of any State or political 
subdivision of a State, including any municipal corporate 
instrumentality of 1 or more States, or any public agency or 
authority of any State or political subdivision of a State . . . 
.''). In addition, a number of banking regulations also include 
agencies as examples of political subdivisions or define political 
subdivision to include municipal agencies, authorities, districts, 
municipal corporations and similar entities. See, e.g., 12 CFR 1.2; 
12 CFR 160.30; 12 CFR 161.38; 12 CFR 330.15. Further, for purposes 
of the tax-exempt bond provisions in the Internal Revenue Code, 
Treasury regulations treat obligations issued by or ``on behalf of'' 
States or political subdivisions by ``constituted authorities'' as 
obligations of such States or political subdivisions, and the 
Treasury regulations define the term ``political subdivision'' to 
mean ``any division of any State or local governmental unit which is 
a municipal corporation or which has been delegated the right to 
exercise part of the sovereign power of the unit. . . .'' See 26 CFR 
1.103-1(b).
    \1393\ See ABA (Keating); Ashurst; Ass'n. of Institutional 
Investors (Feb. 2012); Citigroup (Jan. 2012); Comm. on Capital 
Markets Regulation; Sens. Merkley & Levin (Feb. 2012); MSRB; Wells 
Fargo (Prop. Trading); SIFMA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------

    On the other hand, one commenter contended that bonds issued by 
agencies and instrumentalities of States or municipalities pose risks 
to the banking system because the commenter believed the market for 
these bonds has not been properly regulated or controlled.\1394\ A few 
commenters also recommended tightening the proposed municipal 
securities trading exemption to exclude conduit obligations that 
benefit private businesses and private organizations.\1395\ One 
commenter suggested that the proposed municipal securities trading 
exemption should not apply to tax-exempt municipal bonds that benefit 
private businesses (referred to as ``private activity bonds'' in the 
Internal Revenue Code\1396\) and that allow private businesses to 
finance private projects at lower interest rates as a result of the 
exemption from Federal income taxation for the interest received by 
investors.\1397\
---------------------------------------------------------------------------

    \1394\ See Occupy.
    \1395\ See AFR et al. (Feb. 2012); Occupy.
    \1396\ See 26 U.S.C. 141. In general, the rules applicable to 
the issuance of tax-exempt private activity bonds under the Internal 
Revenue Code of 1986, as amended (the ``Code'') are more restrictive 
than those applicable to traditional governmental bonds issued by 
States or political subdivisions thereof. Section 146 of the Code 
imposes an annual State bond volume cap on most tax-exempt private 
activity bonds that is tied to measures of State populations. 
Sections 141-150 of the Code impose other additional restrictions on 
tax-exempt private activity bonds, including, among others, eligible 
project and use restrictions, bond maturity restrictions, land and 
existing property financing restrictions, an advance refunding 
prohibition, and a public approval requirement.
    \1397\ See AFR et al. (Feb. 2012).
---------------------------------------------------------------------------

    The final rule includes the statutory exemption for proprietary 
trading of obligations of any State or political subdivision 
thereof.\1398\ In response to the public comments and for the reasons 
discussed below, this exemption uses the definition of the term 
``municipal security'' modeled after the definition of ``municipal 
securities'' under section 3(a)(29) of the Exchange Act,\1399\ but

[[Page 5646]]

with simplifications.\1400\ The final rule defines the term ``municipal 
security'' to mean ``a security which is a direct obligation of or 
issued by, or an obligation guaranteed as to principal or interest by, 
a State or any political subdivision thereof, or any agency or 
instrumentality of a State or any political subdivision thereof, or any 
municipal corporate instrumentality of one or more States or political 
subdivisions thereof.''
---------------------------------------------------------------------------

    \1398\ See final rule Sec.  ----.6(a)(3).
    \1399\ Many commenters requested that the final rule use the 
definition of ``municipal securities'' used in the federal 
securities laws because, among other reasons, the industry is 
familiar with that definition and such an approach would promote 
consistent treatment of these securities under banking and 
securities laws. See, e.g., ABA (Keating); Ashurst; BoA; Comm. on 
Capital Markets Regulation; Citigroup (Jan. 2012); NCSL; Port 
Authority; SIFMA (Municipal Securities) (Feb. 2012); MSRB. Section 
3(a)(29) of the Exchange Act defines the term ``municipal 
securities'' to mean ``securities which are direct obligations of, 
or obligations guaranteed as to principal or interest by, a State or 
any political subdivision thereof, or any agency or instrumentality 
of a State or any political subdivision thereof, or any municipal 
corporate instrumentality of one or more States, or any security 
which is an industrial development bond (as defined in section 
103(c)(2) of Title 26) the interest on which is excludable from 
gross income under section 103(a)(1) of Title 26 if, by reason of 
the application of paragraph (4) or (6) of section 103(c) of Title 
26 (determined as if paragraphs (4)(A), (5), and (7) were not 
included in such section 103(c)), paragraph (1) of such section 
103(c) does not apply to such security.'' See 15 U.S.C. 78c(a)(29).
    \1400\ The definition of municipal securities in section 
3(a)(29) of the Exchange Act has outdated tax references to the 
prior law under the former Internal Revenue Code of 1954, including 
particularly references to certain provisions involving the concept 
of ``industrial development bonds.'' The successor current Internal 
Revenue Code of 1986, as amended, replaces the prior definition of 
``industrial development bonds'' with a revised, more restrictive 
successor definition of ``private activity bonds'' and related 
definitions of ``exempt facility bonds'' and ``small issue bonds.'' 
In recognition of the numerous tax law changes since the last 
statutory revision of section 3(a)(29) of the Exchange Act in 1970 
and the potential attendant confusion, the Agencies determined to 
use a simpler, streamlined, independent definition of municipal 
securities for purposes of the municipal securities trading 
exception. This revised definition is intended to encompass, among 
others, any securities that are covered by the definition of the 
term ``municipal securities'' under section 3(a)(29) of the Exchange 
Act.
---------------------------------------------------------------------------

    The final rule modifies the proposal to permit proprietary trading 
in obligations issued by agencies and instrumentalities acting on 
behalf of States and municipalities (e.g., port authority bonds and 
bonds issued by municipal agencies or corporations).\1401\ As noted by 
commenters, many States and municipalities rely on securities issued by 
agencies and instrumentalities to fund essential activities, including 
utility systems, infrastructure projects, affordable housing, 
hospitals, universities, and other nonprofit institutions.\1402\ Both 
obligations issued directly by States and political subdivisions 
thereof and obligations issued by an agency or instrumentality of such 
a State or local governmental entity are ultimately obligations of the 
State or local governmental entity on whose behalf they act. Moreover, 
exempting obligations issued by State and municipal agencies and 
instrumentalities in the same manner as the direct obligations of 
States and municipalities lessens potential inconsistent treatment of 
government obligations across States and municipalities that use 
different funding methods for government projects.\1403\
---------------------------------------------------------------------------

    \1401\ Many commenters requested that the municipal securities 
trading exemption be interpreted to include a broader range of State 
and municipal obligations issued by agencies and instrumentalities. 
See, e.g., ABA (Keating); Ashurst; BoA; BDA (Feb. 2012); Fixed 
Income Forum/Credit Roundtable; Sens. Merkley & Levin (Feb. 2012); 
SIFMA (Municipal Securities) (Feb. 2012); Citigroup (Jan. 2012); 
Comm. on Capital Markets Regulation.
    \1402\ See, e.g., Citigroup (Jan. 2012); Ashurst; SIFMA et al. 
(Prop. Trading) (Feb. 2012); SIFMA (Municipal Securities) (Feb. 
2012); Chamber (Dec. 2011); BlackRock; Fixed Income Forum/Credit 
Roundtable.
    \1403\ Commenters represented that the proposed rule would 
result in inconsistent applications of the exemption across States 
and political subdivisions. The Agencies also recognize, as noted by 
commenters, that the proposed rule would likely have resulted in a 
bifurcation of the municipal securities market and associated 
administrative burdens and disruptions. See, e.g., MSRB; Am. Pub. 
Power et al.; Port Authority; Citigroup (Jan. 2012); SIFMA et al. 
(Prop. Trading) (Feb. 2012); SIFMA (Municipal Securities) (Feb. 
2012).
---------------------------------------------------------------------------

    The Agencies believe that interpreting the language of section 
13(d)(1)(A) of the BHC Act to provide an exemption to the prohibition 
on proprietary trading for obligations issued by States and municipal 
agencies and instrumentalities as described above is consistent with 
the terms and purposes of section 13 of the BHC Act.\1404\ The Agencies 
recognize that state and political subdivision agency obligations 
generally present the same level of risk as direct obligations of 
States and political subdivisions.\1405\ Moreover, the Agencies 
recognize that other federal laws and regulations define the term 
``political subdivision'' to include municipal agencies and 
instrumentalities.\1406\ The Agencies decline to exclude from this 
exemption conduit obligations that benefit private entities, as 
suggested by some commenters.\1407\
---------------------------------------------------------------------------

    \1404\ Commenters asserted that permitting trading in a broader 
group of municipal securities would be consistent with the terms and 
purposes of section 13. See, e.g., Ashurst; Citigroup (Jan. 2012); 
Eaton Vance; Am. Pub. Power et al.; SIFMA (Municipal Securities) 
(Feb. 2012).
    \1405\ Commenters argued that obligations issued by agencies and 
instrumentalities generally have the same level of risk as direct 
obligations of States and political subdivisions. See, e.g., CHFA; 
Sens. Merkley & Levin (Feb. 2012); Am. Pub. Power et al.; North 
Carolina. In response to one commenter's concern that the markets 
for bonds issued by agencies and instrumentalities are not properly 
regulated, the Agencies note that all types of municipal securities, 
as defined under the securities laws to include, among others, State 
direct obligation bonds and agency or instrumentality bonds, are 
generally subject to the same regulations under the securities laws. 
Thus, the Agencies do not believe that obligations of agencies and 
instrumentalities are subject to less effective regulation than 
obligations of States and political subdivisions. See Occupy.
    \1406\ Commenters noted that a number of federal statutes and 
regulations define ``political subdivision'' to include municipal 
agencies and instrumentalities. See, e.g., MSRB; Citigroup (Jan. 
2012).
    \1407\ See AFR et al. (Feb. 2012); Occupy. The Agencies do not 
believe it is appropriate to exclude conduit obligations, which are 
tax-exempt municipal bonds, from this exemption because such 
obligations are used to finance important projects related to, for 
example, multi-family housing, healthcare (hospitals and nursing 
homes), colleges and universities, power and energy companies and 
resource recovery facilities. See U.S. Securities & Exchange 
Comm'n., Report on the Municipal Securities Market 7 (2012), 
available at http://www.sec.gov/news/studies/2012/munireport073112.pdf.
---------------------------------------------------------------------------

    The proposal did not exempt proprietary trading of derivatives on 
obligations of States and political subdivisions. The proposal 
solicited comment on whether exempting proprietary trading in options 
or other derivatives referencing an obligation of a State or political 
subdivision thereof was consistent with the terms and purpose of the 
statute.\1408\ The Agencies did not receive persuasive information on 
this topic and, for the same reasons discussed above related to 
derivatives on U.S. government securities, the Agencies have determined 
not to provide an exemption for proprietary trading in municipal 
securities, beyond the underwriting, market-making, hedging and other 
exemptions provided generally in the rule. The Agencies note that 
banking entities may trade derivatives on municipal securities under 
any other available exemption to the prohibition on proprietary 
trading, providing the requirements of the relevant exemption are met.
---------------------------------------------------------------------------

    \1408\ See Joint Proposal, 76 FR 68,878.
---------------------------------------------------------------------------

d. Determination to Not Exempt Proprietary Trading in Multilateral 
Development Bank Obligations
    The proposal did not exempt proprietary trading in obligations of 
multilateral banks or derivatives on multilateral development bank 
obligations but requested comment on this issue.\1409\ A number of 
commenters argued that the final rule should include an exemption for 
obligations of multilateral development banks.\1410\
---------------------------------------------------------------------------

    \1409\ See id.
    \1410\ Commenters argued that including obligations of 
multilateral developments banks in a foreign sovereign debt 
exemption is necessary to avoid endangering international 
cooperation in financial regulation and potential retaliatory 
prohibitions against U.S. government obligations. See Ass'n. of 
German Banks; Sumitomo; SIFMA et al. (Prop. Trading) (Feb. 2012). 
Additionally, some commenters represented that an exemption for 
obligations of international and multilateral development banks is 
appropriate for many of the same reasons provided for exempting U.S. 
government obligations and foreign sovereign debt generally. See 
Ass'n. of German Banks; Barclays; Goldman (Prop. Trading); IIB/EBF; 
ICFR; ICI Global; FIA; Sumitomo Trust; Allen & Overy (Gov't. 
Obligations); SIFMA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------

    The Agencies have not included an exemption to permit banking 
entities to engage in proprietary trading in obligations of 
multilateral development banks at this time. The Agencies do not 
believe that providing an exemption for

[[Page 5647]]

trading obligations of multilateral development banks will help enhance 
the markets for these obligations and therefore promote and protect the 
safety and soundness of banking entities and U.S. financial stability.
6. Section ----.6(c): Permitted Trading on Behalf of Customers
    Section 13(d)(1)(D) of the BHC Act provides an exemption from the 
prohibition on proprietary trading for the purchase, sale, acquisition, 
or disposition of financial instruments on behalf of customers.\1411\ 
The statute does not define when a transaction or activity is conducted 
``on behalf of customers.''
---------------------------------------------------------------------------

    \1411\ 12 U.S.C. 1851(d)(1)(D).
---------------------------------------------------------------------------

a. Proposed Exemption for Trading on Behalf of Customers
    Section ----.6(b) of the proposed rule implemented the exemption 
for trading on behalf of customers by exempting three types of trading 
activity. Section ----.6(b)(i) of the proposed rule provided that a 
purchase or sale of a financial instrument occurred on behalf of 
customers if the transaction (i) was conducted by a banking entity 
acting as investment adviser, commodity trading advisor, trustee, or in 
a similar fiduciary capacity for the account of that customer, and (ii) 
involved solely financial instruments for which the banking entity's 
customer, and not the banking entity or any affiliate of the banking 
entity, was the beneficial owner. This exemption was intended to permit 
trading activity that a banking entity conducts in the context of 
providing investment advisory, trust, or fiduciary services to 
customers provided that the banking entity structures the activity so 
that the customer, and not the banking entity, benefits from any gains 
and suffers any losses on the traded positions.
    Section ----.6(b)(ii) of the proposed rule exempted the purchase or 
sale of a covered financial position if the banking entity was acting 
as riskless principal.\1412\ Under the proposed rule, a banking entity 
qualified as a riskless principal if the banking entity, after having 
received an order to purchase or sell a covered financial position from 
a customer, purchased or sold the covered financial position for its 
own account to offset a contemporaneous sale to or purchase from the 
customer.\1413\
---------------------------------------------------------------------------

    \1412\ See Joint Proposal, 76 FR 68,879.
    \1413\ This language generally mirrors that used in the Board's 
Regulation Y, OCC interpretive letters, and the SEC's Rule 3a5-1 
under the Exchange Act. See 12 CFR 225.28(b)(7)(ii); 17 CFR 240.3a5-
1(b); OCC Interpretive Letter 626 (July 7, 1993).
---------------------------------------------------------------------------

    Section ----.6(b)(iii) of the proposed rule permitted trading by a 
banking entity that was an insurance company for the separate account 
of insurance policyholders. Under the proposed rule, only a banking 
entity that is an insurance company directly engaged in the business of 
insurance and subject to regulation by a State insurance regulator or 
foreign insurance regulator was eligible for this prong of the 
exemption for trading on behalf of customers. Additionally, the 
purchase or sale of the covered financial position was exempt only if 
it was solely for a separate account established by the insurance 
company in connection with one or more insurance policies issued by 
that insurance company under which all profits and losses arising from 
the purchase or sale of the financial instrument were allocated to the 
separate account and inured to the benefit or detriment of the owners 
of the insurance policies supported by the separate account, and not 
the banking entity. These types of transactions are customer-driven and 
do not expose the banking entity to gains or losses on the value of 
separate account assets even though the banking entity is treated as 
the owner of those assets for certain purposes.
b. Comments on the Proposed Rule
    Several commenters contended that the Agencies construed the 
statutory exemption too narrowly by limiting permissible proprietary 
trading on behalf of customers to only three categories of 
transactions.\1414\ Some of these commenters argued the exemption in 
the proposal was not consistent with the statutory language or 
Congressional intent to permit all transactions that are ``on behalf of 
customers.'' \1415\ One of these commenters expressed concern that the 
proposed exemption for trading on behalf of customers may be construed 
to permit only customer-driven transactions involving securities and 
not other financial instruments such as foreign exchange forwards and 
other derivatives.\1416\
---------------------------------------------------------------------------

    \1414\ See, e.g., Am. Express; BoA; ISDA (Apr. 2012); RBC; SIMFA 
et al. (Prop. Trading) (Feb. 2012); Wells Fargo (Prop. Trading).
    \1415\ See, e.g., Am. Express; SIMFA et al. (Prop. Trading) 
(Feb. 2012).
    \1416\ See Am. Express.
---------------------------------------------------------------------------

    Several commenters urged the Agencies to expand the exemption for 
trading on behalf of customers to permit other categories of customer-
driven transactions in which the banking entity may be acting as 
principal but that serve legitimate customer needs including capital 
formation. For example, one commenter urged the Agencies to permit 
customer-driven transactions in which the banking entity has no ready 
counterparty but that are undertaken at the instruction or request of a 
customer or client or in anticipation of such an instruction or 
request, such as facilitating customer liquidity needs or block 
positioning transactions.\1417\ Other commenters urged the Agencies to 
exempt transactions where the banking entity acts as principal to 
accommodate a customer and substantially and promptly hedges the risks 
of the transaction.\1418\ Commenters argued that these kinds of 
transactions are similar in purpose and level of risk to riskless 
principal transactions.\1419\ Commenters also argued that these 
transactions could be viewed as market-making related activities, but 
indicated that the potential uncertainty and costs of making that 
determination would discourage banking entities from taking principal 
risks to accommodate customer needs.\1420\ Commenters also requested 
that the Agencies expressly permit transactions on behalf of customers 
to create structured products, as well as for client funding needs, 
customer clearing, and prime brokerage, if these transactions are 
included within the trading account.\1421\
---------------------------------------------------------------------------

    \1417\ See RBC. The Agencies note that acting as a block 
positioner is expressly contemplated and included as part of the 
exemption for market making-related activities under the final rule.
    \1418\ See BoA; SIMFA et al. (Prop. Trading) (Feb. 2012).
    \1419\ See SIMFA et al. (Prop. Trading) (Feb. 2012).
    \1420\ See SIMFA et al. (Prop. Trading) (Feb. 2012).
    \1421\ See SIMFA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------

    In contrast, some commenters supported the proposed approach for 
implementing the exemption for trading on behalf of customers or urged 
narrowing the exemption.\1422\ One commenter expressed general support 
for the requirement that all profits (or losses) from the transaction 
flow to the customer and not the banking entity providing the service 
for a transaction to be exempt.\1423\ One commenter contended that the 
statute did not permit transactions on behalf of customers to be 
performed by an investment adviser.\1424\ Another commenter argued that 
the final rule should permit a banking entity to engage in a riskless 
principal transaction only where the banking entity has already 
arranged for another customer to be on the other side of the 
transaction.\1425\ Other commenters urged the Agencies to ensure that 
both parties to the transaction agree

[[Page 5648]]

beforehand to the time and price of any relevant trade to ensure that 
the banking entity solely stands in the middle of the transaction and 
in fact passes on all gains (or losses) from the transaction to the 
customers.\1426\ Commenters also urged the Agencies to define other key 
terms used in the exemption. For instance, some commenters requested 
that the final rule define which entities may qualify as a ``customer'' 
for purposes of the exemption.\1427\
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    \1422\ See, e.g., Alfred Brock; ICBA; Occupy.
    \1423\ See ICBA.
    \1424\ See Occupy.
    \1425\ See Public Citizen.
    \1426\ See Occupy; Alfred Brock.
    \1427\ See Occupy; Public Citizen. Conversely, other commenters 
supported the approach taken in the proposed rule without requesting 
such a definition. See Alfred Brock.
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    Some commenters urged the Agencies to provide uniform guidance on 
how the Agencies will interpret the riskless principal exemption.\1428\ 
One commenter urged the Agencies to clarify how the riskless principal 
exemption would be implemented with respect to transactions in 
derivatives, including a hedged derivative transaction executed at the 
request of a customer.\1429\
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    \1428\ See, e.g., Am. Express; SIMFA et al. (Prop. Trading) 
(Feb. 2012).
    \1429\ See Am. Express.
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    Several commenters generally expressed support for the exemption 
for trading for the separate account of insurance policyholders under 
the proposed rule.\1430\ One commenter requested that the final rule 
more clearly articulate who may qualify as a permissible owner of an 
insurance policy to whom the profits and losses arising from the 
purchase or sale of a financial instrument allocated to the separate 
account may inure.\1431\
---------------------------------------------------------------------------

    \1430\ See ACLI; Chris Barnard; NAMIC; Fin. Services Roundtable 
(Feb. 3, 2012).
    \1431\ See Chris Barnard.
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    Several commenters argued that certain types of separate account 
activities, including the allocation of seed money by an insurance 
company to a separate account or the offering of certain non-variable 
separate account contracts by the insurance company, would not appear 
to be permitted under the proposal.\1432\ Commenters also expressed 
concern that these separate account activities might not satisfy the 
proposed requirement that all profits and losses arising from the 
purchase or sale of the financial position inure to the benefit or 
detriment of the owners of the insurance policies supported by the 
separate account, and not the insurance company.\1433\ In addition, 
commenters argued that under the proposed rule, these activities would 
appear to fall outside of the exemption for activities in the general 
account of an insurance company because the proposed rule defined a 
general account as excluding a separate account.\1434\ Commenters urged 
the Agencies to more closely align the exemptions for trading by an 
insurance company for the general account and separate account.\1435\ 
According to these commenters, this change would permit insurance 
companies to continue to engage in the business of insurance by 
offering the full suite of insurance products to their customers.\1436\
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    \1432\ See ACLI; Sutherland (on behalf of Comm. of Annuity 
Insurers); Fin. Services Roundtable (Feb. 3, 2012); NAMIC.
    \1433\ See ACLI; Sutherland (on behalf of Comm. of Annuity 
Insurers); Fin. Services Roundtable (Feb. 3, 2012); NAMIC.
    \1434\ See ACLI; Sutherland (on behalf of Comm. of Annuity 
Insurers); Fin. Services Roundtable (Feb. 3, 2012); NAMIC.
    \1435\ See ACLI; Sutherland (on behalf of Comm. of Annuity 
Insurers); Fin. Services Roundtable (Feb. 3, 2012); NAMIC.
    \1436\ See ACLI; Sutherland (on behalf of Comm. of Annuity 
Insurers); Fin. Services Roundtable (Feb. 3, 2012); NAMIC.
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c. Final Exemption for Trading on Behalf of Customers
    The Agencies have carefully considered the comments and are 
adopting the exemption for trading on behalf of customers with several 
modifications. The Agencies believe that the final rule implements the 
exemption in section 13(d)(1)(D) in a manner consistent with the 
legislative intent to allow banking entities to use their own funds to 
purchase or sell financial instruments when acting on behalf of their 
customers.\1437\ At the same time, the limited activities permitted 
under the final rule limit the potential for abuse.\1438\
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    \1437\ See 156 Cong. Rec. S5896 (daily ed. July 15, 2010) 
(statement of Sen. Merkley) (arguing that ``this permitted activity 
is intended to allow financial firms to use firm funds to purchase 
assets on behalf of their clients, rather than on behalf of 
themselves.'').
    \1438\ Some commenters urged narrowing the exemption. See, e.g., 
Alfred Brock; ICBA; Occupy. The Agencies believe the final rule is 
appropriately narrow to limit potential abuse.
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    The final rule slightly modifies the proposed rule by providing 
that a banking entity is not prohibited from trading on behalf of 
customers when that activity is conducted by the banking entity as 
trustee or in a similar fiduciary capacity for a customer and so long 
as the transaction is conducted for the account of, or on behalf of the 
customer and the banking entity does not have or retain a beneficial 
ownership of the financial instruments. The final rule removes the 
proposal's express exemption for investment advisers. After further 
consideration, the Agencies do not believe an express reference to 
investment advisers is necessary because investment advisers generally 
act in a fiduciary capacity on behalf of clients in a manner that is 
separately covered by other exclusions and exemptions in the final 
rule. Additionally, the final rule deletes the proposal's express 
exemption for commodity trading advisors because the legal relationship 
between a commodity trading advisor and its client depends on the facts 
and circumstances of each relationship. Therefore, the Agencies 
determined that it was appropriate to limit the discussion to fiduciary 
obligations generally and to omit any specific discussion of commodity 
trading advisors. In order to ensure that a banking entity utilizes 
this exemption to engage only in transactions for customers and not to 
conduct its own trading activity, the final rule (consistent with the 
proposed rule) requires that the purchase or sale of financial 
instruments be conducted for the account of the customer and that it 
involve solely financial instruments of which the customer, and not the 
banking entity, is beneficial owner.\1439\ The final rule, like the 
proposed rule, permits transactions in any financial instrument, 
including derivatives such as foreign exchange forwards, so long as 
those transactions are on behalf of customers.\1440\
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    \1439\ See final rule Sec.  ----.6(c)(1)(ii)-(iii). See also 
proposed rule Sec.  ----.6(b)(2)(i)(B)-(C).
    \1440\ Some commenters expressed concern that the proposed 
exemption for trading on behalf of customers may be construed to not 
permit transactions in foreign exchange forwards and other 
derivatives. See Am. Express; SIFMA et al. (Prop. Trading) (Feb. 
2012).
---------------------------------------------------------------------------

    While some commenters requested that the final rule define 
``customer'' for purposes of this exemption,\1441\ the Agencies believe 
the requirements of this exemption address commenters' underlying 
concerns about what constitutes a ``customer.'' Specifically, the 
Agencies believe that requiring a transaction relying on this exemption 
to be conducted in a fiduciary capacity for a customer, to be conducted 
for the account of the customer, and to involve solely financial 
instruments of which the customer is beneficial owner address the 
underlying concerns that a transaction could qualify for this exemption 
if done on behalf of an indirect customer or on behalf of a customer 
not served by the banking entity.
---------------------------------------------------------------------------

    \1441\ See Occupy; Public Citizen.
---------------------------------------------------------------------------

    The final rule also provides that a banking entity may act as 
riskless principal in a transaction in which the banking entity, after 
receiving an order to purchase (or sell) a financial instrument from a 
customer, purchases (or sells) the financial instrument for its

[[Page 5649]]

own account to offset the contemporaneous sale of the financial 
instrument to (purchase from) the customer.\1442\ Any transaction 
conducted pursuant to the exemption for riskless principal activity 
must be customer-driven and may not expose the banking entity to gains 
(or losses) on the value of the traded instruments as principal.\1443\ 
Importantly, the final rule does not permit a banking entity to 
purchase (or sell) a financial instrument without first having a 
customer order to buy (sell) the instrument. While some commenters 
requested that the Agencies modify the final rule to permit activity 
without a customer order,\1444\ the Agencies are concerned that 
broadening the exemption in this manner would enable banking entities 
to evade the requirements of section 13 and engage in prohibited 
proprietary trading under the guise of trading on beha